rr-09-09.pdf

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Part I

Section 165.—Losses.

26 CFR: § 1.165-8: Theft losses.
(Also: §§ 63, 67, 68, 172, 1311, 1312, 1313, 1314, 1341)

Rev. Rul. 2009-9
ISSUES
(1) Is a loss from criminal fraud or embezzlement in a transaction entered into for
profit a theft loss or a capital loss under § 165 of the Internal Revenue Code?
(2) Is such a loss subject to either the personal loss limits in § 165(h) or the limits
on itemized deductions in §§ 67 and 68?
(3) In what year is such a loss deductible?
(4) How is the amount of such a loss determined?
(5) Can such a loss create or increase a net operating loss under § 172?
(6) Does such a loss qualify for the computation of tax provided by § 1341 for the
restoration of an amount held under a claim of right?
(7) Does such a loss qualify for the application of §§ 1311-1314 to adjust tax
liability in years that are otherwise barred by the period of limitations on filing a claim for
refund under § 6511?

2

FACTS
A is an individual who uses the cash receipts and disbursements method of
accounting and files federal income tax returns on a calendar year basis. B holds
himself out to the public as an investment advisor and securities broker.
In Year 1, A
, in a transaction entered into for profit, opened an investment
account with B, contributed $100x to the account, and provided B with power of attorney
to use the $100x to purchase and sell securities on A’s behalf. A instructed B to
reinvest any income and gains earned on the investments. In Year 3, A contributed an
additional $20x
to the account.
B periodically issued account statements to A that reported the securities
purchases and sales that B
purportedly made in A’s investment account and the
balance of the account. B also issued tax reporting statements to A and to the Internal
Revenue Service that reflected purported gains and losses on A’s investment account.
B
also reported to A that no income was earned in Year 1 and that for each of the Years
2 through 7 the investments earned $10x of income (interest, dividends, and capital
gains), which A
included in gross income on A's federal income tax returns.
At all times prior to Year 8 and part way through Year 8, B was able to make
distributions to investors who requested them. A took a single distribution of $30x from
the account in Year 7.
In Year 8, it was discovered that B
’s purported investment advisory and
brokerage activity was in fact a fraudulent investment arrangement known as a “Ponzi”

3

scheme. Under this scheme, B
purported to invest cash or property on behalf of each
investor, including A, in an account in the investor’s name. For each investor’s account,
B
reported investment activities and resulting income amounts that were partially
wholly fictitious. In some cases, in response to requests for withdrawal,
or
B
made
payments of purported income or principal to investors. These payments were
least in part, fr
made, at
om amounts that other investors had invested in the fraudulent
arrangement.
When B
’s fraud was discovered in Year 8, B had only a small fraction of the
funds that B reported on the account statements that B issued to A and other investors.
A did not receive any reimbursement or other recovery for the loss in Year 8. The
period of limitation on filing a claim for refund under § 6511 has not yet expired for
Years 5 through 7, but has expired for Years 1 through 4.
B
's actions constituted criminal fraud or embezzlement under the law of the
jurisdiction in which the transactions occurred. At no time prior to the discovery did A

know that B's activities were a fraudulent scheme. The fraudulent investment
arrangement was not a tax shelter as defined in § 6662(d)(2)(C)(ii) with respect to A
.

Issue 1
LAW AND ANALYSIS
. Theft loss.
Section 165(a) allows a deduction for losses sustained during the taxable year
and not compensated by insurance or otherwise. For individuals, § 165(c)(2) allows
deduction for losses incurred in a transaction entered into for profit, and § 165(c)(3)
allows a deduction for certain losses not connected to a transaction entered into for
a

