Insult to Injury Properly Documenting and Taking Bad-Luck Deductions

In a recent case involving taxpayers Ronnie S. Baum and Teresa K. Baum, the IRS disallowed many deductions, including deductions for theft losses and worthless securities.[1] This case is a quick and helpful reminder of some common deduction rules.

Fact Summary

This case relates to events occurring between years 2010 and 2019. The tax years at issue were 2015 and 2016. In the years at issue, Mr. Baum was a self-employed consultant for Harrington Capital Partners, LLC which provided management, scientific, technical, and consulting services. Mrs. Baum was involved in real estate. Both of their business ventures were reported on Schedule C of their joint Form 1040. In 2015 and 2016, the Baums claimed a number of deductions, including certain deductions for meals and entertainment expenses, office expenses, and car and truck expenses, many of which were disallowed.

In 2010, Mr. Baum sought investment opportunities. In his search, Mr. Baum crossed paths with Scott Zeilinger. Mr. Zeilinger offered Mr. Baum the opportunity to invest in Globe Protect, Inc. (“Globe”). Two years later, in 2012, Mr. Baum entered into a stock purchase agreement with Christel Zeilinger (Scott’s mother) for 100,000 shares of Global for an investment of $150,000. One week later, another 100,000 shares were purchased at the same price.

In late 2014, Mr. Zeilinger filed for bankruptcy. Two of Mr. Zeilinger’s creditors, Angelica and Raul Relucio, received a judgment in their favor in February 2016 related to their acquisition of Global stock.

Tax Return

The Baums’ 2015 tax return claimed a $300,000 theft loss on Schedule A (Itemized Deductions) for the investment in Globe. The return was filed late, in March 2018. Their 2016 return was filed late as well, May 2018.

Basic Deduction Reminders

In typical fashion for a deduction-related case, the Court walked through a mindful, yet cut-and-paste summary of laws relating to deductions.[2] A few of these points are as follows:

  1. The Commissioner’s determinations in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving those determinations are incorrect;[3]
  2. Deductions are a matter of legislative grace, and a taxpayer must prove his or her entitlement to a deduction;[4]
  3. Taxpayers are required to substantiate each claimed deduction by maintaining records sufficient to establish the amount of the deduction and to enable the Commissioner to determine the correct tax liability;
  4. A taxpayer may deduct all ordinary and necessary expenses paid or incurred in carrying on a trade or business; and [5]
  5. The Court may estimate the amount of a deductible expense if a taxpayer establishes that an expense is deductible but is unable to substantiate the precise amount.[6]

Substantiation (Documentation, Documentation, Documentation)

While deductions are subject to substantiation requirements, deductions under IRC § 274 (entertainment-related deductions) are subject to strict substantiation requirements. Typical deductions covered by this statute are travel expenses, including meals, and lodging, and expenses pertaining to passenger vehicles. To meet the heightened standard for substantiation, a taxpayer must substantiate the amount, time, and business purpose of the expense presented as a deduction under IRC § 274.[7]

In the case as issue, the Baums provided no such evidence to support mosttheir deductions claimed for the years at issue under IRC § 274. Unsurprisingly, the IRS denied these deductions and the Court dispensed of the issues quickly in favor of the IRS.

Usually, a taxpayer must produce evidence to substantiate a deduction. Anything helpful can make the difference between getting taxed on gross revenue and getting taxed on the actual profit. Generally, deductions related to business operations are taken under IRC § 162. While a discussion of ordinary and necessary expenses in carrying on a trade or business is beyond the scope of this article, it is noteworthy to point out that the government will extend more deference to deductions under IRC § 162 versus deductions under IRC § 274. Here, however, it can likely be presumed the taxpayer would have failed under IRC § 162 as well considering the taxpayers provided no evidence relating to the deductions or even anything supporting estimates. In previous articles, we have stated time and time again, document, document, document. Something, in lieu of nothing, can be the make or break in supporting and sustaining a considerable deduction.

Theft Losses? No Wait, Worthless Securities!

The Baums initially claimed theft losses for the $300,000 related to the Global stock. Presumably, upon finding out that the claim would not prove successful, the Baums tried to call an audible and opt to take a worthless securities deduction. Both claims ultimately failed.

