No Theft Loss for “Phantom” Income

The section 165 theft loss deduction seldom benefits taxpayers to the extent they think it should. This can be especially true if the thief is their investment manager and they discover only belatedly they’ve been paying taxes on investment income that never existed.

Between 1992 and 2000, Michael and Anita Kaplan transferred approximately $5.7 million to Reed Slatkin, an investment adviser and money manager in California. He reported to them that their investment earned $519,157 from 1992 through 1996 and $3,617,953 from 1997 through 1999. The Kaplans reported this income on their tax returns and paid tax on it. Slatkin, however, was running a Ponzi scheme, for which he pleaded guilty in 2002 to 15 felony counts. A year earlier, Slatkin filed for bankruptcy, and the trustee notified the Kaplans and other creditors that they could expect approximately a 21% recovery.

The government agreed to refund taxes the Kaplans paid on the “phantom” income for years still within the statute of limitations—1997 through 1999. The Kaplans then filed a refund claim on their 2001 return stemming from a theft loss deduction under section 165(a) equal to their investment, fictitious income and taxes paid on that income for 1992 through 1996. The claim was denied, and the issue went to district court in Tampa, Fla.

Based on Slatkin’s guilty plea, there was no question that a theft loss existed. The question was the appropriate year for it to be reported—according to regulation 1.165-1(b), the first year in which the Kaplans no longer had any reasonable chance of recovery (see “ ‘Reasonable Certainty’ for a Theft Loss Deduction,” JofA, Oct. 07, page 74). This is determined based on foresight and not hindsight, and in 2001, the court ruled, the Kaplans did have a chance of recovery, as estimated by the bankruptcy trustee.

The court next considered a theft loss for the phantom income. The government’s position, adopted by the court, was that since there was no proof that the income existed, there could not have been a theft. As for the taxes, they could not be considered a theft either, the court concluded. The proper approach would be to file amended returns. But if, as in this case, the statute of limitations has run, the taxpayer is out of luck.

It is critical that taxpayers determine the credentials and honesty of any cash manager before transferring money. Theft loss deductions, even when allowed, will not restore taxpayers to their pre-theft position.

Michael and Anita Kaplan v. U.S. , 100 AFTR2d 2007-5674

Prepared by Edward J. Schnee , CPA, Ph.D., Hugh Culverhouse Professor of Accounting and director, MTA Program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.