4

be taken into account in determining gains or losses for a taxable year under
§ 1231
rds
profit, including theft losses. Under § 165(e), a theft loss is sustained in the taxable
year the taxpayer discovers the loss. Section 165(f) permits a deduction for capital
losses only to the extent allowed in §§ 1211 and 1212. In certain circumstances, a theft
loss may
.
For federal income tax purposes, "theft" is a word of general and broad
connotation, covering any criminal appropriation of another's property to the use of the
taker, including theft by swindling, false pretenses and any other form of guile. Edwa
v. Bromberg, 232 F.2d 107 (5th Cir. 1956); see also § 1.165-8(d) of the Income Tax
Regulations ("theft" includes larceny and embezzlement). A taxpayer claiming a theft
loss must prove that the loss resulted from a taking of property that was illegal under the
law of the jurisdiction in which it occurred and was done with criminal intent. Rev. Ru
72-112, 1972-1 C.B. 60. However, a taxpayer need not show a conviction

l.
for theft.
Vietzke v. Commissioner
, 37 T.C. 504, 510 (1961), acq., 1962-2 C.B. 6.
The character of an investor’s loss related to fraudulent activity depend
on the nature of the investment. For example, a loss that is sustained on the
worthlessness or disposition of stock acquired on the open market for investment is
capital loss, even if the decline in the value of the stock is attributable to fraudulent
activities of the corporation’s officers or directors, because the officers or directors did
not have the specific intent to
s, in part,
a
deprive the shareholder of money or property. See
Rev.
Rul. 77-17, 1977-1 C.B. 44.

5

In the present situation, unlike the situation in Rev. Rul. 77-17, B
specifically
intended to, and did, deprive A of money by criminal acts. B’s actions constituted a theft
from A
, as theft is defined for § 165 purposes. Accordingly, A's loss is a theft loss, not a
capital loss.
Issue 2.
Deduction limitations.
Section 165(h) imposes two limitations on casualty loss deductions, including
theft lo
uction for a loss described in § 165(c)(3)
(includ
able year, the losses
are allo
ney
r

into for
profit. Tax Reform Act of 1984, Pub. L. No. 98-369, § 711 (1984). As a result, Rev.
ss deductions, for property not connected either with a trade or business or with
a transaction entered into for profit.
Section 165(h)(1) provides that a ded
ing a theft) is allowable only to the extent that the amount exceeds $100 ($500
for taxable years beginning in 2009 only).
Section 165(h)(2) provides that if personal casualty losses for any taxable year
(including theft losses) exceed personal casualty gains for the tax
wed only to the extent of the sum of the gains, plus so much of the excess as
exceeds ten percent of the individual's adjusted gross income.
Rev. Rul. 71-381, 1971-2 C.B. 126, concludes that a taxpayer who loans mo
to a corporation in exchange for a note, relying on financial reports that are late
discovered to be fraudulent, is entitled to a theft loss deduction under § 165(c)(3).
However, § 165(c)(3) subsequently was amended to clarify that the limitations
applicable to personal casualty and theft losses under § 165(c)(3) apply only to those
losses that are not connected with a trade or business or a transaction entered

6

tered into for profit are deductible under § 165(c)(3), rather than under
§ 165(
Rul. 71-381 is obsolete to the extent that it holds that theft losses incurred in a
transaction en
c)(2).
In opening an investment account with B
, A entered into a transaction for profit.
A's theft loss therefore is deductible under § 165(c)(2) and is not subject to the § 165(h)
limitati
s. A theft loss is not allowable
under
me.
(2) or (3) are excepted from the
definiti
er § 68(c)(3),
ons.
Section 63(d) provides that itemized deductions for an individual are the
allowable deductions other than those allowed in arriving at adjusted gross income
(under § 62) and the deduction for personal exemption
§ 62 and is therefore an itemized deduction.
Section 67(a) provides that miscellaneous itemized deductions may be deducted
only to the extent the aggregate amount exceeds two percent of adjusted gross inco
Under § 67(b)(3), losses deductible under § 165(c)
on of miscellaneous itemized deductions.
Section 68 provides an overall limit on itemized deductions based on a
percentage of adjusted gross income or total itemized deductions. Und
losses deductible under § 165(c)(2) or (3) are excepted from this limit.
Accordingly, A
's theft loss is an itemized deduction that is not subject to the limits
67 and 68.
Issue 3
on itemized deductions in §§
.
Year of deduction.
Section 165(e) provides that any loss arising from theft is treated as sustain
during the taxable year in which the taxpayer discovers the loss. Under §§ 1.165-
ed

