Federal Circuit Vacates Claims Court Decision on Timing of Investment Scheme Loss; Couple Gets Second Shot at Arguing for Deduction

(Parker Tax Publishing May 2017)

The Federal Circuit vacated a decision by the Federal Claims Court, which had held that a couple did not prove that their loss from an investment scheme occurred in 2004 and, thus, rejected their refund claim. The court rejected the lower court's interpretation of Reg. Sec. 1.165-1(d)(3) as setting forth two different standards that had to be met in order for a taxpayer to take a theft loss deduction. Adkins v. U.S., 2017 PTC 218 (Fed. Cir. 2017).

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 loss. 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, 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 Donald & Co. pump-and-dump scheme and most of the rest was attributable to purchases made via the third-party brokers. The IRS disallowed the refund claims and the Adkinses protested to the IRS Office of Appeals.

An Appeals Officer issued a memorandum on April 5, 2011, which concluded that the Adkinses had sustained a theft loss of $2.5 million - the claimed theft loss minus the portion of the loss attributable to the stock purchased through third-party brokers - and were therefore entitled to the corresponding refunds. However, at the time the Appeals Officer issued his memorandum, the IRS Office of Appeals lacked jurisdiction to settle the case because the Adkinses had filed a refund suit in the U.S. Court of Federal Claims. That suit had been filed on December 10, 2010. In the suit, the Adkinses sought income tax refunds totaling almost $320,000 for investment losses in their Donald & Co. accounts. The couple determined that the loss occurred in 2004 and carried back losses not used up in that year to earlier years. In that case (Adkins v. U.S., 2013 PTC 386 (Fed. Cl. 2013)), the court disallowed refunds relating to losses the Adkinses suffered from stock purchased through third-party brokers because there was no privity between the Adkinses and Donald & Co. with respect to those purchases. With respect to the other losses, the court held that whether the Adkinses had a reasonable prospect of recovery in 2004 was a genuine issue of material fact and that neither the IRS nor the Adkinses was entitled to summary judgment.

The Adkinses filed suit again, arguing that they were entitled to a refund for investment theft losses sustained in 2004. According to the couple, they sustained the loss in 2004 because by the end of that year, they had no reasonable prospect of recovering on their arbitration claim.

Federal Claims Court Rejects Refund Claim

The Federal Claims Court held that the Akinses did not prove that their loss occurred in 2004 and, thus, rejected their refund claim. Under the factual circumstances presented, the court said, the test 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. 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. Because they failed to do so, the court concluded that they were not entitled to a theft loss deduction for the 2004 tax year.

In reaching its holding, the court cited Reg. Sec. 1.165-1(d)(3), which provides that if a taxpayer has a reasonable prospect for recovery in the year that he discovers his loss, then he cannot claim the theft loss deduction until the year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. Whether or not such reimbursement will be received, the court noted, may be ascertained with reasonable certainty, for example, by a settlement of the claim, by an adjudication of the claim, or by an abandonment of the claim. And, the court observed, Reg. Sec. 1.165-1(d)(2)(i) requires that, when a taxpayer claims that the year he sustained his loss is fixed by his abandonment of the claim for reimbursement, he must be able to produce objective evidence of his having abandoned the claim, such as the execution of a release.

In interpreting and applying this regulation, the Claims Court reiterated the conclusion reached in Johnson v. U.S., 74 Fed. Cl. 360 (2006). That is, the court said, although other courts tend to combine the "reasonable prospect of recovery" inquiry and the "ascertain with reasonable certainty" inquiry, the Claims Court found the two inquiries are distinct and the standards to be applied are different.

According to the Claims Court, the objective evidence in the record supported two abandonment dates other than 2004: (1) 2003, when the Adkinses' arbitration attorneys requested that the NASD adjourn a scheduled hearing and when the Adkinses stopped paying their arbitration attorneys, or (2) 2008, when the Adkinses formally withdrew their arbitration claim. Accordingly, the court found that the Adkinses did not meet their burden of establishing that they sustained their theft loss in 2004. The Adkinses appealed to the Federal Circuit.

