Federal tax law allows taxpayers to deduct so-called “theft losses”, provided certain conditions are met. First of all, a taxpayer must prove that he will not replace the damage with insurance or another third party. When this threshold is reached, the taxpayer must overcome additional hurdles, including demonstrating: (1) the occurrence of theft; (2) the amount of theft; and (3) the date the taxpayer discovered the theft. As will be discussed in more detail below, these requirements are not always that easy to meet.
The occurrence of a theft.
It is reasonable for a taxpayer to first demonstrate the existence or occurrence of theft in order to obtain a Loss of Theft Deduction under Section 165 of the Code. For these purposes, theft is defined as "including, but not necessarily limited to, theft, embezzlement and robbery". Trees. Registration number. § 1.165-8 (d); see also Littlejohn v. Comm’r, T.C. Memo. 2020-42 (“The term“ theft ”in section 165 is a general and broad word intended to cover any criminal appropriation of someone else's property, including theft by theft, embezzlement, fundraising through false pretenses, and all other forms of ruse "). Additionally, according to the IRS and a majority of federal courts:
(D) to qualify as a "theft" loss for the purposes of Section 165 () of the Act, the taxpayer only needs to demonstrate that his loss resulted from illegal possession under the law of the state in which it arose, and that the ingestion was done with criminal intent.
Rev. Rule. 72-112, 1972-1 C. B. 60; see also Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956); see also Citron v. Comm’r, 97 T.C. 200, 207 (1991) ("To determine whether theft or embezzlement has occurred, the law of the place of jurisdiction in which the damage occurred."). This rule applies even if it was assumed that the theft took place in a foreign jurisdiction. See first chi. Corp. & affiliated corps. v. Comm & # 39; r, T.C. Memo. 1995-109 (the application of Brazilian criminal law and the assumption that the taxpayer was entitled to a loss allowance for theft); Williams v. Comm’r, T.C. Memo. 1985-201 (Application of Costa Rican Criminal Law to Determine If the Taxpayer Qualifies for Theft Loss Deductions under Section 165), aff’d, 786 F.2d 1170 (8th Cir. 1986). (I)
Federal case law makes it clear that the burden of proof is on the taxpayer to prove that the theft occurred under applicable state or foreign law. Sometimes this is not easy to prove. See e.g. B. Bruno v. Comm’r, T.C. Memo. 2020-156; Guinta v. Comm’r, T.C. Memo. 2018-180. In Guinta, for example, the taxpayer claimed he had lost $ 2.5 million to an alleged foreign Ponzi scheme. In the process, the taxpayer even presented evidence of the investment contract in connection with his statement that he had lost the money. However, the tax court found that he was not entitled to the loss allowance as he was unable to prove theft under applicable law (New York or the UK) or even under which law would apply.
In many cases of theft and loss, the taxpayer may believe that the theft occurred, but they may not be able to identify the thief or thieves. While there is state jurisprudence that supports the position that a taxpayer need not necessarily do this to support a loss of theft, see Leslie v. Comm’r, T.C. Memo. 2016-171, a taxpayer may find the burden of proof of theft insurmountable without this evidence, see Guinta, T.C. Memo. 2018-180. The same applies if the taxpayer has not reported the theft damage to the law enforcement authorities or if the taxpayer cannot prove that a thief has been convicted of the theft. See e.g. B. Vincent v. Comm’r, 219 F.2d 228 (9th Cir. 1955); Moser v. Comm’r, 18 T.C.M. 116 (1959).
The amount of theft.
In addition to providing evidence of theft, a taxpayer must also provide evidence of the correct amount of the theft loss for federal income tax purposes. In principle, the amount of the theft damage is limited to the basis of the stolen goods. Raifman v. Comm & # 39; r, T.C. Memo. 2018-101; Trees. Registration number. Sections 1.165-7 (b) (1), -8 (c). In addition, the rules for determining the amount of the theft damage are based on an assumed sale under Treas. Registration number. Section 1.1011, where "the market value of the property is deemed to be zero immediately after the theft". Trees. Registration number. § 1.165-8 (c).
The indication of the amount of the theft damage is often overlooked and is deceptively simple. To demonstrate this requirement, taxpayers should have good books and records or other documentary evidence showing the basis and fair market value of the property at the time of the theft. If the taxpayer is unable to do so, the taxpayer runs the risk of the entire theft damage being rejected.
The time of the loss of theft deduction.
A final requirement for the assertion of a theft loss deduction under Section 165 is that the taxpayer must state the tax year in which the loss occurred and that there is no reasonable prospect of recovery in the same year. See I.R.C. Section 165 (e). Generally, the year of discovery is the year that a reasonable person, under similar circumstances, would have discovered the theft damage. Cramer v. Comm & # 39; r, 55 T.C. 1125, 1133 (1971). If there is a reasonable prospect of recovery in the year of discovery, the time of withdrawal is delayed until there is no longer any prospect of recovery. Trees. Registration number. Section 1.165-1 (d) (3). Whether there is a reasonable prospect of recovery is determined by examining all facts and circumstances, including any settlement of the claim, any decision on the claim and any waiver of the claim. Trees. Registration number. § 1.165-1 (d) (2); Tree v. Comm’r, T.C. Memo. 2021-46.
In general, determining whether there is a reasonable prospect of recovery is based primarily on objective factors; the subjective opinion of the taxpayer can also be taken into account, but this is not the sole or controlling criterion. Tree, above. Significantly, the taxpayer is not obliged to pursue all recovery options, especially those that have little chance of success. Adkins, 960 F.3d at 1365 (Fed. Cir. 2020).
Of all the requirements, this is the one that is most severely challenged by the IRS. This is because it is de facto intense and if the IRS manages to prove another year in which the taxpayer should have claimed the theft, the taxpayer may lose the deduction entirely. See Giambrone v. Comm’r, T.C. Memo. 2020-145, discussed here. Accordingly, taxpayers should carefully analyze their particular facts and circumstances to ensure that, prior to claiming the allowance, they are certain that the theft loss occurred that year and that there is no reasonable prospect of redress in the same year.
Identifying theft loss for tax reasons is not always easy. Aside from the numerous requirements mentioned above, Congress has made it difficult for taxpayers to claim certain theft losses due to the recent amendment to the law that completely prohibits theft losses. See I.R.C. Section 165 (h) (5). Before claiming a theft damage deduction in a tax return, a careful analysis of the law is required in addition to the facts. Failure to exercise caution can lead to the complete non-crediting of the loss-of-theft deduction and to considerable penalties for the tax return.
(i) At least one federal court has refused to use applicable state or foreign law to determine whether a Section 165 theft has occurred. See Goeller v US, No. 1: 10-cv-00731-FM (Fed. Cl. March 20, 2013). However, subsequent federal court decisions – including decisions of the tax court – continued to use relevant state or foreign law to make that decision. See e.g. B. Rochlis v U.S., 146 Fed. Class 743 (Fed. Class 2020).