IRS criminal investigations

Why the Tax Court Denied a Theft Loss


In the case of theft loss due to embezzelment, it’s up the business to prove the existence of the loss. In a new case, Torres, TC Memo 2021-66, 6/2/21, the business owner failed to meet his burden of proof.

Aug 17th 2021
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If a small business is victimized from inside by embezzlement, the business can generally deduct a theft loss on its tax return for the year of the loss.

Under Section165 (a) of the Tax Code, a business may deduct losses sustained during the tax year and not compensated by insurance or some other means. Generally, to substantiate a theft loss deduction, the taxpayer must prove that a theft actually occurred under the law of the relevant state and the amount of the loss.

For these purposes, a “theft” is broadly defined to include larceny, embezzlement and robbery. Normally, a loss is regarded as arising from theft only if there is a criminal element to the appropriation of the taxpayer’s property.

To be able to claim a theft loss deduction, the taxpayer must prove:

  • That a theft occurred under the law of the jurisdiction where the alleged event took place
  • The amount of the loss
  • The date the taxpayer discovered the loss

The taxpayer bears the burden of proving by a preponderance of evidence that a theft actually occurred.

Facts of the new case: The taxpayer, a resident of California, co-founded an S corporation specializing in water products. He was the sole shareholder, president and chief executive officer in 2016. Beginning around 2010, the co-founder was no longer an owner, but she continued to manage the company’s books and records.

The taxpayer suffered an injury from an illness in 2016 that left him unable to work for the most of the year and he didn’t file a timely federal income tax return. At this point, he was unable to read and relied upon others to handle the company’s taxes. Pursuant to the advice of a bookkeeper, the company issued the co-founder a Form 1099-MISC, reporting more than $166,000 in nonemployee compensation for 2016.

Eventually, the taxpayer was able to read again and resumed handling the company’s tax matters. In 2018, the taxpayer filed a civil suit against the co-founder and later amended the complaint in 2019. In his complaint, the taxpayer alleged that he had discovered the co-founder’s embezzlement in 2017.

The taxpayer deducted the embezzlement loss on the company’s 2016 return, but the IRS issued a deficiency. In his response, the taxpayer offered an alternative claim of deductible compensation. Now, the Tax Court has decided the matter.

Tax outcome: The Tax Court examined the definition of embezzlement under state law. One of the requirements is a clear intent to defraud, but the taxpayer didn’t provide any evidence that the co-founder intended to defraud the company. So, the Court denied the deduction outright.

Furthermore, the Court noted that even if a theft loss had occurred, it wasn’t discovered until 2017, and not 2016. As stated earlier, such a loss can only be deducted in the year of discovery.

Finally, the Court also denied the taxpayer's alternate argument of a deduction for compensation. Case closed.

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