“Reasonable Certainty” for a Theft Loss Deduction

The Internal Revenue Code often requires the calculation of amounts that are less than absolute but more than mere guesses. IRC § 165 allows taxpayers to deduct theft and other casualty losses but requires them to take reasonable action to recover those losses. If a claim for reimbursement has a reasonable prospect of recovery, the loss is not treated as sustained “until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.” Treas. Reg. § 1.165-1(d)(3); see also Jeppsen v. Commissioner , 128 F.3d 1410 (10th Cir. 1997).

“INCORRIGIBLE OPTIMISM ” NOT REQUIRED
What is reasonable certainty? “A reasonable prospect of recovery exists when the taxpayer has bona fide claims for recoupment from third parties or otherwise, and when there is a substantial possibility that such claims will be decided in his favor.” Jeppsen, quoting Ramsay Scarlett & Co. Inc. v. Commissioner, 61 TC 795, 811 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975). The taxpayer is not required to be an “incorrigible optimist,” United States v. S.S. White Dental Mfg. Co., 274 U.S. 398, 402–03 (1927), and claims with only “remote or nebulous” potential will not postpone the deduction (Ramsay Scarlett). Whether a reasonable prospect of recovery exists is determined by reviewing all facts and circumstances. Treas. Reg. § 1.165-1(d)(2)(i).

“CREDIBLE EVIDENCE ” REQUIRED
It is settled law that deductions are a matter of legislative grace, and the taxpayer must prove that he or she is entitled to the claimed deductions. INDOPCO Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). “The law does not require that they [damages] be determined with mathematical certainty. It only requires that damages be capable of measurement based upon known reliable factors without undue speculation.”Ashland Management Inc. v. Janien, 82 N.Y.2d 395, 604 N.Y.S.2d 912 (1993).

A taxpayer must provide the IRS with “credible evidence” of an amount for which it is “reasonably certain” that the loss will be sustained, before a theft loss amount may be deducted. If a client claimed a loss under IRC § 165, and the reimbursement exceeded what was estimated, that portion of the reimbursement that was previously deducted under IRC § 165 will be treated as ordinary income for tax purposes. The reimbursement that exceeds the adjusted basis will be treated as a capital gain. Because the IRC takes into account the possibility that the expected reimbursement may turn out to have been inaccurate, it stands to reason that absolute certainty is not required to take the deduction.

AN EXPERT OPINION
A recommended practice when submitting a theft loss deduction is to provide the IRS an independent, expert opinion as to the amount of the unrecoverable loss. In Premji v. Commissioner, TC Memo 1996-304, aff’d, 139 F.3d 912 (10th Cir. 1998), the Tax Court found the taxpayer’s subjective belief inadequate to sustain the claim and noted that the taxpayer never contacted a bankruptcy attorney to ascertain his chances for a recovery. An expert may be qualified under the Federal Rules of Evidence: “If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case (Fed. R. Evid. 702).

A RECOVERY CALCULATION
An appropriate entity, using an appropriate methodology, can provide an estimate of the recoverable portion of a loss, allowing the taxpayer to file an IRC § 165 claim. In situations where CPAs represent investors or creditors of fraudulent or bankrupt enterprises, reasonable certainty of a prospect of recovery may be based upon an estimate by a bankruptcy receiver or other authority of assets available to pay claims in proportion to the original amount of funds invested.

The IRS should accept a calculation of this nature as long as it can be demonstrated that it was accomplished with due diligence, sufficient data and reasonable methodology.

By Bart Siegel, CPA, CFE, MBA, PFS, and president of Siegel Forensic Accounting and Consulting of Tampa, Fla. His e-mail address is bsiegel@tampabay.rr.com.