US Taxpayers who lose funds due to “fraud” may declare an income tax deduction for their theft loss in the tax year they discover the theft loss (see: IRC sec. 165(a), 165(c)(3), 165 (e) (1). For IRS audits, it is not required that the affected Taxpayer recover their “fraud losses” only that they pursue collection of their lost funds (by lawsuit, or otherwise). Under IRC Sec. 111, in the event the Taxpayer recovers any of their lost funds they must declare the recovery as income in the tax year received.
As an income tax planning strategy, a “theft loss” may generate: tax savings, tax refunds, tax-free income:
1) In 2014, the maximum California/Federal “blended tax rate” is approximately 55%. So if the fraud loss is $10m, the income tax savings may be as high as $5.5m;
2) Tax Refunds: Under IRC Sec. 172 (b) (1) (F), the theft tax loss may be “carried back” for 3 years (by filing form 1040x for those tax years) with any income taxes paid (during the 3 prior carry back years) subject to refund;
3) Tax-free Income: The Tax Loss for theft may be carried forward for up to 20 years under IRC Sec. 172, offsetting any taxable income, creating tax-free income up to the amount of the theft loss.
Theft is the illegal taking of money or property with the intent to deprive the owner of it. (W. Lafave, Criminal Law section 8.5, at 721 (2d Ed. 1986)). Theft includes, but is not limited to, larceny, embezzlement, and robbery. (Reg. Section 1.165-8(d)).
California Penal Code Section 484(a)
Taxpayer is a resident of the State of California. Under State Law, California Penal Code Section 484(a) theft is defined to include fraud:
Every person who shall feloniously steal, take, carry, lead, or drive away the personal property of another, or who shall fraudulently appropriate property which has been entrusted to him or her, or who shall knowingly and designed by, any false or fraudulent representation or pretense, defraud any other person of money, labor or real or personal property, or who causes or procures others to report falsely of his or her wealth or mercantile character and by thus imposing upon any person, obtains credit and thereby fraudulently gets or obtains possession of money, or property or obtains the labor or service of another, is guilty of theft.
Gerstell v. Commissioner of IRS (Federal Law)
In the case of Gerstell (Petitioner) v. Commissioner of Internal Revenue (Respondent) 46 T.C. 161 (Docket No. 4299-64, filed May 4,1966) (Exhibit “2”), the Tax Court States (at Page 7):
Section 165 of the Internal Revenue Code of 1954 provides for the deduction of losses arising from theft. The term Theft . . . converting any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.
Edwards v. Bromberg (C.A. 5) 232 F. 2d 107, Perry A. Nichols, 43 T.C. 842 (appeal dismissed C.A. 5) See also Sec. 1.165-8(d), Income Tax Regs. The parties are not at odds on this respect. Indeed, the Respondent concedes on brief that losses sustained by reason of criminally false pretenses are deductible under Section 165 of the Code. Whether a loss arises from theft depends upon the law of the jurisdiction where the loss was sustained. Edwards v. Bromberg, supra.
And it has been held that a criminal conviction is not a necessary element in a Taxpayer’s proof that a theft loss has been sustained.
See: Michele Montelone 34 T.C. 688, Paul C.F. Vietzke 37 T.C. 504