In a recent Tax Court opinion[1], the taxpayer Michael Shaut (“Mr. Shaut”), representing himself, contested the IRS’s determination of a tax deficiency. The court had to decide on several key issues, including whether Mr. Shaut was entitled to deductions for theft loss, legal fees, and net operating losses, as well as whether he was liable for an accuracy-related penalty under Section 6662(a).
Mr. Shaut, an attorney and entrepreneur, invested heavily in Downing Investment Partners, LLP (“Downing”) both in equity, as well as loans to Downing which were never repaid to Mr. Shaut. Mr. Shaut himself served as Downing’s president and fundraiser for a short period of time, before resigning from such positions and later describing Downing as a Ponzi scheme. His investment and involvement in Downing led to substantial financial losses and legal troubles. Mr. Shaut claimed approximately $600,000 in legal fees and $720,000 in losses related to his investment in Downing, although he lacked complete documentation for these amounts.
The IRS examined Mr. Shaut’s 2019 tax return and issued a Notice of Deficiency, determining a deficiency of $38,149. In response, Mr. Shaut filed an amended return to correct errors and claim additional deductions. Specifically, Shaut asserted he was entitled to a theft loss deduction related to Downing and a carryover net-operating loss of approximately $570,000. His previous tax returns for 2017 and 2018, which included significant losses and carryforward amounts, were also relevant to his 2019 claims. Ultimately, the court found that Mr. Shaut failed to substantiate any theft loss deduction (as well as other claims he made in the alternative which are beyond the scope of this article) and sustained the IRS’s deficiency and penalty determinations, with adjustments based on the parties’ concessions.
Mr. Shaut’s Burden of Proof
The taxpayer generally bears the burden of providing a Notice of Deficiency erroneous[2], as well as proving entitlement to any deduction claimed.[3] To meet this burden, the taxpayer claiming a deduction must demonstrate the relevant deduction is provided for by statute and must maintain sufficient records in support of such deduction.[4]
Theft Loss Deduction, Generally[5]
Generally, a taxpayer may deduct losses arising from a casualty or loss, including theft, when such loss is not compensated or reimbursed by insurance or otherwise.[6] However, the process of claiming such deductions is intricate and requires substantial evidence and adherence to specific regulations.
To qualify for a theft loss deduction, a taxpayer must prove the existence of the theft, the amount of the deductible loss, and the year in which the loss was discovered.[7] Additionally, the alleged loss must be the result of a criminal act under the law of the state where the theft occurred,[8] and to be valid, there must be no reasonable prospect of recovery for the theft loss deduction.[9] The measure of a theft loss is the difference between the fair market value of the property before and after the theft.[10]
Mr. Shaut Did Not Qualify for a Theft Loss Deduction
Any loss arising from theft is treated as sustained during the taxable year in which the taxpayer discovers the loss.[11] In the case of Mr. Shaut, he failed to provide reliable evidence indicating when he discovered the purported theft. Pursuant to Mr. Shaut’s own testimony, the court found that his investments and purported loans to Downing occurred before 2019, and most of his legal fees were for years other than 2019, the tax year at issue. Further, Mr. Shaut’s testimony revealed Mr. Shaut was aware in 2016 that a principal of Downing had been misleading him and other investors. Therefore, Mr. Shaut knew before 2019 that Downing was a financial failure and that he would not recover his investment. Consequently, he failed to demonstrate that his purported theft losses were discovered in 2019, disqualifying him from claiming a theft loss deduction for that year, and the statute of limitations had since run for any prior year in which Mr. Shaut could have claimed such theft loss deduction.
Moreover, Mr. Shaut did not meet the burden of proving that he was the victim of theft. Despite his claims of no intimate involvement in Downing’s operations after his role as president ended, the court found that his extensive business expertise and involvement in raising funds for Downing suggested otherwise, and that his self-serving testimony was insufficient to meet the burden of proof required, being that Mr. Shaut was the victim of theft under relevant state law. Furthermore, the court deemed Mr. Shaut’s investments in Downing to be bad business decisions rather than theft losses. The theft loss provision under Section 165 is not designed to cover all economic losses.[12] The court found that there was no credible evidence that Mr. Shaut lost all his investment and was never repaid for his loans, and therefore found that Mr. Shaut failed to meet his burden of demonstrating the amount of the theft loss as required under Section 165.
Additionally, Mr. Shaut failed to demonstrate that his legal fees or expenses were the result of a purported theft loss. Litigation costs may be included as further or additional theft losses in certain circumstances.[13] However, since there was no theft loss in the first instance, Mr. Shaut’s claimed legal fees and other costs related to Downing civil litigation were not eligible as deductions for a theft loss. Despite the financial difficulties Mr. Shaut faced, he failed to substantiate his entitlement to a theft loss deduction for 2019 or any other year.
Conclusion
The case of Mr. Shaut highlights the complexities involved in claiming theft loss deductions. Taxpayers must provide substantial evidence and adhere to specific regulations to qualify for such deductions. The burden of proof lies with the taxpayer to demonstrate the existence, amount, and timing of the loss. Without credible evidence and proper documentation, claims for theft loss deductions are likely to be disallowed.
[1] Michael H. Shaut v. Comm’r, T.C. Memo. 2024-103.
[2] Welch v. Helvering, 290 U.S. 111, 115 (1933).
[3] INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).
[4] Hradesky v. Comm’r, 65 T.C. 87, 89–90 (1975), aff’d per curiam, 540 F.2d 821 (5th Cir. 1976).
[5] For a more in-depth dive into deductions under IRC § 165, see Josh Sage’s prior article here: https://esapllc.com/baum-2021/
[6] IRC § 165(a), (c).
[7] IRC § 165(e).
[8] Paine v. Comm’r, 63 T.C. 736, 740 (1975).
[9] Treas. Reg. §1.165-8(a)(2).
[10] Treas. Reg. §§1.165-7(b)(1), 1.165-8(c).
[11] IRC § 165(e); Treas. Reg. §1.165-1(a).
[12] Friedman v. Comm’r, T.C. Memo. 1992-588.
[13] Ander v. Comm’r, 47 T.C. 592, 595 (1967).
