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Baum v. Commissioner (T.C. Memo. 2021-46)

On April 27, 2021, the Tax Court issued a Memorandum Opinion in the case of Baum v. Commissioner (T.C. Memo. 2021-46). The primary issues presented in Baum were whether the petitioners were entitled to deductions for expenses as reported on Schedules C (Profit or Loss from Business) for the years in issue and whether the petitioners were entitled to a theft loss deduction pursuant to IRC § 165 for 2015.

Background: Bamboozled, Hoodwinked, Swindled, and Scammed

Bamboozled Baum

In 2010, the petitioner-husband was looking for new investment opportunities. He met an individual, who offered him the opportunity to invest in a business.  It seemed like a good investment, so the petitioners entered into a stock purchase agreement in June 2012 with the individual’s mother (no idea why, but these are the facts, Jack) for 100,000 shares at $1.50/share and a similar agreement with the individual for the same amounts a week later.  Two years later, the individual entered into bankruptcy.  Certain creditors received judgments, and the deadline to file a claim against the bankruptcy estate was June 2015.

The petitioners did, however, claim a theft loss on their 2015 return, and took an itemized deduction of $300,000 on Schedule A (Itemized Deductions).  They filed their 2015 return (due October 15, 2016) in March 2018.  Similarly, they filed their 2016 return (due October 15, 2017) in May 2018.  The IRS disallowed many of the petitioners’ deductions and ultimately determined a deficiency for both years.

Grace (the Legislative Kind)

Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction. INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). To that end, taxpayers are required to substantiate each claimed deduction by maintaining records sufficient to establish the amount of the deduction and to enable the Commissioner to determine the correct tax liability. IRC § 6001; see Higbee v. Commissioner, 116 T.C. 438, 440 (2001).

The petitioners provided no evidence to support the deductions claimed on their Schedules C for the years in issue. Accordingly, the Tax Court sustained the IRS’s disallowance of petitioners’ Schedule C deductions.

Theft Losses, Generally

IRC § 165(a) allows a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise. In the case of an individual, pursuant to IRC § 165(c), a loss is deductible under IRC § 165(a) only if the loss

  1. is incurred in a trade or business;
  2. is incurred in a transaction entered into for profit; or
  3. arises from other causes including casualty or theft.

Stealing Baum

The term “theft” is broadly defined to include larceny, embezzlement, and robbery. Treas. Reg. § 1.165-8(d); see also Bellis v. Commissioner, 61 T.C. 354, 357 (1973), aff’d, 540 F.2d 448 (9th Cir. 1976). Normally, a loss will be regarded as arising from theft only if there is a criminal element to the appropriation of the taxpayer’s property. See Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956). The taxpayer bears the burden of proving by a preponderance of evidence that a theft actually occurred. Jones v. Commissioner, 24 T.C. 525, 527 (1955). In order to deduct a theft loss, the taxpayer must prove

  1. that a theft occurred, under the law of the jurisdiction wherein the alleged loss occurred;[1]
  2. the amount of the loss;
  3. and (3) the date the taxpayer discovered the loss.[2]

The petitioners’ alleged theft occurred in California, and certain requirements must be met under California law for a theft to have occurred. This California statute consolidates the historic categories of larceny, theft by false pretenses, and embezzlement into the general crime of theft. People v. Gonzales, 392 P.3d 437, 441-442 (Cal. 2017). Proving a theft requires evidence meeting the elements of one of the consolidated offenses. Id. at 442.

The petitioners argue that they suffered losses from “fraud in inducement,” which would fall under the category of theft by false pretenses. In California, theft by false pretenses requires the following elements:

  1. the defendant made a false pretense or representation to the owner of property;
  2. with the intent to defraud the owner of that property; and
  3. the owner transferred the property to the defendant in reliance on the representation.[3]

Intent to defraud is a question of fact to be determined from all the circumstances of the case and usually must be proved circumstantially. People v. Fujita, 117 Cal. Rptr. 757, 765-766 (Cal. Ct. App. 1974). Courts must examine the evidence to determine whether an alleged thief behaved in a manner consonant with an intent to defraud; a record establishing a mere ordinary breach of contract or fiduciary duty will be insufficient to support a finding of a party’s intent to defraud. See People v. Ashley, 267 P.2d 271, 282 (Cal. 1954).

The petitioners failed to provide specific evidence that the individual’s representations were false or that they were made with the intent to defraud. The only evidence of fraud that petitioners offered was petitioner-husband’s testimony at trial. As a consequence, the petitioners did not meet their burden of proving that there was a “theft” that met the elements of theft by false pretenses under California law.

A Reasonable Prospect for Recovery

Whether a reasonable prospect of recovery exists is a question of fact to be determined upon an examination of all facts and circumstances. Treas. Reg. § 1.165-1(d)(2)(i). A reasonable prospect of recovery exists when the taxpayer has “bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor.” Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 811 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975).

The determination as to whether there is a reasonable prospect of recovery is based primarily on objective factors.  However, the taxpayer’s subjective belief may also be considered, but it is not the sole or controlling criterion. Id. at 811-812; see also Jeppsen v. Commissioner, 128 F.3d 1410, 1418 (10th Cir. 1997), aff’g T.C. Memo. 1995-342.

The petitioners did not prove that there was not a “reasonable prospect of recovery” of their investments in 2015. At the end of 2015, the individual’s bankruptcy proceedings were ongoing. Petitioner-husband testified that he had learned about the bankruptcy from other investors. He filed a proof of claim in the bankruptcy case on June 24, 2015. However, the bankruptcy proceedings did not conclude until 2019, when the Trustee’s Final Report was filed. As a consequence, the petitioners could not have known in 2015 whether the individual had sufficient assets to allow them to recover their investments.

Because of this, the Tax Court sustained the disallowance of the 2015 theft loss.

(T.C. Memo. 2021-46) Baum v. Commissioner

 

Footnotes:

[1] Monteleone v. Commissioner, 34 T.C. 688, 692 (1960).

[2] IRC § 165(e); Elliott v. Commissioner, 40 T.C. 304 (1963).

[3] People v. Williams, 305 P.3d 1241, 1248 (Cal. 2013) (quoting People v. Wooten, 52 Cal. Rptr. 2d 765, 770 (Cal. Ct. App. 1996)).

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