7

r not the
questio
8(a)(2) and 1.165-1(d), however, if, in the year of discovery, there exists a claim for
reimbursement with respect to which there is a reasonable prospect of recovery, no
portion of the loss for which reimbursement may be received is sustained until the
taxable year in which it can be ascertained with reasonable certainty whether o
reimbursement will be received, for example, by a settlement, adjudication, or
abandonment of the claim. Whether a reasonable prospect of recovery exists is a
n of fact to be determined upon examination of all facts and circumstances.
A
may deduct the theft loss in Year 8, the year the theft loss is discovered,
provided that the loss is not covered by a claim for reimbursement or other recovery as
to which

A has a reasonable prospect of recovery. To the extent that A’s deduct
reduced by such a claim, recoveries on the claim in a later taxable year are not
includible in
ion is
A’
s gross income. If A recovers a greater amount in a later year, or an
amount that initially was not covered by a claim as to which there was a reasonable
prospect of recovery, the recovery is includible in A’
s gross income in the later year
under the tax benefit rule, to the extent the earlier deduction reduced A's income tax.
See
§ 111; § 1.165-1(d)(2)(iii). Finally, if A recovers less than the amount that wa
covered by a claim as to which there was a reasonable prospect of recovery that
reduced the deduction for theft in Year 8, an additional deduction
s
is allowed in the year
tained with reasonable certainty.
Issue 4
the amount of recovery is ascer
. Amount of deduction.
Section 1.165-8(c) provides that the amount deductible in the case of a theft los
is determined consistently with the manner described in § 1.165-7 for determining the
s

8

ly
eft
ount of money) that was lost, less any
reimbu
gement is
r
year of
vests the amount in the arrangement, this amount increases the deductible
theft lo
amount of a casualty loss, considering the fair market value of the property immediate
after the theft to be zero. Under these provisions, the amount of an investment th
loss is the basis of the property (or the am
rsement or other compensation.
The amount of a theft loss resulting from a fraudulent investment arran
generally the initial amount invested in the arrangement, plus any additional
investments, less amounts withdrawn, if any, reduced by reimbursements or othe
recoveries and reduced by claims as to which there is a reasonable prospect of
recovery. If an amount is reported to the investor as income in years prior to the
discovery of the theft, the investor includes the amount in gross income, and the
investor rein
ss.
Accordingly, the amount of A
’s theft loss for purposes of § 165 includes A’s
original Year 1 investment ($100x
) and additional Year 3 investment ($20x). A’s loss
also includes the amounts that A reported as gross income on A's federal income ta
returns for Years 2 through 7 ($60
x
x
). A’s loss is reduced by the amount of money
distributed to A
in Year 7 ($30x). If A has a claim for reimbursement with respect t
which there is a reasonable prospect of recovery,
o
A
may not deduct in Year 8 the
red by the claim.
Issue 5
portion of the loss that is cove
.
Net operating loss.
Section 172(a) allows as a deduction for the taxable year the aggregate of the
net operating loss carryovers and carrybacks to that year. In computing a net operating

9

(3) is treated as
a busin
g loss arising from casualty or theft may be carried back 3 years and forward 20
years.
.
3, 4, o
applied by

