Court Objects to Reliance on State Law in Determining Deductible Theft Losses.

(Parker Tax Publishing March 28, 2013)

The deduction for losses is one of the oldest provisions in the Code. The first section authorizing a loss deduction was included in the Revenue Act of 1867. Subsequently, language similar to the current Code Sec. 165(c), which provides for a tax deduction for theft and casualty losses, was added to the statute in the Revenue Act of 1916.

Under the regulations interpreting Code Sec. 165, the term theft is deemed to include, but is not necessarily limited to, larceny, embezzlement, and robbery. The regulations, however, stop there in terms of providing any further guidance on how to determine whether a particular conduct amounts to theft or any one of the other enumerated crimes. As a result, many cases have sought further guidance on this point from state law, often citing Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), for the proposition that whether a theft loss has occurred within the purview of Code Sec. 165(c)(3) depends on the criminal law of the jurisdiction where the loss was sustained.

In Goeller v. U.S., 2013 PTC 36 (Fed. Cl. 3/20/13), the Court of Federal Claims was confronted with a similar question. Both the taxpayer and the IRS cited case law for the proposition that whether a theft occurred for purposes of Code Sec. 165(c)(3) depended on whether a theft occurred under state law. However, the parties disputed whether the controlling law was that of Ohio or California. Instead of following the typical state law analysis of prior court decisions, the Court of Federal Claims questioned relying on state law at all, citing the fact that nothing in the legislative history suggests any reliance on state law. The court also noted that in the near century since the original version of what would become Code Sec. 165(c) was passed, the IRS has issued over a dozen regulations on this subject, none of which suggest that state law should play a definitive role in determining the deductibility of a theft loss. Indeed, the court noted that Reg. Sec. 1.165-8(f), which has been around since 1960, has an example regarding the deductibility of a theft loss related to a stolen diamond brooch, without ever discussing whether the brooch was taken via an action that qualified as theft under a given state law.

As a result, the court rejected the notion that the deductibility of the taxpayers' losses hinged on the specific provisions of either Ohio or California criminal law. It concluded, instead, that the term theft in Code Sec. 165(c)(3) means the fraudulent taking of property belonging to another, from his possession, or from the possession of some person holding the same for him, without his consent, with the intent to deprive the owner of the value of the same, and to appropriate it to the use or benefit of the person taking.

The court listed several questions that had to be answered before it could enter summary judgment for either the Goellers or the IRS. According to the court, the questions were suitable only for resolution at trial. However, the court admonished the parties to try to settle the case rather than bring it back to the court.

OBSERVATION: If the case makes it back to the court, the court's rejection of reliance on state law for determining whether a theft loss has occurred, if upheld by other courts, could simplify the determination of whether a theft loss has occurred for purposes of Code Sec. 165(c). Practitioners would not be required to become experts in state criminal laws on what constitutes a theft in order to take a theft loss deduction for federal tax purposes.

Facts

Complete Property Resources (CPR) was the trade name for several Columbus, Ohio-based companies engaged in the business of buying and selling residential real estate from 1992 through at least 2004. CPR was financed by private investment; it issued promissory notes to private lenders that were secured by mortgages on CPR properties. CPR also offered tandem investments, whereby an investor purchased a CPR property by making a capital contribution to CPR of 20 percent of the purchase price and taking out a loan for the remainder. CPR then paid the investor interest on both the loan and the capital contribution. In the course of its business, CPR regularly sold the property that secured a given promissory note, obtaining, for that purpose, a release from the affected investors. CPR sometimes obtained multiple mortgages on a single property; in some cases, investors, including Robert Goeller and his wife, Jeanette, agreed to have a promissory note secured by a future, not yet acquired, CPR property. As a result of these practices, the CPR property associated with any given promissory note intermittently changed, as was reflected on financial statements sent to investors.

The Goellers began investing in CPR in 1995, after meeting with CPR president, Steve Vilardo. From 1995 to 2004, the Goellers wrote 12 checks to CPR, making investments totaling $769,542. While seven of those checks could be traced to particular promissory notes, the remaining five totaling $133,542 could not. Additionally, the Goellers invested approximately $48,000 in CPR tandem investments and $91,420 in Individual Retirement Account (IRA) funds held in CPR accounts. Between 1995 and 2004, the Goellers received regular payments of interest and returns of principal from CPR, although they could not substantiate how much they actually received during this period. In July 2004, the Goellers requested a $260,000 return of investment capital. Vilardo agreed, but the Goellers never received their $260,000.

