Claiming a Theft Loss? Be Careful, Tax Court Decision Shows
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Matthew L. Roberts
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Federal income tax laws have allowed theft loss deductions since 1916. Surprisingly, however, there has been a great deal of confusion more recently on whether taxpayers may claim theft loss deductions. Much of this confusion stems from enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), which limited certain theft loss deductions to those attributable solely to a federally declared disaster.
On March 14, 2025, IRS Chief Counsel released a memorandum that clears up much of the confusion. In the memorandum, the agency opined that theft losses incurred as part of a trade or business or through a profit motive remained outside the federally declared disaster limitation. But the memorandum cautioned that other statutory and regulatory restrictions may apply and that the applicability of a theft loss deduction depends on the taxpayer’s specific facts.
Although a pre-TCJA case, the Tax Court’s recent decision in Potts v. Commissioner, T.C. Memo. 2025-108 demonstrates the potential risks in claiming a theft loss deduction. In Potts, the Tax Court disallowed a theft loss deduction and sustained significant accuracy-related penalties against the taxpayers. Cautious taxpayers who seek to claim theft loss deductions can learn many lessons from Potts to avoid the same fate.
Potts v. Commissioner
Mr. and Mrs. Potts made a large investment in a gambling operation in the Turks and Caicos Islands (Turks and Caicos). According to the taxpayers, an individual, Mr. Tatum, represented that their investment would be used to construct a Turks and Caicos airport casino. After discussions with Mr. Tatum, the taxpayers entered into a Share Purchase Agreement with VT Enterprises in which they purchased 25 shares of Carib Gaming for $2.5 million.
After the Share Purchase Agreement, Mr. Tatum and another individual, Mr. Olsen, effectively controlled Carib Gaming through their ownership interests in VT Enterprises—that is, VT Enterprises owned a majority of Carib Gaming. Carib Gaming was not a new business enterprise, having recorded $20,913,449 in gross revenue by 2007 through its other casino operations. However, Mr. and Mrs. Potts understood that their investment would be used to develop the new airport casino operation.
All went well until 2014. Although Carib Gaming made distributions to Mr. and Mrs. Potts, they learned in 2014 that Carib Gaming had failed to remit its gambling taxes to the Turks and Caicos authorities and rent monies owed to the lessee of the airport casino space. Around this same time, the taxpayers also lost contact with Mr. Tatum.
According to trial testimony of the taxpayers’ Turks and Caicos attorney, Mr. Tatum had admitted that he had transferred $2 million of the taxpayers’ investment to his and Mr. Olsen’s personal bank accounts. After discussions, the taxpayers released Mr. Tatum and Mr. Olsen from liability through a settlement and release agreement in exchange for all of the ownership of Carib Gaming. The taxpayers never filed a lawsuit against Mr. Tatum, Mr. Olsen, or VT Enterprises.
The taxpayers used a large tax preparation firm to prepare their 2014 tax return. On the return, the taxpayers claimed a theft loss deduction of $2 million. The IRS examined the tax return and disallowed the theft loss deduction, resulting in a proposed assessment of approximately $430,000 of tax due and an accuracy-related penalty of roughly $90,000.
Prior to discussing the Potts decision, it is helpful to have a general understanding of the theft loss rules, which are located in section 165 of the Internal Revenue Code. Under that provision, a taxpayer may claim a loss as a deduction if the taxpayer is not compensated for the loss by a third party (e.g., insurance). If the taxpayer is an individual, the taxpayer’s theft loss falls within one of three buckets: (i) it is incurred in a trade or business; (ii) it is incurred in a transaction entered into for profit (although not in a trade or business); or (iii) it falls under neither (i) nor (ii) (the “catch-all” provision). If the theft loss falls within the catch-all provision, the theft loss is subject to the federally declared disaster area limitation. Other theft losses are not.
As the taxpayers in Potts learned, there are additional hurdles that taxpayers must meet to claim a theft loss deduction. First, taxpayers must show a theft occurred as that term is defined under the relevant jurisdiction where the loss took place. Second, taxpayers must prove they claimed the theft loss in the proper tax year. For these purposes, the proper tax year is the year the theft is discovered, provided that there is no reasonable prospect of recovery from the fraudster. Third, taxpayers must prove the amount of the theft loss, which is limited to their basis.
Generally, taxpayers have the burden of proof with respect to all of these requirements.
In Potts, the taxpayers and the IRS agreed that, if a theft occurred, it would have to have occurred under Turks and Caicos law. Under that jurisdiction’s laws, a theft occurred if a person dishonestly appropriates property belonging to another with the intent to permanently deprive the other of it. Turks and Caicos also recognized that a theft could occur by deception—i.e., a person using trickery or deception to obtain property belonging to another.
Given these definitions of theft, the Tax Court concluded that the taxpayers had failed to prove a theft occurred. According to the taxpayers, Mr. Tatum or Mr. Olsen stole $2 million of their investment funds by diverting those funds to their personal bank accounts. However, the Share Purchase Agreement indicated that the taxpayers had purchased ownership in Carib Gaming from VT Enterprises. The Tax Court recognized that no documents indicated that VT Enterprises was required to use the taxpayers’ $2 million investment in any manner or towards the construction and development of the airport casino. In addition, the evidence suggested that the taxpayers had purchased an operating business, Carib Gaming, with a significant history of prior revenues that made distributions to the taxpayers after 2008.
The Tax Court also held that theft by deception had not occurred. Upon its reading of Turks and Caicos law, the court reasoned that theft by deception had to occur when a fraudster had the present intent to defraud. Therefore, the taxpayers’ allegations that Mr. Tatum had made a future promise to use their investment funds towards the airport casino did not fall within the Turks and Caicos definition of theft. In sum, the Tax Court disallowed the theft loss because it did not fit within the foreign jurisdiction’s meaning of theft.
The Tax Court also sustained the accuracy-related penalty. The court recognized that taxpayers can often rely on their tax professionals for reporting positions but noted that the taxpayers had not offered evidence to show reliance.
Lessons From Potts
As Potts demonstrates, claiming a theft loss deduction comes with risks including potential accuracy-related penalties. Given these risks, cautious taxpayers who seek a theft loss deduction should ask their tax professionals to provide specific advice on their eligibility.
At a minimum, taxpayers who claim theft loss deductions should be ready to prove that theft actually occurred under the relevant laws of the jurisdiction where the loss took place. In Potts, that jurisdiction was Turks and Caicos. Unfortunately, the relevant jurisdiction may be more difficult to determine in other cases. For example, in internet theft loss cases, does the theft occur where the taxpayer resides or where the fraudster resides? In the latter instances, taxpayers may have difficulty determining whether the fraudster resides due to the deception employed.
Potts also shows the significance of receiving tax advice in written form. Although the taxpayers argued that they reasonably relied on a large tax preparation firm, they were unable to provide any proof to this effect. Specifically, the Tax Court concluded that they had failed to offer any evidence that their tax professional reviewed the issue and gave tax advice on the applicability of a theft loss deduction. If the taxpayers had filed an IRS Form 8275, Disclosure Statement, regarding the theft loss, they may have been able to better show their reliance (as their tax professional likely would have prepared the disclosure statement on their behalf). In other instances, taxpayers should maintain written records they receive from their tax professionals, including emails that discuss the theft loss issue.
For any questions about this blog post or any other legal or tax-related matter, please feel free to contact mroberts@meadowscollier.com.