Theft Loss

While IRC § 165(a) allows a taxpayer to deduct certain losses not compensated by insurance or otherwise, a taxpayer must prove certain elements in order to take a theft loss. Under IRC § 165(a), the taxpayer must prove (1) that a theft occurred, under the law of the jurisdiction wherein the alleged loss occurred;[8] (2) the amount of the loss; and (3) the date the taxpayer discovered the loss.[9] Further, the taxpayer bears the burden of proving by a preponderance of evidence that a theft actually occurred.[10]

In the case of the Baums, certain other rules applied as well. First, in the case of an individual, a loss is deductible under IRC §165(a) only if the loss: (1) is incurred in a trade or business; (2) is incurred in a transaction entered into for profit; or (3) arises from other causes including casualty or theft.[11] “Theft” is broadly defined to include larceny, embezzlement, and robbery.[12] Normally, a loss will be regarded as arising from theft only if there is a criminal element to the appropriation of the taxpayer’s property.[13]

It is worth noting that the test for proving theft here is preponderance of the evidence. In Elliot, the Court discussed further that the burden includes presentation of proof which, absent positive proof, reasonably leads us to conclude that the article was stolen, and that if the reasonable inferences from the evidence point to theft, the proponent is entitled to prevail. The Tax Court provided further in Elliot, stating:

We think that the reasonable inferences from the evidence point to a theft, rather than to a “mysterious disappearance,” as contended by respondent. The jewelry was in a locked jewelry box of about the size of an attache case. The box was kept on a dresser in petitioner’s apartment; and the apartment was in turn secured by two locks. The disarray of the dresser top and the fact that articles had been knocked therefrom to the floor, lead to the inference that the jewelry box was hurriedly snatched by a thief. Also, petitioner filed a claim with an insurance company for a theft loss in respect of two rings that were in the jewelry box and that were insured against loss from theft, as well as other causes; and the insurance company, after investigation, paid petitioner for the rings as a theft loss. We are satisfied that a thief, identity unknown, stole petitioner’s jewelry from her apartment in May 1955. Accordingly, we hold that she sustained a theft loss in that month and year.

Therefore, one can conclude that, while helpful, a criminal conviction against the thief is not a necessity in Tax Court.

Element 1: Occurrence of a Theft

In the Baums’ case, the Court looked to California law in determining whether a theft occurred as the theft purportedly occurred in California. The Baums argued the theft was a result of “fraudulent inducement,” essentially theft by false pretenses, a type of theft recognized under the laws of California (i.e. Mr. Zeilinger effectively swindled the Baums of their $300,000).

California requires a showing (1) of the making of a false pretense or representation to the owner of property, (2) with the intent to defraud the owner of that property, and (3) a transfer by the owner of the property to the person making the false pretense in reliance on such representation.

The Court discussed the fact that Mr. Baum’s testimony indicated that he decided to invest in Globe based on Mr. Zeilinger’s representations that Globe had technology that would purify, disinfect, and desalinate water. Mr. Baum also stated he reviewed the patents owned by Globe with the USPTO as well as viewed a demonstration of the technology. Mr. Baum believed Globe, or its technology, would be sold in short order. Mr. Baum’s belief was based on certain letters of intent related to the acquisition of Globe as well as discussions with the persons sending the letters.

Unfortunately, of all of the information provided, no evidence was presented that specifically indicated that Mr. Zeilinger’s representations were false or made with the intention defraud. At this point, the Baum’s claim for theft loss deductions failed.

Elements 2 and 3: Amount and Time of Loss Due to Theft

As the first element effectively dispensed of the Baum’s theft loss argument, the Court noted that the Baums would not prevail even if the theft element were satisfied, because a taxpayer must also establish the amount and year of the loss. The Court also reminded that a loss has not yet occurred if there exists a “reasonable prospect of recovery” on a claim of reimbursement and that such loss will not be sustained until “the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.”[14]

Whether a reasonable prospect of recovery exists is a fact question to be determined upon examination of all facts and circumstances.[15] While based primarily on objective factors, the taxpayer’s subjective belief may also be considered but is not the sole or controlling criterion.[16]

The Baums failed to prove there was no reasonable prospect of recovery of their investments in 2015. As the Court pointed out, Mr. Zeilinger’s bankruptcy case was still ongoing and Mr. Baum had even filed a proof of claim in the bankruptcy matter, although no separate civil action was filed. Further, the Relucios managed some level of recovery in the bankruptcy case. In short, all was not lost, yet. Accordingly, the Court disallowed the theft loss deductions.