In January 2005, CPR described a restructuring program under which it would reduce interest rates on private investments and temporarily withhold payments to investors. In April 2005, CPR outlined a proposal under which unsecured investments would be converted to equity in CPR, while the terms of secured investments would remain unchanged but with a lower rate of return. During the restructuring process following CPR's default, the Goellers received additional returns of principal and interest on their tandem investments and certain promissory notes. As to the former, the Goellers received a return of capital on all but one investment. With regard to their promissory note investments, the Goellers received post-default returns of capital as secured properties were sold, but nothing on their unsecured investments. Despite its restructuring efforts, CPR informed investors in December 2005 that it intended to file a prepackaged reorganization plan under Chapter 11 of the Bankruptcy Code. On September 11, 2006, the Goellers filed an unsecured proof of claim in CPR's bankruptcy case for $708,000. Despite Vilardo's periodic expressions of regret and claims that he was personally obligated to CPR's investors, the Goellers ultimately recovered nothing on their claim.

Goellers' Theft Loss Claim

In early 2006, the Goellers hired Tobias Elsass of the Fraud Recovery Group, which also represented other CPR investors, to prepare a federal tax refund claim based on CPR losses. The Goellers filed a Form 1040X amended tax return for 2004, which claimed a theft loss of $417,819 for that year under Code Sec. 165(c) and also filed a Form 1045, Application for Tentative Refund, on which they claimed carrybacks of the 2004 net operating loss to 2001 through 2003.

During an audit of the Goellers' claim, Elsass sent the IRS a letter explaining that in CPR's bankruptcy, the Goellers realized an unsecured loss of $708,000, of which $300,690 was IRA funds, leaving a theft loss of $407,310.

The Goellers argued that their involvement with CPR resulted in theft losses that were deductible on their 2004 return because Code Sec. 165(a) allows a deduction for any loss sustained during the tax year and not compensated for by insurance or otherwise. Both the Goellers and the IRS cited authority for the proposition that whether a theft has occurred, for purposes of Code Sec. 165(c)(3), depends on whether a theft has occurred under state law. However, they disputed whether the controlling law was that of Ohio (where CPR was based) or in California (where the Goellers were located). Within the various state law regimes, the parties also disputed which criminal statutes were controlling, and whether the requisite elements of a given theft crime (e.g., theft by false pretenses) had been satisfied. They further disagreed as to when the Goellers discovered the theft, whether they had a reasonable chance to recover their losses in 2004, and the amount of any loss, if at all, that was deductible.

Federal Claims Court's Analysis

The Court of Federal Claims began its analysis by noting that, under Reg. Sec. 1.165-8(d), the term theft is deemed to include, but is not necessarily limited to, larceny, embezzlement, and robbery. The regulations do not provide any further guidance on how to determine whether a particular conduct amounts to theft or any one of the other enumerated crimes.

The court then noted that many cases sought further guidance on this point from state law, often citing Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), for the proposition that whether a loss from theft occurs for purposes of Code Sec. 165(c) depends on the law of the jurisdiction where it was sustained. From this point, the Court of Federal Claims observed, many courts embark on an extended analysis of whether the actions that occasioned the loss of funds constituted one of the requisite theft crimes under state criminal laws. The court noted, however, that neither the Edwards' court nor any of its progeny explain why state law should control the definition of what is a theft. Thus, none of them explain why Congress would want state-by-state variability in the treatment of theft losses for federal income tax purposes, particularly via a provision in which all the other triggering events for deductible losses fire, storm, shipwreck, or casualty are defined not by state law, but by reference to their plain meanings.

While the Court of Federal Claims said it was hesitant to re-plow a field that has been so extensively cultivated, it was obliged to do so, as none of the precedents adopting state law were binding in this case. Try as it might, the court said, it could not resist concluding that the idea that Code Sec. 165(c)(3) somehow incorporates state criminal law into what is otherwise a federal taxing statute was illogical. For one thing, the court stated, having the deductibility of a theft loss under Code Sec. 165(c) turn on a specific state's criminal statutes runs counter to the interpretative rules generally applicable to the construction of federal taxing statutes i.e., that the plain meaning of the statute should control. A fundamental canon of statutory construction, the court noted, is that, unless otherwise defined, words are interpreted by taking their ordinary, contemporary, common meaning.

The Court of Federal Claims also noted that the Supreme Court, in its seminal 1932 opinion in Burnet v. Harmel, 287 U.S. 103 (1932), rejected an argument that the capital gains treatment of sales proceeds was controlled by how Texas law treated the sale of oil and gas in place. In that opinion, the Supreme Court stated that state law may control only when the federal taxing act, by express language or necessary implication, makes its own operation dependent upon state law.

Consistent with this approach, the Court of Federal Claimst said, the implied incorporation of state law into federal tax law has occurred almost exclusively in cases involving property interests. The court cited numerous cases that hinged on the need to strike a proper balance between the legitimate and traditional interest the state has in creating and defining the property interest of its citizens, and the necessity for a uniform administration of the federal revenue statutes.

According to the court, there was no such need to strike a balance in the Goeller case because as several titles of the U.S. Code (e.g., Titles 18 and 31) attest, the definition of crimes is certainly not the exclusive province of the states, even with respect to such traditional offenses as theft. Given this, the court observed, one would think that the necessity for a uniform administration of the federal revenue statues would require courts to adopt a relatively uniform federal definition of the term theft, as used in Code Sec. 165(c)(3) one that does not require a taxpayer to research the particulars of state criminal law applicable at the time of the loss before claiming such a deduction.

