Step 4: Determine whether the investor has a reasonable prospect of recovery.

Treasury Department Circular 230 § 10.22(a) Diligence as to Accuracy states:

A practitioner must exercise due diligence in determining the correctness of oral or written representations made by the practitioner to clients with reference to any matter administered by the Internal Revenue Service.

It is settled law that deductions are a matter of legislative grace and the taxpayer must prove that they are entitled to the claimed deductions. INDOPCO Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934). “The law does not require that the damages be determined with mathematical certainty. It only requires that damages be capable of measurement based upon known reliable factors without undue speculation.” Ashland Management Inc. v. Janien, 82 N.Y.2d 395, 604 N.Y.S.2d 912 (1993).

I.R.C. § 165(e) states that any loss arising from theft shall be treated as sustained in the taxable year the taxpayer discovers the loss. Under §§ 1.165-8(a)(2) and 1.165-1(d), however, if in the year of discovery, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until the taxable year in which it can be ascertained with reasonable certainty whether or not the reimbursement will be received. The Court in Estate of Scofield v. Commissioner, 266 F.2d 154, 163 (6th Cir. 1959) held as follows:

In determining the reasonableness or unreasonableness of a taxpayer's delay in claiming a 23(e) loss deduction, the situation should be viewed as of the time the determination was originally made by the taxpayer, and not as of the time of the tax litigation many years afterward. The only fair test is foresight, not hindsight. Callan v. Westover, D.C.S.D.Cal.1953, 116 F.Supp. 191, 199, affirmed Riddell v. Callan, 9 Cir. 1956, 235 F.2d 190.

            A recommended practice when submitting a theft loss deduction is to provide the IRS an independent, expert opinion as to the amount of the unrecoverable loss. In Premji v. Commissioner, TC Memo 1996-304, aff’d, 139 F.3d 912 (10th Cir. 1998), the Tax Court found the taxpayer’s subjective belief inadequate to sustain the claim and noted that the taxpayer never contacted a bankruptcy attorney to ascertain his chances for a recovery. An expert may be qualified under the Federal Rules of Evidence: “If scientific, technical, or other specialized knowledge will assist the trier of fact to understand the evidence or to determine a fact in issue, a witness qualified as an expert by knowledge, skill, experience, training, or education, may testify thereto in the form of an opinion or otherwise, if (1) the testimony is based upon sufficient facts or data, (2) the testimony is the product of reliable principles and methods, and (3) the witness has applied the principles and methods reliably to the facts of the case (Fed. R. Evid. 702).[1]

Determining whether the investors had a claim for reimbursement that provided a reasonable prospect for recovery is an objective inquiry requiring an examination of the facts and circumstances surrounding the deduction. See Boehm v. Commissioner, 326 U.S. 287, 292-93, 66 S. Ct. 120, 123, 90 L. Ed. 78 (1945) (interpreting predecessor to I.R.C. § 165, § 23(e) of the Revenue Act of 1936, 49 Stat. 1648, 1659); Ramsey Scarlett & Co., 61 T.C. at 811-12.

The existence of a bankruptcy, receivership, or other organized process for marshaling the assets of the party or entity who committed the underlying fraud has been consistently viewed by the IRS as well as the federal courts, as an indicator that a theft loss (or investment loss) should not be claimed. Rather, the loss can only be claimed once it can be “ascertained with reasonable certainty” what precise percentage of the victims loss can be reimbursed. Treas. Regs. §§ 1.165-8(a)(2) and 1.165-1(d), Jeppsen, 128 F.3d at 1415 (quoting Ramsay Scarlett &Co. v. Comm'r, 61 T.C. 795, 811-12 (1974)). Vincentini, 429 F. App'x at 564. Zinn v. United States, 885 F. Supp. 2d 866 (N.D. Ohio 2012), Jensen v. Commissioner, Tax Court Memo. 1993-393, IRS Chief Counsel Advise Memoranda 200305028, 1994.


[1] In Rev. Rul. 2009-9, the Commissioner described the rationale for allowing the taxpayer to deduct a theft loss as soon as there is no known claim for reimbursement:

A may deduct the theft loss in Year 8, the year the theft loss is discovered, provided that the loss is not covered by a claim for reimbursement or other recovery as to which A has a reasonable prospect of recovery.

If A recovers a greater amount in a later year or an amount that initially was not covered by a claim as to which there was a reasonable prospect of recovery, the recovery is includible in A’s gross income in the later year under the tax benefit rule, to the extent the earlier deduction reduced A’s income tax.

Rev. Rul. 2009-9 at 7.