No Wait, Worthless Securities!

In their post-trial brief, the Baums, for the first time, raised deductibility under IRC § 165(c) (trade or business loss) or alternatively IRC § 165(g) (worthless securities). As an initial matter, these issues came up in post-trial briefs as untimely arguments. A party may not raise an issue for the first time on brief if the Court’s consideration of the issue would surprise and prejudice the opposing party.[17] The Baums did not give fair warning to the IRS of their intention to raise this alternative argument.[18] Accordingly, the Court ruled against the Baums.

However, once again the Court gave some “even if” insight with respect to the claims, notwithstanding the fact the issue had already been ruled upon. As to the trade or business loss under IRC § 165(c), an investor is not considered to be in a trade or business with respect to his or her investment activities.[19] While Mr. Baum stated Globe may eventually hire him, there was no evidence before the Court providing that Mr. Baum’s activities were anything north of investing. While another option to deduct did exist under IRC § 165(c)(2) (loss incurred in transaction entered into for profit), the Baums would fail there as well because the “reasonable prospect of recovery” rule applied, which the Court already determined that the Baum’s failed (above).

Lastly, the Court addressed the final argument, worthless securities. The Baums argued that the Globe stock was worthless and therefore they should be entitled to a deduction for their investment as a loss under IRC § 165(g). IRC § 165(g)(1) provides that “[i]f any security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.”

While the taxpayer claimed that the Globe stock was worthless, the Baums failed to provide evidence to support their position that the Globe stock became worthless in 2015 and that there was no “reasonable prospect of recovery.”

Closing Thoughts

We have written many times on a multitude of cases citing the dire importance of documentation if a taxpayer desires to have at least a fighting chance to have its deductions upheld. While admittedly in the hustle and bustle of running a business and trying to make a profit it can be hard to catch every little item, scan each receipt, and keep appropriate logs when necessary, the importance of good, contemporaneous, and consistent documentation cannot be stressed enough. Additionally, different deductions carry different substantiation requirements. Unfortunately, here however, and in many other cases, the Court is given nothing. While it may seem like the Court and the IRS are harsh on taxpayers, something must be presented to support a deduction if a taxpayer enjoys gross income and wants to pay tax on less than the gross amount via a deduction.

[1] Baum v. Comm’r, TC Memo 2021-46.

[2] Because of the number of these types of cases and taxpayer disputes involving such issues, consistent and citable reminders are helpful to drive these points home.

[3] Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933).

[4] INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

[5] IRC § 162(a).

[6] Cohan v. Comm’r, 39 F.2d 540, 543-544 (2d Cir. 1930); Vanicek v. Comm’r,  85 T.C. 731, 742-743 (1985).

[7] IRC § 274(d); see also Treas. Reg. § 1.274-5T(b).

[8] Monteleone v. Comm’r, 34 T.C. 688, 692 (1960).

[9] IRC § 165(e); Elliott v. Comm’r, 40 T.C. 304 (1963).

[10] Jones v. Comm’r, 24 T.C. 525, 527 (1955).

[11] See IRC § 165(c).

[12] Treas. Reg. § 1.165-8(d); see also Bellis v. Comm’r, 61 T.C. 354, 357 (1973), aff’d, 540 F.2d 448 (9th Cir. 1976)

[13] See Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956).

[14] Treas. Reg. § 1.165-1(d)(3).

[15] Treas. Reg. § 1.165-1(d)(2)(i).

[16] Ramsay Scarlett & Co. v. Comm’r, 61 T.C. 795, 811-812 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975); see also Jeppsen v. Comm’r, 128 F.3d 1410, 1418 (10th Cir. 1997), aff’g T.C. Memo. 1995-342.

[17] See Smalley v. Comm’r, 116 T.C. 450, 456 (2001).

[18] Pagel, Inc. v. Comm’r,  91 T.C. 200, 212 (1988), aff’d, 905 F.2d 1190 (8th Cir. 1990).

[19] King v. Comm’r, 89 T.C. 445, 459 (1987); Purvis v. Comm’r, T.C. Memo. 1974-164, aff’d per curiam, 530 F.2d 1332 (9th Cir. 1976).