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Losses in Pump-and-Dump Stock Scheme Are Capital, Not Theft, Losses.

(Parker Tax Publishing July 5, 2015)

Because there was no direct transfer of money from the taxpayers to the individuals operating a pump-and-dump stock scheme, or to such individuals' corporate alter egos, the taxpayers were limited to a capital loss, rather than theft loss, deduction. Greenberger v. U.S., 2015 PTC 205.

Background

Robert and Penny Greenberger first heard of Spongetech Delivery Systems, Inc. in 2008 from their friend, Douglas Furth. Furth was a professional financial and investment advisor, and was also one of the biggest individual shareholders in Spongetech, owning over 50 million shares. Furth spent years aggressively promoting Spongetech and, as a result, the Greenbergers purchased Spongetech stock. Robert began extensively trading in the stock and all his stock trades were made on the open market; none of the purchases were directly from Spongetech, its affiliates, or any individuals associated with Spongetech. Furth introduced Robert to Steven Moskowitz, Spongetech's Chief Operating Officer and Chief Financial Officer. Robert and Moskowitz talked on the phone dozens of times from 2008 to 2009, and Moskowitz promoted Spongetech's prospects to Robert.

Spongetech reported large revenue gains in 2007 through 2009. In reality, several of Spongetech's executives, including Moskowitz, were running a "pump-and-dump" scheme. They publicized fictitious sales to nonexistent customers that accounted for the vast majority of Spongetech's reported sales. When the price of Spongetech stock increased in response to these reported sales, Moskowitz and the others illegally profited by selling approximately 2.5 billion unregistered shares through various corporations they controlled, pocketing millions of dollars. Eventually, Spongetech's implausible reported sales raised suspicions. Rumors of fraud circulated in the press and online investor forums. Spongetech failed to timely make required Securities and Exchange Commission filings, raising more red flags.

In July 2010, Spongetech filed for bankruptcy and trading in its stock was permanently banned in November 2010. The following month, Moskowitz and several other Spongetech executives were indicted for criminal securities fraud. By the end of 2010, the SEC had permanently barred trading in Spongetech stock, making the billions of outstanding shares worthless. The Greenbergers were left holding 7.5 million worthless shares, losing approximately $569,000 on the stock. In 2012, the Greenbergers filed an amended 2010 tax return claiming a theft-loss deduction and requesting a refund of $177,000. The IRS disallowed the theft-loss deduction and the Greenbergers filed suit in district court.

Analysis

Code Sec. 165(c)(3) and Reg. Sec. 1.165-8 allow individual taxpayers to deduct from their taxable income losses arising from theft crimes such as "larceny, embezzlement, and robbery."

The disagreement between the Greenbergers and the IRS was not whether the Greenbergers could claim a loss on their Spongetech stock but rather what type of loss a theft loss or a capital loss. The main point of contention was whether Moskowitz or Furth intentionally took the Greenbergers' property because, under Rev. Rul. 2009-9, a taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Alternatively, the Greenbergers argued that even if they were not the victims of a "theft," they were still the victims of a "theft offense" and therefore qualified for a theft-loss deduction. Since the transactions occurred in Ohio, the district court looked to the definition of "theft" and "theft offense" under Ohio law to determine whether the Greenbergers were eligible for a theft loss deduction.

The district court held that the Greenbergers were not entitled to a theft loss deduction. Under Ohio law, the court noted, a person is guilty of "theft" if "with purpose to deprive the owner of property . . . [he] knowingly obtain[s] or exert[s] control over the property" in any of five specified ways, including deception. To establish theft by deception, the court said, it must be proven that the accused engaged in a deceptive act to deprive the owner of the possession of property or services, and that the accused's misrepresentation actually caused the victim to transfer property to the accused. According to the court, for the Greenbergers to succeed, they had to show two things: (1) that Moskowitz or the other Spongetech executives acted with the specific intent to take the Greenbergers' property through their fraud; and (2) that as a result, the Greenbergers transferred their property to these wrongdoers. The court noted that, due to the lack of direct connection between a wrongdoer and a victim, a theft-loss deduction is generally not allowed in cases where the value of shares bought on the open market declines due to fraud.

The Greenbergers, the court said, bought their Spongetech shares on the open market, without any knowledge of who was on the other side of the transaction. The court did note that it was very possible that at least some of the shares the Greenbergers bought came from the fraud perpetrators, given that the number of Spongetech shares illegally distributed by the fraudsters (about 2.5 billion) far exceeded the number of legitimately issued and outstanding shares (about 700 million). But this was ultimately immaterial, the court said, as the purchase of these shares was done in the open market on the OTC Bulletin Board, rather than being purchased directly from Spongetech or its executives. Just as importantly, the court found that the Greenbergers did not show that Moskowitz or any other Spongetech executive targeted the Greenbergers with the specific intent to take their money. The court noted that, while Robert talked with Moskowitz dozens of time, he did not allege, nor present any evidence, that Moskowitz ever encouraged him to buy Spongetech stock.

Separately, the court considered the Greenbergers' argument that Furth specifically targeted them and that created sufficient privity to make them the victims of a theft. The court concluded that, even if Furth was an agent of Spongetech, the fact that the Greenbergers purchased their shares on the open market still made the Greenbergers ineligible for the theft-loss deduction.

Finally, the court found that the Spongetech executives committed a "theft offense" through their violations of federal securities law. However, the court said, the term "theft offense" does not itself define a substantive crime it is merely a list of other crimes that are grouped together under Ohio law. The term "theft offenses," the court said, is broadly defined and captures a wide array of property crimes and crimes of dishonesty. Not all "theft offenses" require the accused to have taken the property of the victim; for example, forgery and record tampering are both "theft offenses," but neither requires taking property. As such, the court concluded, these would not fit within the IRS's theft-loss regulations as "theft crimes such as larceny, embezzlement, and robbery" even under a general and broad reading, as there is no "criminal appropriation of another's property to the use of the taker.

Because the Greenbergers were not victims of theft within the meaning of Code Sec. 165(c)(3), the district court held the taxpayers were not able to take theft loss deductions from their worthless securities and thus were not entitled to the refunds they sought.

For a discussion of the deductibility of declines in stock value, see Parker Tax, ¶84,512. (Staff Editor Parker Tax Publishing)

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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