Category: Individuals; Deductions & Credits
Subject: Losses
Title: Theft Loss/Bank Seizure
IRC Sections: 165(g)
Filename: 1259.html
Date Produced: 08/95

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Background
Individual taxpayer, TP, was a major shareholder in a commercial bank. Due to various acts of embezzlement, presumably criminal acts, the bank was seized by the FDIC. TP's investment became worthless as a result.

Issue
Is there any basis on which TP can claim a theft loss rather than a short-term capital loss under Section 165(g)?

Answer
Unless the embezzlement constitutes theft under state law with respect to TP, there is no basis for claiming a theft loss in the circumstances set out above.

Discussion
Theft is the unlawful taking of money or other property with the criminal intent of depriving the owner of such money or property. Whether or not an act constitutes theft for tax purposes is determined under the laws of the state in which the act occurred. Edwards v. Bromberg 32 F.2d 107, 56-1 USTC ¶9448 (C.A. 5, 1956) and Paine v. Commissioner [Dec. 33,113], 63 T. C. 736, 740 (1975), affd. without opinion 523 F. 2d 1053 (5th Cir. 1975).

Quite a number of cases have considered whether admittedly criminal acts on the part of corporate officers resulting in loss of stock value constitutes a theft loss at the shareholder level. All have concluded in the negative. The cases involve various criminal violations of federal and/or state securities laws leading to total loss of market value. The cases conclude that the acts do not constitute theft with respect to the shareholder either because such acts do not constitute theft under state law or because the taxpayer-shareholder lacked privity. See Crowell v Commr, TC Memo 1986-314, 51 TCM 1556, ¶86,314 P-H TC Memo. DeFusco v. Commissioner [Dec. 36,129(M)], T.C. Memo. 1979-230. Barry v. Commissioner [Dec. 35,205(M)], T.C. Memo. 1978-215, Paine v. Commissioner [Dec. 33,113], 64 T.C. 736, 741-742 (1975), affd. without published opinion 523 F.2d 1053 (5th Cir. 1975). Unfortunately, none of these cases involve embezzlement of corporate funds, per se.

In the case of D.C. Solomon v. Commr., 37 TCM 218, the taxpayer lost what was presumably a capital contribution to her closely-held corporation because a corporate officer allegedly misappropriated the funds. In Solomon, the taxpayer was not even able to establish that the alleged misappropriate constituted embezzlement with respect to the corporation, let alone the individual.

Various courts and published rulings have considered whether a taxpayer's bad debt loss, in contrast with the worthless stock loss in our case, is converted into a theft loss because the debtor's inability to repay the taxpayer is the result of theft. The taxpayers were denied theft losses in all instances. See Locke v. Comr., 8 B.T.A. 534 (1927), acq., VII-1 C.B. 19 (1928); Rev. Rul. 77-383, 1977-2 C.B. 66; Perrotto v. Comr., 36 T.C.M. 464 (1977); and Sandquist v. Comr., 37 T.C.M. 1191 (1978). Incidentally, all these cases, with the exception of Locke, deal with bank depositors who lost funds deposited in failed banks which were closed due to embezzlement of bank funds.

In think it is quite clear that the reasoning enunciated in these cases applies equally to the facts at hand. Embezzlement of bank property does not convert what would otherwise be a loss on worthless securities into a loss from theft.

I think the language of Perrotto, supra, is quite telling.

In our case petitioner's property was not embezzled. Rather, the bank's property was embezzled and as a consequence the bank became insolvent. Petitioner cites us to no authority which would extend the concept of a theft loss to cover a theft's indirect secondary result to the victim's creditor. Nor has petitioner advanced any plausible reasons why this kind of bad debt is any less a bad debt than any other.

Again, I see no reason why the principle of Perrotto and the other related cases should not be equally applicable to the present situation. If a bad debt cannot be transformed into a theft loss, why should a worthless stock loss be so transformed?
Incidentally, even if the stock loss could be properly treated instead as a theft loss, it is very likely that the alternative minimum tax system would deny any substantial benefit. A theft loss of an asset held for profit but not used in a trade or business [a Section 165(b)(2) loss] is a miscellaneous itemized deduction (subject to the 2% floor) and added back for purposes of AMT.

From a technical point of view, Section 56(b)(1)(A) prohibits an AMT deduction for miscellaneous itemized deductions. Casualties with respect to personal use property under Section 165(c)(3) are excluded from the category of miscellaneous itemized deductions by Section 67(b)(3) and thus avoid the add-back for AMT purposes. Casualties with respect to trade or business property [Section 165(c)(1) losses] are above-the-line and thus avoid the AMT issue altogether.

As a practical matter, the easiest way to see this result is to look at Form 4684 and the treatment of line 34(b)(i) [trade or business property] versus the treatment of line 34(b)(ii) [property held for investment or production of income].