Arguments on Appeal

On appeal, the Adkinses made essentially four arguments: (1) the Claims Court failed to correctly apply Reg. Sec. 1.165-1(d)(3)'s test for determining the year in which a taxpayer can deduct a theft loss under Code Sec. 165; (2) even under the Claims Court's interpretation of Reg. Sec. 1.165-1(d)(3), it improperly required abandonment of their arbitration claim; (3) the Claims Court failed to apply Rev. Proc. 2009-20, which provides an optional safe harbor treatment for taxpayers that experienced losses in certain investment arrangements discovered to be criminally fraudulent; and (4) if 2004 was not the correct loss year, the Claims Court should have ruled in favor of the Adkinses under the mitigation provisions of Reg. Sec. 1.1311(c), using 2003 as the loss year instead.

The Adkinses argued that Reg. Sec. 1.165-1(d)(3), properly interpreted, does not set forth two different standards. Rather, it merely describes two sides of the same probabilistic coin: a "reasonable prospect for recovery" is the inverse of "reasonable certainty" that there will be no recovery. That is, the test in Reg. Sec. 1.165-1(d)(3) may be simplified as follows: the proper year in which to claim a loss is the first year in which no reasonable prospect of recovery exists anymore, starting with the year of discovery.

Federal Circuit's Decision

The Federal Circuit vacated the lower court decision and remanded the case for further proceedings consistent with the Federal Circuit's opinion.

At the outset, the Federal Circuit agreed with the Adkinses' interpretation of Reg. Sec. 1.165-1(d)(3) as not requiring two different standards. The court noted that, while few circuit courts have addressed this issue explicitly, their conclusions appear to be the same. The court cited Vincentini v. Comm'r, 429 F. App'x 560 (6th Cir. 2011), where the Sixth Circuit described Reg. Sec. 1.165-1(d)(3) as setting forth a single test, and describing that test as whether the claimant demonstrated with reasonable certainty that there was no reasonable prospect of recovery; Jeppsen v. Comm'r, 128 F.3d 1410 (10th Cir. 1997), where the Tenth Circuit used "reasonable prospect" and "reasonable certainty" language interchangeably; and Rainbow Inn, Inc. v. Comm'r, 433 F.2d 640 (3d Cir. 1970), where the Third Circuit described "the test" under Reg. Sec. 1.165-1(d)(3) as whether there was a reasonable prospect of recovery at the time the deduction was claimed. The Federal Circuit said it could find no basis in the language of Reg. Sec. 1.165-1(d)(3) to deviate from this straightforward and sensible approach.

The Federal Circuit then turned to the Adkinses' second argument whether, under either interpretation of Reg. Sec. 1.165-1(d)(3), the Claims Court additionally erred by treating abandonment of their arbitration claim as a prerequisite to a reasonable certainty of no recovery. The court found the Adkinses' argument persuasive, and held that the Claims Court so erred. The court disagreed with the lower court's holding that the Adkinses had not met their burden of establishing that they sustained their theft loss in 2004, saying that it read Reg. Sec. 1.165-1(d)(2)(i) as setting forth a general totality-of-the-circumstances standard, followed by an alternative method for a taxpayer to demonstrate that no reasonable prospect of recovery existed as of a certain date.

That is, the Federal Circuit said, rather than make their case under the general "all facts and circumstances" standard, a taxpayer may rely on the date that their arbitration or lawsuit for the loss was settled, abandoned, or adjudicated. In the case of abandonment, because no dated court order or settlement agreement exists, a taxpayer must be able to provide some other form of "objective evidence" as to when abandonment occurred. But even in cases where taxpayers do have a related arbitration or lawsuit, the Federal Circuit did not read Reg. Sec. 1.165-1(d)(2)(i) as precluding taxpayers from making their case under the more general standard, should they so choose.

Because the court agreed with the Adkinses' first two arguments, it did not address the other arguments presented.

For a discussion of when a theft loss is deductible, 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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