On July 20, 2021, the Tax Court issued a Memorandum Opinion in the case of Vennes v. Commissioner (T.C. Memo. 2021-93). The primary issues presented in Vennes v. Commissioner were whether the petitioner was entitled to passthrough theft loss deductions for 2008, and whether the petitioner was liable for the accuracy‑related penalty pursuant to IRC § 6662(a).
The Petitioner’s Checkered Past in Vennes v. Commissioner
In 1990, the petitioner completed a prison sentence for money laundering, narcotics, and firearms offenses. After his release from prison, he worked for a machine shop. Later he started a coin business in which he bought and sold certified numismatic products from and to dealers. To finance his coin business, petitioner sought investments from members of a charitable organization whom he had met while he was in prison.
The Petters Scheme
In 1996 because of the success of initial transactions with a conman named Petters, the petitioner organized Metro Gem as an S corporation for the purpose of making loans to Petters’ company PCI in exchange for PCI notes. At all times the petitioner was the sole shareholder and chief executive officer (CEO) of Metro Gem. He obtained funding for Metro Gem from outside loans, which Metro Gem pooled to lend to PCI. Metro Gem issued interest-bearing promissory notes in exchange for loans, and then lent the cash to PCI in exchange for PCI notes. The petitioner also invested personal funds in Metro Gem to lend to PCI. Metro Gem carried on the Petters Scheme until it became public in 2008. When the Petters Scheme collapsed, Metro Gem held 38 outstanding PCI notes with a total principal (face value) of $130,330,000.
Ultimately, Petters was tried, convicted, and sentenced to imprisonment. He was found guilty of 10 counts of wire fraud, 3 counts of mail fraud, 1 count of conspiracy to commit mail or wire fraud, 1 count of conspiracy to commit concealment of money laundering, and 5 counts of money laundering.
Not to be outdone, in April 2011 petitioner was charged by indictment with securities fraud and money laundering. The petitioner plead guilty to one count of each offense…and was sentenced to 180 months in prison, where he currently resides.
IRC § 6221 provides that the tax treatment of partnership items shall be determined at the partnership level. The TEFRA provisions do not apply when the Secretary “determines and provides by regulations that to treat partnership items as partnership items will interfere with the effective and efficient enforcement” of the internal revenue laws. IRC § 6231(c)(2). This includes “areas that the Secretary determines by regulation to present special enforcement considerations.” IRC § 6231(c)(1)(E). The appointment of a receiver for a partner is one such special enforcement consideration. See Treas. Reg. § 301.6231(c)-7(b) (providing that treatment of items as partnership items with respect to a partner for whom a receiver has been appointed in any receivership proceeding before any court of the United States will interfere with the effective and efficient administration of the internal revenue laws). The IRS contends that pursuant to Treas. Reg. § 301.6231(c)-7(b), the partnership items should be treated as nonpartnership items because a receiver was appointed and the United States could have filed a claim for income tax due in the receivership.
If the IRS had filed a claim for income tax due in the receivership proceeding, such a claim would have been timely if filed at any point from the close of the taxable year at issue until the termination of the receivership in 2011. The petitioner’s 2008 taxable year closed before the termination of the receivership in 2011. Accordingly, the Tax Court concluded that the United States could have filed a claim in the receivership proceeding at any point between the end of the 2008 tax year and the receivership’s liquidation in 2011. The establishment of the receivership meets both requirements of the regulatory exception to TEFRA found in Treas. Reg. § 301.6231(c)-7(b). Therefore, any partnership items allocable to petitioner are treated as nonpartnership items within the Tax Court’s jurisdiction. See id.
Theft Loss Deductions Pursuant to IRC § 165
IRC § 165(a) allows a deduction for losses sustained during the taxable year and not compensated for by insurance or otherwise. 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, 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). Generally, for a taxpayer to substantiate a theft loss, the record must establish 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. 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 IRS did not contest that losses in a Ponzi Scheme are a theft for purposes of IRC § 165(a).
