‘Pump and dump’ theft loss allowed despite open arbitration claim

The Federal Circuit holds that abandonment of a claim for reimbursement of a theft loss is not necessary to prove a reasonable certainty that no reimbursement will be received.
By Charles J. Reichert, CPA

The Federal Circuit, vacating a Claims Court opinion and remanding the case, held that the lower court had erred in its determination of when taxpayers could deduct a loss from a fraudulent investment scheme under Regs. Sec. 1.165-1(d)(3). According to the appellate court, the proper year in which to claim a theft loss is the first year in which no reasonable prospect of recovery exists, starting with the year of discovery.

Facts: Starting in 1997, Charles and Jane Adkins purchased securities through Donald & Co., which later was determined to have been operating a fraudulent "pump and dump" investment scheme. In such a scheme, a broker promotes purchases by its clients of a company's stock it also holds in its own name, which then appreciates in value. The broker then sells its own stock in the company for a profit, while the value of its clients' holdings falls. From February 2000 to December 2001, the value of the Adkinses' portfolio with Donald dropped from $3,589,301 to $9,849.

In 2002, the taxpayers made an arbitration claim against Donald to the National Association of Securities Dealers. After learning that the U.S. Department of Justice was investigating Donald, the Adkinses postponed their arbitration hearing but left their claim open in case the investigation uncovered additional relevant information. In 2004, Donald's principals pleaded guilty to fraud charges.

On their 2004 federal income tax return, the taxpayers deducted a theft loss of $2,118,725, carrying back excess amounts to 2001—2003. That deduction was later disallowed by the IRS. The taxpayers filed a claim for refund with the Court of Federal Claims. That court denied the refund request on the grounds that the Adkinses had not determined in 2004 with reasonable certainty that they would not be reimbursed for their losses, partially due to their failure to abandon their arbitration claim (Adkins, 125 Fed. Cl. 304 (2016)). The Adkinses appealed the decision to the Federal Circuit.

Issues: A theft loss may be deducted in the year it is discovered. However, if in that year there is a reimbursement claim with a reasonable prospect of recovery, the deduction for any part of the loss is postponed until the year in which the taxpayer is reasonably certain whether any reimbursement will be received (Regs. Sec. 1.165-1(d)(3)). Whether a reasonable prospect of recovery exists at the time of discovery is determined by the facts of each case. Reasonable certainty of whether a reimbursement will be received is determined by examining all the facts and circumstances and can be demonstrated by the taxpayer's settling, adjudicating, or abandoning the claim, according to Regs. Sec. 1.165-1(d)(2)(i).

The Court of Federal Claims held that the Adkinses could not take a deduction for their loss in 2004 for two reasons. First, the reasonable-prospect-of-recovery standard for the year of discovery and the reasonable-certainty standard for potential reimbursements in a later year are two different standards, the court held. The reasonable-certainty standard for reimbursements requires taxpayers to produce more evidence to claim a loss in a year after the year of discovery, and the Adkinses had failed to do so and thus meet the reasonable-certainty standard. Second, the court found that under Regs. Sec. 1.165-1(d)(3), a taxpayer that has a claim for reimbursement of a loss must abandon, settle, or adjudicate the claim to prove with reasonable certainty that the loss will not be recovered, and in 2004 the Adkinses had an open arbitration claim related to their losses.

Holding: The appellate court held that the reasonable-prospect-of-recovery standard and the reasonable-certainty standard for reimbursements are the same standard rather than two, and that the rule in Regs. Sec. 1.165-1(d)(3) can be stated as: "[T]he 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." Thus, the Adkinses were not required to meet a stricter standard to claim their loss in a year after it was discovered than in the year it was discovered.

The court also held that it was unnecessary for the Adkinses to have abandoned their arbitration claim to take a tax deduction because Regs. Sec. 1.165-1(d)(2)(i) provides a "general totality-of-the-circumstances standard, followed by an alternative method ... to demonstrate that no reasonable prospect of recovery existed." According to the court, abandonment of an arbitration claim is one example in a nonexhaustive list of examples in Regs. Sec. 1.165-1(d)(2)(i) that the Adkinses could have used to indicate no prospect of any loss recovery, but the Adkinses could also demonstrate the existence of a loss from all the facts and circumstances, which they did when they provided evidence showing that there was no reasonable prospect of recovery as of 2004.

  • Adkins, No. 2016-1961 (Fed. Cir. 5/8/17)

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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