Taxpayers are again denied theft loss for ‘pump and dump’ fraud
The taxpayers could not prove on remand there was no reasonable prospect of recovery by the end of the tax year.
By Charles J. Reichert, CPA
The Court of Federal Claims, rehearing a case remanded to it by the Court of Appeals for the Federal Circuit, held that taxpayers who were victims of a fraudulent investment scheme could not deduct a theft loss for 2004. According to the court, the taxpayers did not provide enough evidence to show that they had no reasonable prospect of recovering their losses in 2004, because it was unknowable at that time whether a reasonable prospect of recovery existed.
Facts: Charles and Jane Adkins began purchasing securities in 1987 through an investment company called Donald & Co. It was later determined that Donald was operating a pump-and-dump scheme, a type of investment fraud where a broker owns certain stock in its own name and promotes the purchase of that stock to its clients. The stock appreciates in value and the broker then sells its holdings of the stock for a profit, while the value of its clients' holdings falls. From February 2000 to December 2001, the value of the Adkinses' portfolio with Donald dropped from $3,589,301 to $9,849.
In 2002, the taxpayers submitted an arbitration claim to the National Association of Securities Dealers against Donald and three of its principals. The Adkinses postponed their arbitration hearing because Donald and its principals were under criminal investigation by the U.S. Department of Justice, but the Adkinses left their claim open in the event the investigation uncovered additional relevant information. In 2004, Donald's principals pleaded guilty to fraud charges.
The taxpayers claimed a theft loss of $2,118,725 on their 2004 federal income tax return and carried back portions of the loss to the years 2001—2003. After the IRS disallowed the deductions for 2001, 2003, and 2004, the taxpayers filed a refund claim with the Court of Federal Claims; however, the claim was denied. The court held that the Adkinses had not determined in 2004 with reasonable certainty that they would not be reimbursed for their losses, partially due to their failure to abandon their arbitration claim (Adkins, 125 Fed. Cl. 304 (2016)). The taxpayers appealed the decision to the Federal Circuit.
The Federal Circuit held that the lower court had incorrectly applied Regs. Sec. 1.165-1(d)(3) and that "the proper year in which to claim a loss is the first year in which no reasonable prospect of recovery exists anymore, starting with the year of discovery." It vacated the lower court's decision and remanded the case back to the lower court, which retried it in 2018 (see "Tax Matters: 'Pump and Dump' Theft Loss Allowed Despite Open Arbitration Claim," JofA, Aug. 2017).
Issues: A theft loss may be deducted in the first year in which there is no reasonable prospect of recovery, beginning with the year of discovery, as determined by the facts and circumstances of the case. Factors used to determine whether taxpayers have a reasonable prospect of recovery are (1) the probability of recovery on the claim; (2) whether the claim has been settled, adjudicated, or abandoned; and (3) the availability of civil and criminal restitution. The determination must be based on what a reasonable taxpayer would have concluded concerning the prospect of recovering something in the year of the claimed loss. No deduction is allowed if the prospect of recovery is unknowable at that time.
The taxpayers argued that by the end of 2004 their losses were not recoverable because arbitration would be fruitless, due to the difficulty of obtaining discovery during arbitration, and that no assets would be available to them, due to the government's seizure of all of the alleged fraud perpetrators' assets. The IRS argued that the taxpayers' reasonable prospect of recovering some amount was unknowable at that time because the taxpayers presented no evidence that they had attempted to determine the alleged perpetrators' financial resources or attempted to make a claim against their known assets.
Holding: Although conceding the taxpayers had suffered a loss by the end of 2004, the court again disallowed the taxpayers' 2004 theft deduction because it was unknowable at that time whether they had no reasonable prospect of recovery. The court held that, at the end of 2004, the taxpayers had three possible approaches to recover their losses: (1) an open arbitration claim against Donald & Co. and three of its principals; (2) a possible claim against the fourth Donald & Co. principal and the two brokers of the company that Charles Adkins had dealt with directly; and (3) criminal restitution. Therefore, according to the court, at the end of 2004 it was unknowable that there was no reasonable prospect of recovery from any of those three approaches; thus, no theft deduction should be allowed for 2004.