The IRS argued that the petitioners were not entitled to a theft loss deduction under IRC § 165 because they do not meet all the requirements of IRC § 165(e). For a taxpayer to deduct a theft loss, the record must establish the amount of the loss and the year in which the loss was sustained. See Treas. Reg. § 1.165-1(c) and (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 deduction 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).
Substantiation of Theft Loss
To substantiate the amount of a claimed theft loss deduction, a taxpayer must prove, at a minimum, the fair market value of the stolen property before the theft and the adjusted basis of the property. Sheridan v. Commissioner, T.C. Memo. 2015-25, at *9 (citing Griggs v. Commissioner, T.C. Memo. 2008-234); Treas. Reg. § 1.165-8(c) (providing that the amount of a theft loss deduction “shall be determined consistently with the manner prescribed in § 1.165-7 for determining the amount of casualty loss”); Treas. Reg. § 1.165-7(b)(1) (providing that amount deductible as a casualty loss is determined by reference to fair market value or adjusted basis of damaged property).
Treas. Reg. § 1.165-7(b)(1) provides that the amount of a casualty loss shall be the lesser of the fair market value of the property before the casualty loss reduced by the fair market value immediately after the casualty, or the amount of the adjusted basis prescribed in Treas. Reg. § 1.1011-1 for determining the loss from the sale or other disposition of the property involved. For purposes of this comparison, fair market value immediately after the casualty is considered to be zero. Treas. Reg. § 1.165-8(c).
Without knowing the market values of the Metro Gem PCI notes, it is not possible to determine whether the theft loss deduction is appropriate under the requirements of the regulations. See Treas. Reg. § 1.165-7(b)(1). Consequently, the petitioners have failed to establish that Metro Gem qualified for a theft loss deduction under IRC § 165.
Reasonable Prospect of 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 loss deduction need not be postponed if the potential for success of a claim is remote or nebulous. Id. “[W]here the financial condition of the person against whom a claim is filed is such that no actual recovery could realistically be expected, the loss deduction need not be postponed.” Jeppsen v. Commissioner, T.C. Memo. 1995-342 (citing Gottlieb Realty Co. v. Commissioner, 28 B.T.A. 418, 420-421 (1933)), aff’d, 128 F.3d 1410 (10th Cir. 1997).
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. Ramsay Scarlett, 61 T.C. at 811; see also Jeppsen, 128 F.3d at 1418. Objective factors relevant to this inquiry include but are not limited to: (1) the probability of recovery, Parmelee Transp. Co. v. United States, 351 F.2d 619, 628 (Ct. Cl. 1965); (2) the status of the claim, Alioto v. Commissioner, 699 F.3d 948, 954 (6th Cir. 2012), aff’g T.C. Memo. 2011-151; Treas. Reg. § 1.165-1(d)(2)(i); and (3) the availability of civil or criminal restitution, Vincentini v. Commissioner, T.C. Memo. 2008-271, supplemented by T.C. Memo. 2009-255, aff’d, 429 F. App’x 560 (6th Cir. 2011). With respect to the second factor, courts may consider claims not actually filed or pursued by a taxpayer. Whitney v. Commissioner, 13 T.C. 897, 901 (1949); Lapin v. Commissioner, T.C. Memo. 1990-343, aff’d, 956 F.2d 1167 (9th Cir. 1992).
If at the close of the year there exists a claim for reimbursement “with respect to which there is a reasonable prospect of recovery,” no portion of the theft loss will be considered to have been sustained in that year, and the theft loss will not be considered sustained until it becomes reasonably certain that reimbursement will not be received. Treas. Reg. § 1.165-1(d)(3). A taxpayer is also not entitled to deduct a theft loss if the prospect of recovery was simply unknowable by the end of the year for which the loss is claimed. Jeppsen, 128 F.3d at 1418.
While a taxpayer’s attitude and conduct are not to be ignored, his or her subjective understanding is not the decisive factor. See Vincentini v. Commissioner, T.C. Memo. 2009-255. Thus, the Tax Court found that petitioner’s conclusion that Metro Gem had “no chance” of recovery at the end of 2008 was not an objectively reasonable decision because at that point, the aftermath of the Petters Scheme was in its early stages and no final decision could have reasonably been made at the time.
