A Not-So-Speedy Recovery

The Court of Federal Claims applied rules on theft loss subject to recovery in a holding that recognized a deduction later than it was initially claimed by a taxpayer but, for a portion of the loss, sooner than the IRS had allowed.

Casualty and theft losses are deductible under IRC § 165 to the extent not reimbursed by insurance. These recoveries can take place years after the loss. Consequently, the proper year in which to deduct the loss can be an issue.

A former Detroit television station owner, Aben Johnson, purchased $83.5 million of gems and jewelry from Palm Beach, Fla., jeweler Jack Hasson during the early and mid-1990s. In 1997 Johnson discovered that the gems were worth only $5.4 million and the remainder of his money had been stolen. Johnson deducted a $58.16 million theft loss ($78.16 million loss less a $20 million estimated recovery) on his 1998 tax return. The government objected and the court agreed that he was not yet entitled to the deduction because he was pursuing litigation to recover some or all of his loss. During extensive discovery, Johnson found that Hasson had transferred most of his assets to bank accounts in the names of various associates, some of them overseas. By the end of 1998, Johnson had located approximately $45,240,000 in assets.

In a criminal proceeding, Hasson was found guilty of wire fraud and other charges, and in 2001 that court ordered him to pay Johnson restitution. According to trial testimony, among the purportedly rare diamonds Hasson sold Johnson was one for $1.5 million that Hasson represented as having once belonged to actress Carole Lombard but was actually a $141 cubic zirconium. Also testifying as fellow victims were golfers Jack Nicklaus and Greg Norman. Johnson recovered approximately $1,404,000 through 2001. After 2001, he recovered an additional $37.9 million, the largest amount ($20,346,000) from a Paris bank account in 2005.

In the tax dispute, Johnson argued he was entitled to a theft loss in 1998 or 2001, while the government contended the loss was deductible in 2005.

The Code and regulations state that casualty and theft losses are deductible in the year sustained. Because theft losses are not always immediately obvious, the regulations define the year a theft is sustained as when it is discovered (see also “Maximize Tax Benefits Under IRC Section 165,” JofA, April 05, page 72). However, no portion of the loss for which there is a reasonable prospect of recovery is deductible. Losses awaiting recovery are deductible when it can be ascertained with reasonable certainty whether reimbursement will be received (see “Reasonable Certainty’ for a Theft Loss Deduction,” JofA, Oct. 07, page 74).

In 1998, Johnson had a reasonable prospect of recovery. He could not deduct any loss, however, until the amount he could recover was reasonably certain, the court said in a 2006 partial ruling for the government. Because under Treas. Reg. § 1.165-1(d)(2) the “reasonable prospect” standard applies only to the year of discovery of the loss, a taxpayer may deduct in that year an amount for which there is no reasonable prospect of recovery. This is a different standard from a reasonable certainty of recovery, the court said, which required that Johnson provide an objective “verifiable determination” of the amount, such as by settlement, adjudication or abandonment of claims—not, as Johnson provided, a rough estimate, particularly one that subsequent developments demonstrated had been too pessimistic.

However, in a subsequent ruling in January 2008, neither did Johnson have to wait until 2005 to deduct any amount of the loss, as argued by the government, because the regulations do not require final recovery. By 2001, a clearly identifiable set of claims had been sufficiently resolved to permit a theft loss of $37.2 million in that year.

n Aben E. and Joan G. Johnson v. U.S., 101 AFTR2d 2008-523 and 99 AFTR2d 2007-328

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