Pursuant to IRC Section 165, a taxpayer can deduct uncompensated losses resulting from a theft. For the years 2018-2025 personal theft loss deductions are limited to those attributable to a federal declared disaster. However a theft loss connected with a trade or business or a transaction entered into for profit is still deductible to the extent the theft loss meets the requirements of Section 165.
A theft is the taking and removal of money or property with the intent to deprive the owner of it. The taking must be illegal under the law of the state where it occurred and must have been done with criminal intent. To qualify for a theft loss deduction, a taxpayer must prove: (1) the occurrence of a loss, (2) the amount of the theft loss, and (3) the year in which the taxpayer discovers the theft loss. Theft losses are generally deductible in the year the taxpayer discovers the loss unless there is a reasonable prospect of recovery through a claim for reimbursement. In that case, no deduction is available until the taxable year in which the taxpayer can determine with reasonable certainty whether or not reimbursement will be received.
In 2009, the IRS published Rev. Rul. 2009-9 and Revenue Procedure 2009-20 which address the proper treatment of losses from certain investment arrangements later discovered to be fraudulent. Rev. Rul. 2009-9 addresses the tax treatment of losses from Ponzi schemes pursuant to Section 165 and its regulations. Rev. Proc. 2009-20 provides “an optional safe harbor under which qualified investors…may treat a loss as a theft loss deduction when certain conditions are met”. The safe harbor is available to a “qualified investor” who experiences a “qualified loss”. 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 with the commission of “fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for purposes of Section 165”. A qualified investor is defined as one 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”. The safe harbor permits a deduction of up to 95% of a qualified investor’s qualified investment. The safe harbor must be claimed on the federal income tax return for the discovery year, which is defined as the taxable year of the investor in which the lead investor was charged with a crime of theft.
In Michael Giambrone, et. al. v. Commissioner, T.C. Memo. 2020-145, the Tax Court held that the taxpayers were not entitled to claim theft loss deductions under the safe harbor of Rev. Proc. 2009-20 because they did not elect the safe harbor treatment in the year the theft was discovered. In Giambrone, the taxpayers were victims of a scheme to misappropriate over $1 billion in funds from various financial institutions, including the taxpayers’ community bank and bank holding company. In 2010, the perpetrator, Lee Bentley Farkas, was charged with conspiracy and bank, wire and securities fraud. Mr. Farkas was convicted in 2011 and sentenced to 30 years in prison. The taxpayers claimed a theft loss on their 2012 income tax returns based on Rev. Proc. 2009-20. The IRS disallowed the theft loss on the grounds that the taxpayers had failed to satisfy the requirements of Rev. Proc. 2009-20. The Tax Court granted the IRS’ motion for partial summary judgment because the taxpayers “plainly did not qualify for the safe harbor”. The Court said that Rev. Proc. 2009-20 requires a taxpayer to elect safe harbor treatment on his tax return for the discovery year, which is defined as the year in which an indictment, information or criminal complaint is filed against the lead figure. The year 2010 was the discovery year, since Mr. Farkas was indicted in June 2010. The court did not address whether the taxpayers qualified for the Section 165 theft loss deduction.
Due to the substantial uncertainty that often exists regarding the proper timing of a theft loss deduction under a specific set of facts, taxpayers should consider filing protective claims for refund for each of the tax years open under the statute of limitations in which the theft loss could have been sustained. By filing the protective refund claim, the taxpayer can preserve his/her right to claim the benefit of the theft loss deduction for each of those years, even when the correct discovery year is not determined until after the limitations period for claiming a refund for that year would have otherwise expired.
For questions related to this or any other civil tax or criminal tax related matter, please feel free to contact Joel Crouch at (214) 749-2456 or firstname.lastname@example.org.