he
proprietorship, that would meet such test if the proprietorship were a
corpor
oss an
loss under § 172(c) and (d)(4), nonbusiness deductions of noncorporate taxpayers are
generally allowed only to the extent of nonbusiness income. For this purpose, however,
any deduction for casualty or theft losses allowable under § 165(c)(2) or
ess deduction. Section 172(d)(4)(C).
Under § 172(b)(1)(A), a net operating loss generally may be carried back 2 years
and forward 20 years. However, under § 172(b)(1)(F), the portion of an individual's net
operatin
Section 1211 of the American Recovery and Reinvestment Act of 2009, Pub. L
No. 111-5, 123 Stat. 115 (February 17, 2009), amends § 172(b)(1)(H) of the Internal
Revenue Code to allow any taxpayer that is an eligible small business to elect either a
r 5-year net operating loss carryback for an “applicable 2008 net operating loss.”
Section 172(b)(1)(H)(iv) provides that the term “eligible small business” has the
same meaning given that term by § 172(b)(1)(F)(iii), except that § 448(c) is
substituting “$15 million” for “$5 million” in each place it appears. Section
172(b)(1)(F)(iii) provides that a small business is a corporation or partnership that meets
the gross receipts test of § 448(c) for the taxable year in which the loss arose (or in t
case of a sole
ation).
Because § 172(d)(4)(C) treats any deduction for casualty or theft losses
allowable under § 165(c)(2) or (3) as a business deduction, a casualty or theft l
individual sustains after December 31, 2007, is considered a loss from a “sole

10

ay
net
)(H)(iv) is
satisfie
proprietorship” within the meaning of § 172(b)(1)(F)(iii). Accordingly, an individual m
elect either a 3, 4, or 5-year net operating loss carryback for an applicable 2008
operating loss, provided the gross receipts test provided in § 172(b)(1
d. See Rev. Proc. 2009-19, 2009-14 I.R.B. (April 6, 2009).
To the extent A's theft loss deduction creates or increases a net operating los
the year the loss is deducted, A
s in
may carry back up to 3 years and forward up to 20
years the portion of the net operating loss attributable to the theft loss. If A’s loss is an
applicable 2008 net operating loss and the gross receipts test in § 172(b)(1)(H)(iv) is
met, A

may elect either a 3, 4, or 5-year net operating loss carryback for the applicable
Issue 6
2008 net operating loss.
.
Restoration of amount held under claim of right.
Section 1341 provides an alternative tax computation formula intended to
mitigate against unfavorable tax consequences that may arise as a result of includ
an item in gross income in a taxable year and taking a deduction for the item in a
subsequent year when it is established that the taxpayer did not have a right to the item.
Section 1341 requires that: (1) an item was included in gross income for a prior taxa
year or years because it appeared that the taxpayer had an unrestricted right to the
item, (2) a deduction is allowable for the taxable year because it was established after
the close of the prior taxable year or years that the taxpayer did not have a right to the
item or to a portion of the ite
ing

ble
m, and (3) the amount of the deduction exceeds $3,000.
Section 1341(a)(1) and (3).

11

year or
years t
41-1(a)(1)-(2);
Alcoa,
If § 1341 applies, the tax for the taxable year is the lesser of: (1) the tax for the
taxable year computed with the current deduction, or (2) the tax for the taxable year
computed without the deduction, less the decrease in tax for the prior taxable
hat would have occurred if the item or portion of the item had been excluded from
gross income in the prior taxable year or years. Section 1341(a)(4) and (5).
To satisfy the requirements of § 1341(a)(2), a deduction must arise because the
taxpayer is under an obligation to restore the income. Section 1.13
Inc. v. United States
, 509 F.3d 173, 179 (3d Cir. 2007); Kappel v. United States,
437 F.2d 1222, 1226 (3d Cir.), cert. denied, 404 U.S. 830 (1971).
When A incurs a loss from criminal fraud or embezzlement by B in a transaction
entered into for profit, any theft loss deduction to which A may be entitled does not arise
from an obligation on A
’s part to restore income. Therefore, A is not entitled to the tax
benefits of § 1341 with regard to A's theft loss deduction.
Issue 7.
Mitigation provisions.
The mitigation provisions of §§ 1311-1314 permit the Service or a taxpayer in
certain circumstances to correct an error made in a closed year by adjusting the ta
liability in years that are otherwise barred by the statute of limitations. O’Brien v. United
x
States, 766 F.2d 1038, 1041 (7th Cir. 1995). The party invoking these mitigation
provisiisfied. ons has the burden of proof to show that the specific requirements are sat
Id
. at 1042.
Section 1311(a) provides that if a determination (as defined in § 1313) is
described in one or more of the paragraphs of § 1312 and, on the date of the

