On June 2, 2021, the Tax Court issued a Memorandum Opinion in the case of Torres v. Commissioner (T.C. Memo. 2021-66). The issues presented in Torres v. Commissioner were whether the petitioner was entitled to reduce his flowthrough income from his wholly owned S corporation for a theft loss deduction pursuant to IRC § 165.
Background to Torres v. Commissioner
As of 2016, the petitioner was illiterate—whether because of an illness or because he didn’t ascribe much to them book learnings, is unclear. In 2018, the petitioner learned to read. Prior to his literacy, he relied on others to handle the taxes of his S corporation. In 2016, the petitioner filed suit against a former co-owner, alleging that she had embezzled money from the company. The petitioner filed his 2016 return in July 2018. The company filed its 2016 return a couple of weeks later. The returns were audited in April 2019. On its amended Form 1120-S, the company reported $166,000 in in expenses for “outside services” for an alleged theft loss due to the defendant’s embezzlement.
Pass Through Losses
IRC § 1366(a) provides that income, losses, deductions, and credits of an S corporation are passed through pro rata to its shareholders on their individual income tax returns. The character of each item of income is determined as if it were realized directly from the source from which the corporation realized it or incurred in the same manner as it was by the corporation. IRC § 1366(b). A shareholder’s gross income includes his or her pro rata share of the S corporation’s gross income. IRC § 1366(c). Where, as here, a notice of deficiency includes adjustments for S corporation items with other items unrelated to the S corporation, the Tax Court has jurisdiction to determine the correctness of all adjustments. See Winter v. Commissioner, 135 T.C. 238 (2010).
IRC § 165(a) allows a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise. Generally, to substantiate a theft loss deduction, the taxpayer must prove that a theft actually occurred under the law of the relevant State and the amount of the loss. See Nichols v. Commissioner, 43 T.C. 842, 884-885 (1965). The term “theft” is broadly defined to include larceny, embezzlement, and robbery. 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).
In order to claim a theft loss deduction, the taxpayer must prove (1) that a theft occurred under the law of the jurisdiction wherein the alleged loss occurred, Monteleone v. Commissioner, 34 T.C. 688, 692 (1960); (2) the amount of the loss; and (3) the date the taxpayer discovered the loss, see IRC § 165(e); Elliott v. Commissioner, 40 T.C. 304 (1963). 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).
Even if a theft pursuant to California law had occurred, the petitioner would not be entitled to a flowthrough loss deduction for 2016. To claim a theft loss deduction, the taxpayer must also establish the amount of the loss and the year in which the loss was sustained. See Treas. Reg. § 1.165-1(c), (d)(1). A loss arising from theft is generally treated as “sustained during the taxable year in which the taxpayer discovers such loss.” IRC § 165(e). If in the year of discovery, the taxpayer has a “reasonable prospect of recovery” on a claim for reimbursement, the loss will not be sustained until “the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.” Treas. Reg. § 1.165-1(d)(3).
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; the taxpayer’s subjective belief may also be considered, but it is not the sole or controlling criterion. Id.; see also Jeppsen v. Commissioner, 128 F.3d 1410, 1418 (10th Cir. 1997), aff’g T.C. Memo. 1995-342.
Petitioner did not provide evidence that he had discovered the loss in 2016. Neither did he provide evidence that the company had no reasonable prospect of recovery in 2016. Petitioner’s civil suit against the defendant was filed in 2018 and was still pending in 2020. Thus, the Tax Court sustained the IRS’s disallowance of petitioner’s theft loss deduction.Add to favorites