Many people have experienced the pain of an investment gone wrong. You put money into a business, loan funds to a friend, or participate in a real estate venture, expecting strong returns. But instead of profits, you end up suffering losses when the deal unravels. It leaves you wondering – can I at least deduct the failed investment on my taxes?
At what point does a breach of contract become a theft for tax purposes? The court explores this question in Johnson v. United States, NO. 2:22-CV-00217 (D.S.C. 2023).
Contents
Facts & Procedural History
The taxpayer is a banker by trade. He ended up making unsecured loans with his friend, Harrison, who was a real estate professional.
The unsecured nature of the loans is at issue in this case, as it shows that financial recovery is not likely. Most investors, particularly a banker, would insist on being a secured creditor. This means having a loan filed and perfected against a hard asset, such as real estate.
Harrison ended up being indicted and pleaded guilty to federal bank fraud. The case does not go into a lot of details about this, but presumably Harrison was operating a ponzi scheme. Following the indictment and plea, the taxpayer filed amended returns to report a theft loss and claimed refunds from the IRS for his investments with Harrison.
The IRS audited the tax refund claims and disallowed the claims. Tax litigation ensued in the U.S. District Court.
About Theft Losses
The tax code allows individual taxpayers to deduct certain losses from their taxable income. This is provided for in Section 165.
The provision just says that deductions for any losses sustained during the tax year that are not reimbursed by insurance or otherwise are deductible. Subsection 165(c)(3) clarifies that individuals can deduct losses arising from theft crimes like embezzlement and robbery.
A theft loss is different from a casualty loss.
To claim a theft loss deduction, the taxpayer must prove three things:
- A theft occurred
- The amount of the deductible loss
- The year when the loss was discovered
For 2018-2025, personal casualty and theft losses are only deductible to the extent they are attributable to a federally declared disaster under Section 165(h).
The tax code defines “theft” broadly to include any criminal taking of property for the thief’s own use, especially by deception, swindling, or other forms of fraud. Courts determine whether a theft happened based on the law of the jurisdiction where it occurred. That is the issue in this case.
Theft Under State Law
To claim a theft loss deduction under federal tax law, taxpayers must prove a theft occurred based on the law of the state where it happened. This case involves the law of South Carolina.
In South Carolina, according to the court, theft by false pretenses requires proof of the following elements:
- The defendant made a false representation of a material fact;
- The defendant intended to cheat or defraud the victim;
- The defendant obtained money or property from the victim;
- The victim was induced to part with the money or property because of the false representation.
See S.C. Code Ann. §16-13-240.
The court notes that a theft requires the defendant to knowingly mislead the victim and intend to commit fraud, versus simply failing to fulfill a contractual obligation. Providing false financial statements to secure a loan could meet the standard. But losing money in a failed business deal, without proof of intentional deception, generally does not qualify as theft by false pretenses.
So in South Carolina, taxpayers cannot claim a theft loss merely because an investment failed or a debtor did not repay. The same result happens for other agreed to losses, such as gambling losses. To justify the deduction, the taxpayer needs evidence showing the debtor committed intentional fraud or deception through actions like doctoring financial documents. The state follows the same overall framework as federal tax law, but makes taxpayers demonstrate theft based specifically on South Carolina statutes.
The court highlighted the absence of evidence showing that Harrison made false representations or provided false or misleading financial statements to the taxpayer at the time the loans were made. Based on this, the court concluded that there was no theft and, consequently, no thelf loss deduction was available.
Theft Under Texas Law
The theft laws vary widely from state-to-state. For example, the Texas Theft Liability Act has a similar deception requirement, but what counts as deception is different:
In Texas “deception” means:
(A) creating or confirming by words or conduct a false impression of law or fact that is likely to affect the judgment of another in the transaction, and that the actor does not believe to be true;
(B) failing to correct a false impression of law or fact that is likely to affect the judgment of another in the transaction, that the actor previously created or confirmed by words or conduct, and that the actor does not now believe to be true;
(C) preventing another from acquiring information likely to affect his judgment in the transaction;
(D) selling or otherwise transferring or encumbering property without disclosing a lien, security interest, adverse claim, or other legal impediment to the enjoyment of the property, whether the lien, security interest, claim, or impediment is or is not valid, or is or is not a matter of official record; or
(E) promising performance that is likely to affect the judgment of another in the transaction and that the actor does not intend to perform or knows will not be performed, except that failure to perform the promise in issue without other evidence of intent or knowledge is not sufficient proof that the actor did not intend to perform or knew the promise would not be performed.
Subparagraphs A and B could apply to most ponzi schemes, as making false representations is what a ponzi scheme is all about. Subparagrah C could also apply to many ponzi schemes as withholding information is key to furthering most ponzi schemes.
Subparagprah E could cover the situation described in this case. Just an intent or knowledge to not perform is enough. Knowledge to not perform could likely be proven by factors showing that the financial transaction could not be completed, i.e., the bad actor did not have enough funds, did not have a viable business or investment that could produce the promised returns, etc.
Thus, the outcome may have been different had Texas law applied. The taxpayer’s arguments about the guilty plea to bank fraud and evidence of testimony of a certified public accountant who had analyzed Harrison’s financial statements may have been enough.
The Takeaway
Those taking tax losses for theft should carefully document the theft. This starts with an analysis of state law. The elements of the state statutes set out what has to be documented. As this court case shows, the failure to perform alone may not be sufficient. The state statute may require more. Some states may allow evidence of the inability to perform, which could be shown in a typical ponzi scheme (i.e., that the bad actor did not have sufficient funds or a viable busienss or investment to complete the transaction).
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