No Theft Loss Allowed for Taxpayer's "Bad Business Decisions"

(Parker Tax Publishing November 2024)

The Tax Court held that a taxpayer could not deduct as a theft loss under Code Sec. 165 legal fees he incurred after he was named as a defendant in lawsuits brought by investors in a company he managed and invested in, which later turned out to be a Ponzi scheme. The taxpayer claimed that the legal expenses were related to his protection and defense of his investment in the company, but the court found that he failed to prove he was a victim of theft given his extensive business background and his efforts to bring on investors who were ultimately victims of the scheme. Shaut v. Comm'r, T.C. Memo. 2024-103.

Background

Michael Shaut is an attorney with significant experience in business, economics, and finance. Shaut worked as a bank lawyer and then at a firm in a business consulting role. Eventually, he started a student loan company with former clients, which he ultimately sold to a Fortune 200 company. In 2008, Shaut started a solar energy company named Carbon Vision, LLC (Carbon Vision), where he served as the chief executive officer.

In February 2014, Shaut began investing in a company called Downing Investment Partners, LLP (Downing). Initially, Shaut transferred $250,000 to Downing as part of his investment, and he made additional investments in Downing. Though Downing purported to be engaged in the development of patentable technology, the first investment started what Shaut described as a ten-year saga related to the Downing 'Ponzi" scheme. Shaut also made several loans to Downing from approximately 2014 through 2016, as the partnership experienced cashflow issues. The loans, ranging from the low five figures to over $100,000, were never repaid.

In March 2014, Shaut began working as Downing's president with a salary of $200,000. He served in that role until September 2014. According to Shaut, he stopped receiving a salary after he made his second investment in Downing and stopped serving as its president at that time. In total, Shaut received approximately $100,000 of his salary in 2014.

In February 2015, Shaut became a managing director of Downing, instead of an officer, so that he could fundraise for the company. In this role, he recruited several individuals to invest substantial sums, each investing $1 million or more. Shaut disclaimed receiving any compensation for raising funds. However, he was given preferred or special investment options, such as warrants.

Eventually, a potential investor conducted significant due diligence into Downing's business practices. Despite potential financial issues with Downing, in June 2016, the investor lent $1,250,000, secured by Downing's anticipated patent technology. The loan was funded on the condition that the money be used for technological developments. In June of that year, Shaut also lent another $60,000 to Downing. Shaut was not repaid from any investor contributions.

Meanwhile, no progress was made on the development of Downing technology. Eventually, in approximately 2016, investors determined that principals of Downing had been misleading them and mismanaging Downing. Shaut stated that it became clear that one of the principals was dishonest and could not be trusted.

These discoveries led to legal action, including approximately 17 lawsuits, wherein Shaut was named as a defendant. These lawsuits predominantly occurred and were resolved in the two years after the 2016 investor discoveries.

Two principals of Downing were eventually investigated, prosecuted, and sentenced to prison in 2019 for their roles in the scheme. Shaut claimed that he spent approximately $600,000 in legal fees related to Downing. Further, Downing cost him all the money he had previously made, leaving him broke. Thus in 2019, Shaut began practicing law again at the age of 67.

On a Form 4684, Casualties and Thefts, attached the Shaut's 2019 tax return, Shaut claimed a fraud or casualty loss related to Downing. His purported loss was comprised of a $720,000 investment in Downing and approximately $600,000 in attorney's fees. On the form, Shaut stated that he was the victim of investment fraud, with no recovery made.

Code Sec. 165(a) and (c) allows a deduction for losses arising from a qualifying casualty or loss, including theft, not compensated for by insurance or otherwise. Under Reg. Sec. 1.165-8(d), theft includes, but is not limited to, larceny, embezzlement, or robbery.

To deduct a theft loss, a taxpayer is required under Code Sec. 165(e) and Reg. Sec. 1.165-8(a) to prove (1) the existence of a theft, (2) the amount of the deductible loss, and (3) the year in which the loss was discovered. The act resulting in the alleged theft loss must have been a criminal act under the law of the state in which the alleged theft occurred. Under Code Sec. 165(e) and Reg. Sec. 1.165-1(a) and (d)(3), any loss arising from theft is treated as sustained during the tax year in which the taxpayer discovers such loss. Reg. Sec. 1.165-8(a)(2) provides that there can be no reasonable prospect of recovery for a theft loss deduction.

Shaut claimed that he was entitled to a theft loss deduction for the $600,000 in legal expenses he incurred because the expenses were related to his protection and defense of his investment in Downing. Alternatively, Shaut contended that his legal expenses were deductible as ordinary and necessary business expenses under Code Sec. 162(a).

Analysis

The Tax Court held that Shaut was not entitled to a theft loss deduction or business expense deduction for 2019.

As an initial matter, the court found that there was no evidence indicating when Shaut discovered that the purported theft occurred. Shaut knew before 2019, the court found, that Downing was a financial failure, that improper activity occurred, and that he would not recover his investment. For these reasons alone, the court concluded that Shaut failed to carry his burden of demonstrating that his purported theft losses were "discovered" in 2019, thus entitling him to a casualty loss deduction for that year.

But, to the extent any loss could be attributed to 2019, the court said that Shaut failed to prove that he was the victim of theft. The court noted that Shaut was the president of Downing for six months. Although he claimed no intimate involvement in the Downing operations after his role as president ended, Shaut's explanation was, in the court's view, implausible and not credible. The court observed that Shaut had extensive business expertise; he started multiple successful businesses. After his role as the president at Downing, he served the crucial role of raising millions of dollars for Downing. Indeed, he brought on investors who were ultimately victims of the Downing scheme. Further, to the extent Shaut was somehow unaware of the irregularities at Downing, the court found that he did not demonstrate that his investments in the company were anything more than a "bad business decision." According to the court, the casualty and theft loss provision under Code Sec. 165 is not intended to "take care of all losses that the economic world may bestow on its inhabitants." There was also no evidence, the court said, that Shaut lost all of his investment and was never repaid for his loans.

Finally, the court found that Shaut did not demonstrate that his legal fees or expenses were the result of a purported theft loss. The court explained that litigation costs may be included as further or additional collateral theft losses in certain circumstances. Here, because there was not theft loss in the first instance, Shaut's legal fees and expenses were not eligible as deductions for a theft loss.

The court also rejected Shaut's alternative claim that his legal expenses were deductible under Code Sec. 162 after finding that he failed to show the expenses were incurred in the ordinary course of conducting a trade or business. Rather, Shaut claimed that these expenses were related to a fraud loss. Even more problematic for the court was that Shaut's alternative position was entirely inconsistent with his claimed role at Downing. On the one hand, Shaut claimed that he was merely an individual who helped raise money for Downing and that he had no role in its day-to-day operations. On the other hand, he now claimed that he was engaged in a business at Downing and was entitled to deduct nearly $600,000 in legal fees as an ordinary and necessary expense. The court said that Shaut could not have it both ways.

For a discussion of theft losses in general, see Parker Tax ¶84,510. For a discussion of the deduction for ordinary and necessary business expenses, see Parker Tax ¶90,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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