Theft loss of marital property disallowed

The Tax Court denied a taxpayer’s claimed theft loss for her ex-husband’s failure to transfer marital property under a divorce decree, finding she had a bona fide, recoverable claim to the property in the tax year at issue.

Facts: The taxpayer, Lisa Bruno, was divorced from Stephen Bruno in 2008 in Connecticut, where a state court directed an equitable distribution of the Brunos’ marital property as part of the decree. Stephen subsequently disregarded a number of orders of the divorce court and did not transfer the taxpayer her share of marital property. Between 2008 and 2013, Lisa filed 29 motions for contempt against her ex-husband, and he was found in contempt on at least four occasions. In addition, Stephen filed for bankruptcy in 2015, resulting in further litigation.

Lisa claimed a theft loss of approximately $2.5 million on Form 1040-X, Amended U.S. Individual Income Tax Return, for 2015, filed in 2017, stemming from Stephen’s failure to transfer the marital property. The IRS issued a notice of deficiency in which it disallowed the theft loss. Lisa challenged the IRS’s determination in Tax Court.

Issues: Sec. 165(a) allows individual taxpayers to deduct losses arising from theft that are sustained during the tax year and not compensated by insurance or otherwise. To claim a deduction for a theft loss, a taxpayer must prove a theft occurred under the law of the relevant jurisdiction and that the loss was sustained in the year the deduction is taken.

Sec. 165(e) provides that a theft loss is treated as sustained in the year in which the taxpayer discovers the loss. However, if a claim for reimbursement with respect to which there is a reasonable prospect of recovery exists, Regs. Sec. 1.165-1(d)(3) provides that no portion of the loss is deductible until the tax year in which it can be ascertained with reasonable certainty whether such reimbursement will be received.

Lisa contended that Stephen’s actions constituted felony embezzlement under Connecticut law. The IRS, while agreeing that embezzlement constitutes theft, did not agree that Stephen’s actions were embezzlement under Connecticut law.

Holding: The Tax Court held that Lisa was not entitled to a theft loss deduction for 2015 because she had not sustained the claimed theft loss in that year.

The court first considered whether a theft had occurred under state law. The court noted that the failure to transfer marital property is not an uncommon occurrence and that Lisa pointed to no case law or other Connecticut authority establishing that an ex-spouse commits embezzlement or other theft when held in civil contempt for failing to pay a marital property debt. However, the court found that it did not have to decide whether a theft occurred under Connecticut law, because, assuming a theft had occurred, Lisa was not entitled to a theft loss deduction for 2015, finding that she did not sustain a deductible theft loss in 2015 under Regs. Sec. 1.165-1(d)(3).

Under Regs. Sec. 1.165-1(d)(2)(i), whether a taxpayer has a reasonable prospect of recovery at the end of the year is a question of fact to be determined upon an examination of all facts and circumstances. Based on Lisa’s facts and circumstances, the court found she had a reasonable prospect of recovery on her existing claims for reimbursement from a variety of sources. The court noted that Lisa had over $1 million of marital property by the end of 2015 and had commenced litigation against Stephen, his current spouse, and his mother to recover additional sums, and there was a substantial possibility that the claims would be decided in her favor. Thus, at the end of 2015, reasonable certainty that she would not be reimbursed for her theft loss did not exist, and, therefore, under Regs. Sec. 1.165-1(d)(3), she had not sustained a deductible theft loss in 2015.

• Bruno, T.C. Memo. 2020-156

— By Maria M. Pirrone, CPA, LL.M., and Joseph Trainor, CPA, Ph.D., CFA, both associate professors of accounting at St. John’s University, Queens, N.Y.