n-04-27.pdf

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Part III -- Administrative, Procedural, and Miscellaneous

Loss Deductions for Diminution in Value of Stock Attributable to Corporate Misconduct

Notice 2004-27

The Internal Revenue Service and Treasury Department are aware that some
taxpayers who acquired stock on the open market for investment have been advised
that they may be able to deduct as a theft loss the decline in market value of their stock
caused by disclosure of accounting fraud or other illegal misconduct of the officers or
directors of the corporation that issued the stock. The purpose of this notice is to advise
taxpayers that the Service intends to disallow such deductions and may impose
penalties under § 6662.

Section 165(a) of the Internal Revenue Code allows a deduction for any loss
sustained during the taxable year not compensated for by insurance or otherwise.
Under § 165(c) 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. Section 1.165-1(b) of the Income Tax
Regulations generally provides that, to be allowable as a deduction under section
165(a), a loss must be evidenced by a closed and completed transaction, fixed by an
identifiable event or events, and actually sustained during the taxable year.

Section 1.165-4(a) provides that no deduction shall be allowed under § 165(a)
solely on account of a decline in the value of stock owned by the taxpayer when the
decline is due to a fluctuation in the market price of the stock or to another similar
cause. However, a deduction is allowed under § 165(a) if the stock is worthless and
has no recognizable value. A decline in the value of stock owned by the taxpayer is not
allowed as a deduction under § 165(a) until the taxable year in which the loss is actually
sustained as a result of the sale or exchange of the stock or the stock becoming wholly
worthless.

Section 165(f) provides that losses from sales or exchanges of capital assets
shall be allowed only to the extent allowed in sections 1211 and 1212. Stock held for
investment is a capital asset under section 1221. Sections 1211 and 1212 limit the
amount that individual taxpayers may deduct for losses from sales or exchanges of
capital assets and provide rules for carrying forward to subsequent years the amount of
any excess capital loss.

Under § 165(g)(1), if any stock that is a capital asset in the hands of a taxpayer,

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such as stock purchased as an investment, becomes worthless during a taxable year,
the resulting loss is treated as a loss from the sale or exchange of a capital asset (i.e., a
capital loss). Section 1.165-5(c) explains that if the stock becomes wholly worthless
during a taxable year, the resulting loss may be deducted under § 165(a) subject to the
limitations imposed on capital losses under §§ 1211 and 1212 and the regulations
thereunder.

Therefore, under § 165(a), subject to the limitations of §§ 1211 and 1212, 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.

Sections 165(e) and 1.165-8(a)(2) provide that, in general, a loss arising from a
theft shall be treated under § 165(a) as sustained during the taxable year in which the
taxpayer discovers the loss. Section 1.165-1(d)(3) provides that if in the year of
discovery there exists a claim for reimbursement with respect to which the taxpayer has
a reasonable prospect of recovery, the portion of the loss that may be reimbursed is not
treated as sustained until the tax year in which it can be ascertained with reasonable
certainty that reimbursement will not be received.

Whether a loss constitutes a theft loss is determined by examining the law of the
state where the alleged theft occurred. Edwards v. Bromberg, 232 F.2d 107, 111 (5
th

Cir. 1956); Viehweg v. Commissioner, 90 T.C. 1248, 1253 (1988). Thus, 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.” Rev. Rul. 72-112, 1972-1 C.B. 60.

In cases involving stock purchased on the open market, the courts have
consistently disallowed theft loss deductions relating to a decline in the value of the
stock that was attributable to corporate officers misrepresenting the financial condition
of the corporation, even when the officers were indicted for securities fraud or other
criminal violations. In Paine v. Commissioner, 63 T.C. 736, aff’d without published
opinion, 523 F.2d 1053 (5
th
Cir. 1975), 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 noted that the taxpayers did not purchase
the stock from the corporate officers who made the misrepresentations, but on the open
market. In MTS International Inc. v. Commissioner, 169 F.3d 1018 (6
th
Cir. 1999), 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.
See also Crowell v. Commissioner, T.C. Memo. 1986-314; DeFusco v. Commissioner,
T.C. Memo. 1979-230; Barry v. Commissioner, T.C. Memo. 1978-215; and Rev. Rul.
77-17, 1977-1 C.B. 44.

Accordingly, the Service will disallow a deduction for a theft loss under § 165(a)
relating to a decline in the value of stock that was acquired on the open market for

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investment. If the stock is sold or exchanged or becomes wholly worthless, any
resulting loss is a capital loss.

DRAFTING INFORMATION
The principal author of this notice is Norma Rotunno of the Office of Associate
Chief Counsel (Income Tax and Accounting). For further information regarding this
notice, please contact Ms. Rotunno on (202) 622-7900 (not a toll-free call).