Can a taxpayer claim a casualty or theft loss deduction for the decline in the value of WorldCom stock due to the company’s accounting fraud and resulting bankruptcy?
Taxpayer Says: The stock became worthless due to fraudulent accounting practices and the resulting bankruptcy filing by WorldCom, and is deductible as a theft loss.
Internal Revenue Service Says: The decline in the stock’s value does not rise to the level of casualty or theft, and is not deductible.
From Internal Revenue Code Section 165(a): Allows a deduction for any loss sustained during the taxable year and not compensated for by insurance or otherwise.
From Internal Revenue Code Section 165(c): With respect to individuals, deductions for losses are limited to losses: (1) Incurred in a trade or business; (2) incurred in a transaction for profit; or (3) of property not connected with a trade or business or a transaction entered into for profit if the losses arise from fire, storm, shipwreck, or other casualty, or from theft.
From Federal Tax Regulation 1.165-1(b): In order for the loss to be deductible, the loss must be evidenced by a closed and completed transaction, fixed by an identifiable event, and actually sustained during the taxable year.
From Internal Revenue Code Section 165(e): A loss arising from theft is treated as sustained “during the taxable year in which the taxpayer discovers such loss.”
From Federal Tax Regulation 1.165-8(d): The term “theft” includes larceny, embezzlement, and robbery.
From Virginia Code Ann. secs. 18.2-95, -96, -108, -111, -178 (2008): Under Virginia law, the term “larceny” is defined as “‘the wrongful or fraudulent taking of personal goods of some intrinsic value, belonging to another, without his assent, and with the intention to deprive the owner thereof permanently.’” The term also includes embezzlement, false pretenses, and receiving stolen property knowing it to be stolen.
THE CAUSE OF THE DISPUTE
Under US tax code, you can claim an itemized deduction (subject to certain limitations) when you suffer losses because your property has been damaged, stolen or destroyed. Casualty losses are typically sudden and unexpected, such as destruction during tornados or hurricanes. To prove theft, you have to show criminal intent on the part of the thief. In addition, the act must be illegal under the law of the state where it occurred (Virginia in this instance).
In this case, the taxpayer worked for WorldCom, and acquired stock through options, his 401k, an employee purchase plan and the open market. After the accounting fraud surfaced, WorldCom entered bankruptcy proceedings, and the stock value plunged. The taxpayer believes the deception by corporate executives caused his loss, and was a theft.
The IRS takes the position that a decline in market value is not a casualty or theft loss, despite the reason for the decline.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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