Criminal conviction of corporate officers for misconduct is not enough to allow shareholders to claim a theft loss, the Tax Court ruled.
In cases where a shareholder’s stock becomes worthless due to corporate theft, it would generally be advantageous to treat relatively small losses as capital losses (due to the 10% of AGI floor for theft losses) and larger losses as casualty/theft losses, because a casualty/theft loss is a deduction against ordinary income and recouped more quickly.
A WorldCom Group employee, Mehdi Taghadoss, purchased stock and exercised options through an independent 401(k) and employee stock purchase plan. After WorldCom’s top officials were charged with fraud, the firm filed for bankruptcy in July 2002. (Ex-CEO Bernard Ebbers was convicted of fraud and sentenced to 25 years in prison in July 2005.) A reorganization plan approved in October 2003 provided, inter alia, that Taghadoss’ interests would be canceled when WorldCom emerged from bankruptcy. Taghadoss filed his 2003 tax return claiming a casualty or theft loss of $1,344,863, then received a statement valuing his 31,083 shares at $677. WorldCom emerged from bankruptcy in April 2004. The IRS disallowed the loss for 2003, and Taghadoss sued.
For a casualty loss, the Tax Court noted that Taghadoss did not suffer physical damage to his property, as required in Furer v. Commissioner (TC Memo 1993- 165, aff’d without opinion, 74 AFTR2d 94-6019 (9th Cir. 1994)). In assessing a theft loss, the court relied on cases defining theft consistently with laws of the taxpayer’s state of residence. In Virginia, where Taghadoss lived, theft requires an intention to permanently deprive another of his or her property. Thus, WorldCom officials’ filing of false statements with the SEC was not theft, the court held. Taghadoss bought the securities through independent plans and brokers, none of whom were alleged to have stolen from Taghadoss. The court discounted several internal WorldCom memos stating “that everything is fine,” because Taghadoss did not show a direct causal connection between the memos and his stock purchases.
The court also dismissed Taghadoss’ argument that he could claim a theft loss as a shareholder for a theft against the corporation, stating that this would be allowed only if the corporation were a device to defraud its investors.
Further, since Taghadoss’ holdings were not worthless in 2003, no loss was allowed for that tax year under section 165(g) and Treas. Reg. § 1.165-5(f). The court found that Taghadoss had abandoned his securities when they were canceled in April 2004 without action on his part. Had this happened today, Treas. Reg. § 1.165-5(i)(1), effective for securities abandoned after March 12, 2008, allows that they may be treated as if sold for zero dollars on the last day of the tax year.
Mehdi Taghadoss v. Commissioner, TC Summary Opinion 2008-44
By Valrie Chambers, CPA, Ph.D., associate professor of accounting, and Brian Elzweig, J.D., LL.M., assistant professor of business law, both of Texas A&M University–Corpus Christi.