As Wall Street stocks decline with charges of corporate misconduct, investors may question whether investment losses can turn into tax losses. Tax losses are useful and may help take the sting out of a large investment loss.
Does federal tax law support losses due to corporate misconduct? Will the IRS challenge such deductions? This article answers these important questions.
Some aggressive tax advisors have encouraged investors to deduct stock losses as a "theft loss." Such a theory is premised upon the belief that the decline in market value of their stock is caused by accounting fraud or other illegal misconduct of the officers or directors of the corporation that issued the stock.
But taxpayers beware! The IRS does not agree with this tax-law theory and earlier this spring issued a notice warning taxpayers that it intends to disallow such theft loss deductions and may even impose penalties.
Whether a loss constitutes a theft loss is determined by state law where the alleged theft occurred. To claim a theft loss, the taxpayer must prove that the "loss resulted from a taking of property that is illegal under the law of the state where it occurred and that the taking was done with criminal intent." For almost every stock investor making open market purchases, this proof is difficult to provide.
In cases involving stock purchased on the open market, the courts have consistently disallowed theft loss deductions relating to a decline in stock value. The courts have not endorsed theft losses attributable to corporate officers misrepresenting the corporation's financial condition, even when the corporate officers are indicted for securities fraud or other criminal violations.
For example, in Paine v. Commissioner, the taxpayers claimed a theft loss deduction for a decline in value of stock stemming from misrepresentations of the financial status of the corporation by corporate officials. The court denied the deduction and noted that the taxpayers did not purchase the stock from the corporate officers who made the misrepresentations but rather on the open market. In MTS International Inc. v. Commissioner, an individual taxpayer sold at a loss stock that was acquired on a public stock exchange and argued that the substantial decline in value was due to criminal conduct by the corporation's officers. The Sixth Circuit concluded that the loss was not a theft loss and also denied the tax deduction.
But the tax law does contain provisions allowing loss deductions. The federal tax law allows a deduction for any loss sustained during the taxable year not compensated for by insurance or otherwise. Deductions for losses for individuals are limited to: (1) losses incurred in a trade or business; (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business; and (3) losses of property not connected with a trade or business or a transaction entered into for profit, if such losses arise from fire, storm, shipwreck, or other casualty, or from theft. The individual taxpayer must "evidence" such loss by a closed and completed transaction, fixed by an identifiable event or events, and actually sustained during the taxable year.
For most investors, stock held for investment is a capital asset. The tax law limits the amount that individual taxpayers may deduct for losses from sales or exchanges of capital assets. Under these capital loss limits, a taxpayer who owns stock that was acquired on the open market for investment and that has declined in value is allowed a deduction for a capital loss in the taxable year in which the stock is sold or exchanged or becomes wholly worthless.
Mere Value Decline Not Enough
Just as market appreciation is not currently taxed, market declines generally are not deductible. Tax regulations expressly provide that no deduction shall be allowed solely on account of a decline in the stock value when the decline is due to a fluctuation in the market price of the stock or to another similar cause. A mere decline in stock value is not deductible until the taxable year in which the loss is actually sustained as a result of the sale or exchange or the stock becoming wholly worthless.
Conclusion
In an effort to change taxpayer behavior, the IRS issued a notice warning that it will challenge taxpayers who assert theft loss for stock investment losses. The Service states expressly that it will disallow a deduction for a theft loss relating to a decline in the value of stock that was acquired on the open market for investment. Careful taxpayers will consider this new notice and consider the case law that limits tax deduction for stock losses before such shares are sold or become worthless.
Jim Walker is RJ&L's senior tax partner. His practice focuses on providing clients with expert and innovative tax advice. He regularly represents taxpayers before federal and state administrative agencies, including the Department of Justice and the Colorado Department of Revenue. Mr. Walker is a Fellow of the American College of Tax Counsel and the American College of Trust and Estate Counsel.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
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