Citing Black's Law Dictionary and Webster's New International Dictionary, the Court of Federal Claims said that the key word in the statute theft has a long-standing and well accepted meaning. Black's Law Dictionary defines that term as [t]he fraudulent taking of corporeal personal property belonging to another, from his possession, or from the possession of some person holding the same for him, without his consent, with intent to deprive the owner of the value of the same, and to appropriate it to the use or benefit of the person taking. Webster's New International Dictionary (2d ed. 1948) defines theft as the felonious taking and removing of personal property, with intent to deprive the rightful owner of it. At least by the time the 1954 Code was enacted, the court stated, it also was well accepted that the definition of theft included a crime in which one obtains possession of property by lawful means and thereafter appropriates the property to the taker's own use. These definitions of theft, the court observed, are largely indistinguishable from that employed in the Model Penal Code, which defines a theft as occurring where a person unlawfully takes, or exercises unlawful control over, movable property of another with purpose to deprive him thereof. This is relevant, the court stated, because the Model Code's provisions are often used in determining the scope of an offense referenced in a federal statute.

The Court of Federal Claims also noted that, in U.S. v. Turley, 352 U.S. 407 (1957), the Supreme Court found that, in the absence of a plain indication of an intent to incorporate diverse state laws into a federal criminal statute, the meaning of the federal statute should not depend on state law. Similarly, in Jerome v. U.S., 318 U.S. 101 (1943), the Supreme Court stated that we must generally assume, in the absence of a plain indication to the contrary, that Congress when it enacts a statute is not making the application of the federal act dependent on state law.

The Court of Federal Claims concluded that, where a federal statute uses a common-law term of established meaning without otherwise defining it, the practice is to give that term its common meaning. The court saw no reason why this rule should not apply to Code Sec. 165(c)(3). It found nothing in the statutory language, its legislative history, or the relevant regulations that suggested otherwise. Indeed, the court stated, by defining theft to include a variety of crimes (e.g., embezzlement), Reg. Sec. 1.165-8(d) initially follows the interpretational norms, recognizing that Congress intended that the term theft have content independent from state law and, more specifically, a meaning broader than what a given state might define as theft. The court went on to ask why, after defining theft to encompass a broader range of crimes, it should conclude that Congress intended that each of those individual crimes be viewed only through the prism of a particular state's laws? Did Congress really intend federal trial courts to preside over mini-trials applying state criminal laws often dealing with complicated questions involving the elements or requirements of particular state crime all to resolve the deductibility of a theft loss under federal law?

The court also looked at deduction cases that cite, in holding that a given loss results or doesn't result from a theft sustained in one state, cases involving theft losses sustained in other states, without any consideration as to whether the laws in the respective jurisdictions were analogous. Like signs warning of trouble ahead, the court stated, this string of anomalies and asymmetries strongly suggests that some courts have been led up the garden path in holding that section 165(c)(3) incorporates state criminal laws. Faced with the same fork in the road, and seeing many brambles lying ahead, this court chooses not to bound down this same primula path.

Finally, the court said that its analysis would be for naught if either the Federal Circuit, or the Court of Claims before it, had cemented the state-law approach into the Federal Circuit's jurisprudence. But such is not the case, the court stated. The court's research revealed only one case in which one of those courts, the Federal Circuit, considered the deductibility of an alleged theft loss under Code Sec. 165(c)(3) and did so without the slightest mention of state law.

Conclusion

Based on the foregoing analysis, the Court of Federal Claims rejected the notion that the deductibility of the Goellers' losses hinged on the specific provisions of either Ohio or California criminal law. It concluded, instead, that the term theft in Code Sec. 165(c)(3) means the fraudulent taking of property belonging to another, from his possession, or from the possession of some person holding the same for him, without his consent, with the intent to deprive the owner of the value of the same, and to appropriate it to the use or benefit of the person taking.

Within this framework, to determine whether the Goellers were entitled to the theft loss deduction they claimed, the court said the following four subsidiary questions had to be resolved:

(1) whether the conduct of the CPR officials in question constituted a theft within the meaning of Code Sec. 165;

(2) whether the theft loss, if any, was discovered by the Goellers in 2004, the year the deduction was claimed;

(3) whether, in 2004, there was still a reasonable prospect of recovering the funds lost; and

(4) the amount of the theft loss, if any.

According to the court, it appeared that these questions were suitable only for resolution at trial.

The court ordered the parties to file, on or before March 29, 2013, a joint status report proposing a trial date and trial location, estimating the length of trial, and proposing a schedule for pretrial filings. However, the court said, before filing this report, the parties must have at least one serious discussion regarding settling the matter. (Staff Editor Parker Tax Publishing)

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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