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Individual Tax

Applying Federal Circuit’s reg interpretation, Claims Court again denies theft loss claim

Thomson Reuters Tax & Accounting  

· 9 minute read

Thomson Reuters Tax & Accounting  

· 9 minute read

Adkins v. U.S., (Ct Fed Cl 10/26/2018) 122 AFTR 2d ¶2018-5372

The Court of Federal Claims, on remand from the Court of Appeals for the Federal Circuit and applying its analytical framework for a theft loss deduction reg, has again determined that taxpayers are not entitled to a theft loss deduction in the year claimed.

Background. For tax years beginning before Jan. 1, 2018 and for tax years beginning after Dec. 31, 2025, a theft loss deduction is allowed in the year in which the loss is sustained. (Code Sec. 165(a))

Checkmark Observation: From 2018 through 2025, personal theft losses of an individual are deductible only to the extent they’re attributable to a federally declared disaster.

Taxpayers are generally considered to have sustained a theft loss in the year in which they discover it. (Code Sec. 165(e)) However, regs explain that a theft loss is not sustained if, in the year of discovery, there exists a claim for reimbursement with respect to which there is a “reasonable prospect” of recovery. No portion of the loss with respect to which reimbursement may be received is sustained until the tax year in which it can be “ascertained with reasonable certainty” whether or not such reimbursement will be received. (Reg. § 1.165-1(d)(3))

Whether a reasonable prospect of recovery exists with respect to a claim for reimbursement is a question of fact to be determined upon an examination of all facts and circumstances. Whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. When a taxpayer claims that the tax year in which a loss is sustained is fixed by his abandonment of the claim for reimbursement, he must be able to produce objective evidence of his having abandoned the claim, such as the execution of a release. (Reg. § 1.165-1(d)(2)(i))

Facts.   In February 2002, the Adkinses, after seeing the value of their investments drop significantly, discovered that they had been the victims of fraud by Donald & Co., their stockbrokers, and submitted a statement of claim to the National Association of Securities Dealers (NASD) in support of arbitration against Donald & Co.

In 2003, the Adkinses learned of the existence of a criminal investigation of Donald & Co. and associated individuals, the Adkinses’ attorneys were advised by the U.S. Attorney that an indictment would soon be issued, and the Adkinses’ attorneys were further advised that the U.S. Attorney would request that all civil litigation, including arbitration proceedings, be stayed pending the resolution of the criminal proceedings.

In 2003, the Adkinses’ arbitration attorneys requested that the arbitration hearing be postponed. They also suggested to the Adkinses that they allow the arbitration claim to remain open in the event that the criminal proceedings revealed useful information. The arbitration proceedings remained open, but inactive. The Adkinses did not make any further payments to their arbitration attorneys in 2003 or beyond.

In May 2004, the Donald & Co. principals were indicted and charged with securities fraud. The indictment contained criminal forfeiture allegations. Mr. Adkins saw the indictment, and became aware of the charges against the Donald & Co. principals in 2004. He was advised by his arbitration attorneys that the arbitration proceedings were “trumped” by the indictment. The arbitration proceedings nonetheless remained open, but inactive. Mr. Adkins believed that, as part of the criminal proceedings, the government would seize all of the criminal defendants’ assets, as well as any documentation regarding their assets, foreclosing the Adkinses’ ability to collect an arbitration award.

Later in 2004, several of the principals pleaded guilty to a number of the charges, were barred from acting as brokers or securities dealers, and were ordered to pay restitution. Criminal proceedings against other of the principals were ongoing throughout 2005 and later years.

Meanwhile, on amended returns filed in 2006, the taxpayers took a theft loss deduction on their 2004 tax return. Two years later, in 2008, they withdrew their arbitration claim against Donald & Co.

IRS challenged the theft loss deduction, and the taxpayers brought an action in the Court of Claims.

Claims Court’s decision. At their Claims Court trial, the Adkinses argued that, in 2004, they ascertained with reasonable certainty that they would not recover anything on their arbitration claim. The court said that the facts reflected that the Adkinses did not arrive at this conclusion because they settled or litigated the claim, but instead came to believe that the claim was no longer viable because they would not be able to collect on it, and therefore stopped actively pursuing it. In other words, the Claims Court said, the Adkinses contended that they abandoned their arbitration claim.