The Rev. Proc. 2009-20 Safe Harbor for Ponzi Schemes
In April 2009 the IRS published administrative guidance regarding Ponzi schemes, Rev. Rul. 2009-9 and Rev. Proc. 2009-20, as to what the IRS considered to be the proper treatment of losses from certain investment arrangements that are later discovered to be fraudulent. The former addresses the tax treatment of losses from Ponzi schemes in the light of IRC § 165 and its accompanying regulations. The latter provides “an optional safe harbor under which qualified investors may treat a loss as a theft loss deduction when certain conditions are met.” Rev. Proc. 2009-20, § 2.04. This revenue procedure applies at the entity level.
The safe harbor is made available to a “qualified investor” who experiences a “qualified loss.” Id., § 5.01. A qualified loss is defined to include a loss “from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss,” the lead figure was charged by indictment or information with the commission of “fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for purposes of § 165.” Id., § 4.02(1). A qualified investor is defined as one generally qualified to deduct theft losses under section 165 who “did not have actual knowledge of the fraudulent nature of the investment arrangement prior to it becoming known to the general public.” Id., § 4.03(2).
Petitioners’ calculations fail to include the total amount invested, the income reported, and the amount of cash and property withdrawn in all years, as Rev. Proc. 2009-20 specifies. Petitioners argue that even if the guidance “did technically require the calculation to include closed transactions,” Metro Gem substantially complied with the requirements. As the Court observed in Giambrone v. Commissioner, T.C. Memo. 2020-145, at *11, “Rev. Proc. 2009-20 is an exercise of administrative discretion on the part of the IRS, offering beneficial treatment for categories of theft losses meeting certain well-defined conditions. Taxpayers cannot gain the benefit of it without adhering to its conditions the IRS imposed.” See also Beech Trucking Co. v. Commissioner, 118 T.C. 428, 444 (2002). Accordingly, the Tax Court concluded that the petitioners fail to qualify for safe harbor treatment under Rev. Proc. 2009-20 because they have not substantiated the existence of a qualified investment for Metro Gem.
The Accuracy-Related Penalty
A taxpayer acts with reasonable cause when he or she exercises ordinary business care and prudence with respect to a disputed tax item. Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 98 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002). Good-faith reliance on the advice of an independent, competent professional as to the tax treatment of an item may meet this requirement. See Treas. Reg. § 1.6664-4(b)(1). A taxpayer acts in good faith when he or she acts upon honest belief and with intent to perform all lawful obligations. See Rutter v. Commissioner, T.C. Memo. 2017-174, *45.
A taxpayer alleging reasonable, good-faith reliance on the advice of an independent, competent professional must prove that (1) the adviser was a competent professional who had sufficient expertise to justify reliance, (2) the taxpayer provided necessary and accurate information to the adviser, and (3) the taxpayer relied in good faith on the adviser’s judgment. Neonatology Assocs., 115 T.C. at 99. A taxpayer’s unconditional reliance on an otherwise qualified professional does not constitute reasonable reliance in good faith for purposes of IRC § 6664(c)(1). See Stough v. Commissioner, 144 T.C. 306, 323 (2015). A taxpayer asserting reasonable reliance must show that the opinion of a qualified adviser considered all facts and circumstances and was not based on unreasonable facts or legal assumptions. Treas. Reg. § 1.6664-4(c)(1).
The evidence does not show that petitioners provided the return preparer with the necessary information to file an accurate income tax return. The receivership arranged for the preparation of Metro Gem’s and petitioners’ income tax returns. The accounting firm prepared these tax returns and had done so since 2003. The petitioner was aware of problems with PCI, and there is no evidence showing that he relayed this information to the accounting firm. Also, there is no evidence substantiating that the amount of the loss was known in 2008. Therefore, the petitioners have not shown reasonable cause, and they are liable for an IRC § 6662(a) accuracy-related penalty.Add to favorites