Decisions – IOU: thieves, debt, and general worthlessness

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When you give someone money in the belief you’re investing in a business, and later come to the conclusion that you’re not going to get your money back, you may have a deductible loss for tax purposes. Tax treatments for claiming your loss include a theft loss, a bad debt, or a worthless security.

The treatment that applies affects how you can claim the deduction. For example, theft losses are an itemized deduction. Bad debt can be deductible against ordinary income if the loss is business related, or treated as a short-term capital loss when the loss is nonbusiness. Worthless securities that are capital assets can be a capital loss; non-capital assets result in an ordinary loss. For all three, you must have no reasonable chance of recovery.

In T.C. Memo. 2016-46 (Riley), the taxpayer paid $1.3 million to a neighbor over the course of five years from 2003 through 2008, in the belief that she was investing in his technology company. Her neighbor told her that he had received a patent for a technology device and was seeking investors for his company.

The taxpayer made some payments to her neighbor personally, rather than his company, because he told her to do so. She took out an equity line of credit against her house to make some payments, and made others with distributions from an IRA she had received in her divorce. She received promissory notes for approximately $800,000 of the payments. For others she got nothing tangible.

In 2008, the taxpayer began to suspect her neighbor had stolen her money. She testified in court that he made home improvements, bought a Mercedes, and began to wear nicer clothes.

When she filed her 2008 federal income tax return, the taxpayer reported as income the amounts she had withdrawn from her IRA to give to her neighbor, resulting in tax due of approximately $430,000. Because she didn’t pay the tax due, the IRS filed a federal tax lien against her in 2010.

In 2010, the taxpayer hired an attorney who sent her neighbor a letter requesting repayment, and she notified the FBI, who declined to pursue the case. A separate law firm agreed to take on her case on a contingency basis, but the taxpayer did not want to pay the $10,000 the firm requested up-front to cover costs.

The taxpayer reported the $1.3 million she had given her neighbor as a theft loss on her 2010 tax return. The loss created a carryback that she used to file an amended return for 2008 to reduce her tax for that year.

The IRS said the taxpayer failed to establish that she was eligible for a theft, bad debt, or worthless security loss.

Theft Loss

The court said that to claim a theft loss deduction, the taxpayer had to prove that a theft occurred under the law of the jurisdiction where the loss occurred (California in this case), the amount of that loss, and the year in which she discovered the loss. To claim a theft loss deduction for a particular year, the taxpayer had to discover the loss in that year and show she had no reasonable prospect of recovery.

The taxpayer says her neighbor committed theft by false pretenses under California law. (The elements of theft by false pretenses under California law are a false representation, made with intent to defraud, that causes the owner of property to part with it in reliance on the false representation.)

The taxpayer did not subpoena her neighbor and presented no evidence of his statements or his state of mind other than her testimony. During the trial, the taxpayer said she and her neighbor remained in contact, and that her neighbor stated he wants to return her money to her.

The IRS says the taxpayer cannot use hearsay statements to prove false representation or intent.

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Bad Debt Loss

The court said that to claim a bad debt loss, the taxpayer had to show the debt became totally worthless in the year of the claim and that she had no reasonable chance of recovery.

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Worthless Security Loss

The court said that to claim a worthless security deduction, the security had to be actually worthless, with no recognizable value, and the taxpayer had to show there was no reasonable chance of recovery.

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Note: Taxing Lessons provides a summarized version of sometimes lengthy court decisions. The full case may include facts and issues not presented here. Please use the link provided in the post to read the entire case.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Sorry, wrong answer :(
Right answer!
For the IRS.

We look at the theft loss first, and the IRS begins with an objection to the taxpayer’s use of hearsay statements.
While the taxpayer testified at trial, her neighbor was conspicuously absent. Thus, many of the statements on which the taxpayers bases her case–promises from her neighbor–are inadmissible hearsay if used to prove the truth of the matters asserted in them.

We admitted these statements not for their truth but for the limited use of showing the taxpayer’s state of mind and why she grew suspicious. But she can’t use them to prove that her neighbor had misused her loans or contributions.

The reason neither party subpoenaed her neighbor and why the taxpayer based most of her case on hearsay is unclear. The consequence is clear: large holes in the factual record. Without any evidence of her neighbor’s statements or his own state of mind, there is no real proof of a theft loss.

The taxpayer must show that a theft occurred as defined by California law. Her testimony about her neighbor’s new car and home improvements doesn’t prove that he lied about his use of the money. There are many possible explanations for how he financed his lifestyle, and the taxpayer has given no reason why her theory is the correct one. Therefore, the evidence in the case doesn’t show that her neighbor made false representations.

The sparse record also prevents the taxpayer from showing that her neighbor had an intent to defraud her. There must be actual proof of intent, and the mere showing of nonperformance or the falsity of a statement is insufficient.

We recognize that proof of fraud can (and often must) come through circumstantial evidence and inference. Due to the limited admissibility of the taxpayer’s testimony, however, the facts here are insufficient even to establish any false representations by her neighbor, much less an inference of intent to defraud based on the facts.

Because the taxpayer can’t prove intent or false representation, she can’t show that she suffered a theft by false pretenses under California law, and therefore she can’t claim a theft loss deduction under section 165(c).

Sorry, wrong answer :(
Right answer!
For the IRS.

The taxpayer’s inability to prove fraudulent intent does not preclude a bad debt or worthless securities deduction. To claim either of these deductions, she just needs to show that she lent or invested money, and that the debt or securities are now worthless.

But at no point in the trial did the taxpayer argue that she lent her neighbor money as part of a trade or business of her own. If the taxpayer is entitled to any sort of bad debt deduction, it must therefore be for nonbusiness bad debt, which would mean she at most gets a capital loss, which she cannot carry back from 2010 to 2008. The same is true of any worthless security loss.

The precise nature of each of the taxpayer’s payments is also unclear. At least $800,000 (the amount for which she received a promissory note) is a loan, and it is possible another $100,000 is as well. The rest of the payments are unclear: were they loans, or gifts, or equity investments?

We don’t think we need to decide because it would not affect the outcome.

To claim a bad debt or worthless securities deduction for 2010, the taxpayer must show that the loans or stock became worthless in that year. For both types of deductions, this requires her to show she had no reasonable chance of recovering her money.

The taxpayer has not shown she lacks a reasonable chance of recovery. To the contrary, she testified that a law firm was willing to take her case on contingency; her decision not to pay $10,000 to retain the firm doesn’t affect this. She credibly testified that she remains in contact with her neighbor, and she claims he wants to repay her. And she has not even suggested that her neighbor has insufficient funds to repay her.

She also has not shown that any potential equity investment in her neighbor’s company is worthless. She has pointed to nothing other than hearsay statement, and even that doesn’t show destruction of the potential value of the company.

We are not holding that the taxpayer will never be able to claim some sort of loss deduction. But on the basis of her testimony at trial, we cannot say that she had no reasonable chance of recovery in 2010. Her neighbor is still around, and she is in contact with him. And she potentially has claims she can bring against him. It is simply too soon for her to claim any type of loss deduction, and she has shown no loss that she can carry back to offset her ordinary income for 2008.

Sorry, wrong answer :(
Right answer!
For the IRS.

See the court’s decision for the bad debt deduction above.

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