The Court of Claims held that the Adkinses did not meet their burden of establishing that they abandoned their claim in, and therefore sustained their theft loss in, 2004. In so holding, the Claims Court wrote that the “reasonable prospect of recovery” and “ascertain with reasonable certainty” inquiries are distinct, and that the higher “reasonable certainty” inquiry, which applies for theft loss claims in years after the year that the loss is discovered, was not met in this case. Notably, the taxpayers didn’t formally withdraw their claim until 2008, and they failed to produce any other objective evidence showing that they abandoned their claim in 2004. (For more details, see “Year fraud perpetrators were indicted wasn’t year theft loss was deductible” (3/10/2016).)

Circuit Court vacated & remanded. The Court of Appeals for the Federal Circuit, agreeing with the taxpayers, found that Claims Court misinterpreted Reg. § 1.165-1(d)(3).

On appeal, the taxpayers argued that Reg. § 1.165-1(d)(3) sets forth a single test —namely, that “reasonable prospect for recovery” is the inverse of “reasonable certainty” that there will be no recovery—and that they should not be held to a stricter standard to claim their loss in 2004 than the standard to which they were held in 2002. The Appellate Court agreed, noting that while few of the other circuits have addressed this issue explicitly, those few that have appear to have reached the same conclusion. (See, e.g., Vincentini, (CA 6 2011) 108 AFTR 2d 2011-5247)  The Court also said that this interpretation aligns with common sense incentives for victims of theft as good-faith efforts to recover losses — such as lawsuits and arbitration — will tend to push the claim year later than the year of discovery by creating a probability of recovery, and to the extent that it is rendered more difficult to succeed on a loss claim in years subsequent to discovery, taxpayers will be dissuaded from those good-faith efforts.

The Appellate Court also agreed with the Adkinses that the Claims Court additionally erred by treating abandonment of their arbitration claim as a prerequisite to a reasonable certainty of no recovery. The Adkinses conceded that their arbitration claim was still pending in 2004, but argued that the costs of keeping the case open were negligible and the fact that they didn’t formally withdraw their claim until later didn’t necessarily mean that they believed that they had reasonable prospects of recovery in 2004.

The Appellate Court vacated and remanded the Claims Court’s decision, with a direction to the Claims Court to engage in an analysis that goes beyond the consideration of abandonment. (For more details, see “Federal Circuit disagrees with lower court’s interpretation of theft loss timing reg” (5/18/2017).)

Remand decision. On remand, the Court of Federal Claims, applying the Federal Circuit’s construction of Reg. § 1.165-1(d)(3), again concluded that the taxpayers aren’t entitled to a theft loss deduction for 2004.

The Claims Court, using the “holistic analysis” described by the Federal Circuit, concluded that the taxpayers failed to establish their entitlement to a theft loss deduction in the year claimed. The Claims Court noted that various courts have identified three objective factors relevant to determining whether taxpayers have a reasonable prospect of recovery—the probability of recovery on the claim, the status of the claim (e.g., whether it has been settled or abandoned), and the availability of civil and criminal restitution—and found that all three factors weighed against the Adkinses’ 2004 theft loss deduction.

While the taxpayers argued that they had no reasonable prospect of recovering their losses in 2004, the Claims Court, siding with IRS, found that it was “simply unknowable” whether there was a reasonable prospect of recovery at that time. The Court noted that in 2004, the taxpayers still had several avenues by which they could attempt to recover their losses, such as pursuing arbitration against individual principals at Donald & Co or filing a claim for restitution.

The Claims Court also rejected the taxpayers’ argument that 2004 was the proper year for their theft loss deduction under Rev Proc 2009-20, which created a safe harbor for losses from Ponzi schemes. The Court declined to extend the safe harbor to losses like those in this case—from a so-called “pump-and-dump” scheme (i.e., where an investment’s value is inflated through false or misleading to artificially increase its later sale price)—finding that IRS clearly differentiated the two types of schemes by creating a safe harbor for one but not the other.

The Court also rejected the taxpayers’ assertion that IRS failed to show that a year other than 2004 was the proper deduction year, finding that this argument misapprehended the burden of proof (which clearly lay with the taxpayers).

References: For deduction for theft losses, see FTC 2d/FIN ¶ M-2100United States Tax Reporter ¶ 1654.351.

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