Taxpayers' Bad Investment Didn't Give Rise to Theft Loss Deduction

(Parker Tax Publishing May 2021)

The Tax Court held that a couple, who bought shares in a startup company through an acquaintance who later filed for bankruptcy, were not entitled to a theft loss deduction under Code Sec. 165 because the couple did not provide evidence that the acquaintance made representations that were false, or that were made with the intent to defraud, and therefore did not prove that a theft occurred. The court further found that the couple did not establish the amount of the loss or the year in which the loss was sustained, since the couple filed a claim with the bankruptcy court and the bankruptcy proceedings were ongoing. Baum v. Comm'r, T.C. Memo. 2021-46.

Background

Teresa Baum is self-employed as a realtor. Her husband, Ronnie, is self-employed as a consultant for Harrington Capital Partners, LLC (Harrington), which provides management, scientific, technical, and consulting services. He is also the owner and sole member of Harrington. In 2010, Mr. Baum was looking for new investment opportunities. He met Scott Zeilinger, who offered him the opportunity to invest in a business, Globe Protect, Inc. (Globe). In 2012, Harrington entered into a stock purchase agreement and purchased 100,000 shares of Globe for $150,000. The Baums entered into a separate stock purchase agreement andpurchased an additional 100,000 shares of Globe for $150,000.

In 2014, Zeilinger filed a voluntary petition for bankruptcy in the U.S. Bankruptcy Court for the Northern District of California. Creditors Angelica and Raul Relucio, who had also purchased stock in Globe and filed a bankruptcy claim against Zeilinger in 2015, received a judgment in their favor in February of 2016. The deadline for filing nongovernmental claims against Mr. Zeilinger was June 24, 2015. The Trustee's Final Report filed in May of 2019 showed a balance of $52,725. In August of 2019, the Chapter 7 Trustee's Final Account Distribution Report Certification and Final Decree were filed in the bankruptcy court.

On their 2015 income tax return, the Baums attached a Schedule A, Itemized Deductions, on which they claimed a $300,000 theft loss deduction for their investments in Globe. The IRS disallowed the Baums' claimed deductions and determined deficiencies. The Baums took their case to the Tax Court.

Code Sec. 165(a) allows a deduction for losses sustained during the tax year and not compensated for by insurance or otherwise. Before 2018 and after 2025, an individual may deduct a loss under Code Sec. 165(a) only if the loss: (1) is incurred in a trade or business under Code Sec. 165(c)(1); (2) is incurred in a transaction entered into for profit, though not connected with a trade or business under Code Sec. 165(c)(2); or (3) arises from other causes including casualty or theft under Code Sec. 165(c)(3). Under Reg. Sec. 1.165-1(c) and (d)(1), the taxpayer must establish the amount of a theft loss and the year in which the loss was sustained. In addition, if in the year of discovery the taxpayer has a reasonable prospect of recovery on a claim for reimbursement, then Reg. Sec. 1.165-1(d)(3) provides that the loss will not be sustained until the tax year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received. The taxpayer bears the burden of proving that a theft occurred under the law of the jurisdiction where the alleged loss occurred. Under Code Sec. 165(g), a deduction is allowed for the loss resulting from any security which is a capital asset that becomes worthless during the tax year.

The Baums argued that they suffered losses from "fraud in inducement," which falls under the category of theft by false pretenses under California law. Mr. Baum claimed that his decision to invest in Globe was based on more than Zeilinger's representations. He said he learned from conversations with Zeilinger that Globe had technology that would purify, disinfect, and desalinate water. Before investing, Mr. Baum reviewed patents owned by Globe and viewed a demonstration of Globe's technology. In addition, Mr. Baum reviewed letters of intent purported to be from individuals interested in acquiring Globe or its technology and spoke with these individuals to confirm their interest in purchasing Globe. Mr. Baum learned that Globe would be sold for $50 million, giving him a 300 percent return. The Baums provided records of communications between Zeilinger and Mr. Baum about the investments in Globe.

In a post-trial brief, the Baums argued in the alternative that their losses were deductible either as losses incurred in a trade or business under Code Sec. 165(c)(1), as losses incurred in a transaction entered into for profit under Code Sec. 165(c)(2), or as losses from worthless securities under Code Sec. 165(g).

Analysis

The Tax Court upheld the IRS's denial of the Baums' claimed deductions. The court found that the Baums were not entitled to claim a theft loss because they failed to prove that there was a theft by false pretenses under California law. The court found that the Baums did not provide specific evidence that Zeilinger's representations were false or that they were made with the intent to defraud. Further, the court said that even if there was a theft, the Baums could not take a theft loss deduction because they did not establish the amount of the loss or the year in which the loss was sustained. The court noted that, at the end of 2015, Zeilinger's bankruptcy proceedings were ongoing and that Mr. Baum had filed a proof of claim in the bankruptcy in June of 2015. The court observed that the Relucios, who filed a bankruptcy claim in 2015, received a judgment in their favor in 2016. Additionally, the court noted that Zeilinger's bankruptcy proceedings did not conclude until 2019. Thus, the court concluded that the Baums could not have known in 2015 whether Zeilinger had sufficient assets to allow them to recover their investments in Globe.

With respect to the Baums' alternative arguments, the court found that they were untimely but that, even if they were properly before the court, they would fail. The court reasoned that an investor is not considered to be in a trade or business with respect to his or her investment activities, and the Baums presented no evidence that their involvement with Globe constituted anything more than investing; therefore, Code Sec. 165(c)(1) did not apply. With respect to the Baums' claim for a deduction under Code Sec. 165(c)(2), the court concluded that the Baums had failed to prove there was no reasonable prospect for recovery in 2015 and therefore did not meet the requirements for that deduction. Finally, the court found that the Baums offered no evidence to support their contention that their Globe shares became worthless in 2015, so Code Sec. 165(g) also did not apply.

For a discussion of deducting casualty and theft losses, see Parker Tax ¶84,500.

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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