12

or rule of law (other than §§ 1311-1314 or § 7122), then the
effect oer
or refunded under § 1314, the determination adopts a position maintained by
the Se
determination, correction of the effect of the error referred to in § 1312 is prevented by
the operation of any law
f the error is corrected by an adjustment made in the amount and in the mann
specified in § 1314.
Section 1311(b)(1) provides in relevant part that an adjustment may be made
under §§ 1311-1314 only if, in cases when the amount of the adjustment would be
credited
cretary that is inconsistent with the erroneous prior tax treatment referred to in
§ 1312.
A
cannot use the mitigation provisions of §§ 1311-1314 to adjust tax liability in
Years 2 through 4 because there is no inconsistency in the Service’s position with
respect to A
’s prior inclusion of income in Years 2 through 4. See § 1311(b)(1). The
Service’s position that A is entitled to an investment theft loss under § 165 in Year
computed in Issue 4, above), when the fraud loss is di
8 (as
scovered, is consistent with the
ervice’s position that AS
properly included in income the amounts credited to A’s
account in Years 2 through 4. See
§ 1311(b)(1)(A).

to for
HOLDINGS
(1) A loss from criminal fraud or embezzlement in a transaction entered in
profit is a theft loss, not a capital loss, under § 165.

13

or

is reported to the investor as income prior to
discov
profit may create or increase a net
operat 20
lect either a 3, 4, or 5-year net operating loss
carryb
for profit does not qualify for the
applicad by
(2) A theft loss in a transaction entered into for profit is deductible under
§ 165(c)(2), not § 165(c)(3), as an itemized deduction that is not subject to the personal
loss limits in § 165(h), or the limits on itemized deductions in §§ 67 and 68.
(3) A theft loss in a transaction entered into for profit is deductible in the year the
loss is discovered, provided that the loss is not covered by a claim for reimbursement
recovery with respect to which there is a reasonable prospect of recovery.
(4) The amount of a theft loss in a transaction entered into for profit is generally
the amount invested in the arrangement, less amounts withdrawn, if any, reduced by
reimbursements or recoveries, and reduced by claims as to which there is a reasonable
prospect of recovery. Where an amount
ery of the arrangement and the investor includes that amount in gross income
and reinvests this amount in the arrangement, the amount of the theft loss is increased
by the purportedly reinvested amount.
(5) A theft loss in a transaction entered into for
ing loss under § 172 that can be carried back up to 3 years and forward up to
years. An eligible small business may e
ack for an applicable 2008 net operating loss.
(6) A theft loss in a transaction entered into for profit does not qualify for the
computation of tax provided by § 1341.
(7) A theft loss in a transaction entered into
tion of §§ 1311-1314 to adjust tax liability in years that are otherwise barre
the period of limitations on filing a claim for refund under § 6511.

14
A theft loss in a transaction entered into for profit that is deductible under
determining whether a transaction is a loss
transa
DISCLOSURE OBLIGATION UNDER § 1.6011-4
§ 165(c)(2) is not taken into account in
ction under § 1.6011-4(b)(5). See § 4.03(1) of Rev. Proc. 2004-66, 2004-2 C.B.
966.
EFFECT ON OTHER DOCUMENTS
soleted to the extent that it holds that a theft loss incurred
The principal author of this revenue ruling is Andrew M. Irving of the Office of
Associate Chief Counsel (Income Tax & Accounting). For further information regarding
this revenue ruling, contact Mr. Irving at (202) 622-5020 (not a toll-free call.)

Rev. Rul. 71-381 is ob
in a transaction entered into for profit is deductible under § 165(c)(3) rather than
§ 165(c)(2).
DRAFTING INFORMATION