Federal Circuit Reverses Claims Court for a Second Time on the Same Case; Couple Can Deduct Theft Losses

(Parker Tax Publishing June 2020)

The Federal Circuit reversed the Claims Court for a second time on the same case and held that a couple who suffered investment losses as the result of a pump-and-dump scheme organized by an investment group was entitled to deduct those losses on their 2004 tax return because, by 2004, there was no reasonable prospect of the couple recovering their losses. The court concluded that the Claims Court had, on remand, again misconstrued the relevant legal standard in Reg. Sec. 1.165-1(d)(2) and, accordingly, erred in its finding that the couple failed to establish they lacked a reasonable prospect of recovering their losses in 2004. Adkins v. U.S., 2020 PTC 158 (Fed. Cir. 2020).

Background

Charles and Jane Adkins suffered investment losses resulting from a decline in the value of stock purchased in a pump-and-dump scheme. The scheme was run by brokers at Donald & Co., who would arrange to purchase large blocks of stock in various companies; encouraging its customers to purchase these stocks, artificially inflating the stocks' prices by, among other means, hyping the stock; and then, once the price of a particular stock was sufficiently inflated, selling the stock that it owned, resulting in gains for the company and, due to the subsequent decline in the stock price to a normal, uninflated level, losses for the company's customers.

By the beginning of 2002, the value of the Adkinses' investment with Donald & Co. had dropped dramatically. The Adkinses filed an arbitration claim against Donald & Co and several of its brokers, alleging that they had manipulated the value of the stock, causing the couple to incur substantial losses. In May of 2004, a federal grand jury indicted several principals and employees of Donald & Co (defendants). Mr. Adkins took the indictment to mean that the government intended to seize any documentation concerning the identity and ownership of the defendants' assets, foreclosing his ability to prove the existence of a theft loss and locate assets that could be used to reimburse him and his wife for their losses. Mr. Adkins further interpreted the indictment to mean that the government was going to seize all of the defendants' assets, preventing him from attaching those assets to recover their loss.

In September of 2004, several employees of Donald & Co. pled guilty to securities fraud and other charges. They received prison terms, fines, mandatory restitution in an amount to be determined, and forfeiture. By the end of 2004, no amounts had been paid to the victims of the fraud. In 2005, additional prosecutions were taking place. The broker who had sold stocks to the Adkinses pled guilty to securities fraud and was sentenced to prison, fines, and mandatory restitution. In 2008, the Adkinses formally withdrew their arbitration claim.

While the criminal proceedings were pending against the brokers in charge of the fraud, the Adkinses attempted to recoup some of their losses by claiming a tax deduction under Code Sec. 165. They timely filed amended returns for 2001 through 2004 reflecting a total theft loss of approximately $2.6 million. Approximately $2.3 million of that loss came from the pump-and-dump scheme and most of the rest was attributable to purchases made via the third-party brokers. The IRS rejected the refund claims because it said that the Adkinses still had a reasonable prospect of recovering on their arbitration claim in 2004.

The Federal Claims Court held that the Adkinses did not prove that their loss occurred in 2004 and, thus, rejected their refund claims. According to the court, the test under Reg. Sec. 1.165-1(d)(3) was not whether the Adkinses had a reasonable prospect of recovering on their arbitration claim in 2004, but was instead whether, in 2004, they could have ascertained with reasonable certainty that they would not recover on their arbitration claim. The court said that, while other courts tend to combine the "reasonable prospect of recovery" inquiry and the "ascertain with reasonable certainty" inquiry, the two inquiries are distinct and the standards to be applied are different. To satisfy their burden under the latter test, the court said, the Adkinses were required to produce objective evidence that they abandoned their arbitration claim in 2004 and they failed to do so. The Adkinses appealed to the Federal Circuit.

The Federal Circuit held that the Claims Court misconstrued Reg. Sec. 1.165-1(d)(3) concerning the timing of a theft loss deduction, and vacated the Claims Court's opinion and order, and remanded the case for further proceedings. The court concluded that the Claims Court erred in two ways:

(1) reading Reg. Sec. 1.165-1(d)(3) as imposing a higher burden on taxpayers who at-tempt to recover their losses after discovering a fraud than on taxpayers who claim the same loss immediately upon discovery; and

(2) holding that, where a taxpayer has filed a claim for reimbursement from those who defrauded her, the taxpayer may not claim a loss until that claim is fully resolved or abandoned.

According to the court, what a taxpayer must prove by reasonable certainty is that, as of the time the loss was claimed, there was no reasonable prospect of recovery; the taxpayer is not required to prove that the taxpayer was certain no recovery could be had. The court also explained that, while one could establish the absence of any reasonable prospect of recovery by abandonment of a claim, abandonment is not a prerequisite to such a showing. In short, the court explained that the Claims Court had required too much from the taxpayers - both with regard to what they must prove and with regard to what evidence is needed to satisfy that burden of proof.

On remand, the Claims Court again held that the Adkinses were not entitled to a theft loss deduction for the 2004 tax year because their reasonable prospect of recovering their losses was simply unknowable by the end of 2004 and dismissed the Adkinses' complaint. The Adkinses again appealed to the Federal Circuit.

Federal Circuit's Analysis

The Federal Circuit reversed the Claims Court's decision and remanded for a calculation of the Adkinses' refunds for the tax years implicated by the 2004 loss claim. The court agreed with the Adkinses that the Claims Court (1) misconstrued the governing statute and regulation; and (2) erred when it concluded that the Adkinses failed to establish a lack of a reasonable prospect of recovery in 2004.

The court noted that the record demonstrated that, in 2004, the Adkinses had no reasonable prospect of recovery. By the end of 2004, the Adkinses' pending arbitration proceeding was stagnant. The Adkinses had yet to receive a response to their discovery requests, were informed by a U.S. Attorney that all pending civil litigation would be stayed until disposition of the criminal cases, and had been advised by their arbitration attorneys that they could not go forward with the arbitration given the lack of discovery documents and pending criminal indictments.

Even if there were a positive arbitration outcome for the Adkinses, the court observed, the evidence as of 2004 suggested that the defendants would not have had the ability to pay for the Adkinses' losses.

For a discussion of the timing of theft loss deductions, see Parker Tax ¶84,540.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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