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Riley Out of Luck on Theft Loss Deductions

Posted on Mar. 17, 2016

Riley v Commissioner, a Tax Court CDP case from earlier this month, illustrates the many challenges associated with proving a theft loss deduction. The case involves Kaylan Riley, who over a five-year period from 2003-08 gave over $1.2 million to Frank Nemirofsky. Kaylan testified that Frank convinced her to part with the money and invest in fund a start-up venture of his (called Exphand) that was based on an invention that he called the Ribbon. According to Frank, the Ribbon would supposedly allow cell phone users to interact with televisions. Frank claimed he had a patent for the Ribbon technology. To fund the investments, Kaylan mostly cashed in IRA’s she received pursuant to a divorce that was finalized the year before she first started transferring cash. Cashing in the IRAs triggered a substantial liability, especially in 2008 when the amount she gave for what she believed was an investment exceeded $1,000,000.

In Riley, the Tax Court held that Riley failed to prove that she was entitled to the theft loss. Because the case nicely illustrates some of the procedural (and substantive) issues associated with claiming a theft loss, I will describe the case below.

Background on Theft Losses

To understand the issue one must appreciate the special timing rules associated with theft losses. Here, Riley reported the liability from the IRA distributions on her tax 2008 tax return though did not pay the liability. In her 2010 return she claimed a theft loss deduction, which would have offset the proposed 2008 liability. Why 2010 and how would that relate to 2008? While each year generally stands on its own, the Code provides that individuals subject to theft losses can treat the losses essentially as business losses and carry those losses back (and forward, as per the net operating loss rules). Moreover, the timing of when a taxpayer can claim a theft loss is tied to when the taxpayer discovers the theft, not when the alleged theft takes place.

Summing it up nicely, Judge Holmes notes then that to prove entitlement to a theft loss deduction the taxpayer must prove the following three things:

  1. A theft occurred under the law of the jurisdiction where the loss occurred
  2. The amount of that loss, and
  3. The year in which she discovered the loss.

Morevover, the “burden of establishing a theft loss is on the taxpayer, who must prove that a theft, and not just a mysterious disappearance of her property, occurred.” As a further limit on the timing of deductibility, as Judge Holmes succinctly explains, the regulations provide that a “taxpayer may also not claim a deduction for any portion of the loss for which she has a claim for reimbursement with a reasonable prospect of recovery.”

One of the interesting parts of the case is the intersection of federal tax law and state law. As a sidebar I have taught an introductory course for masters students in Villanova’s graduate tax program, where I often use cases under Section 165 to illustrate the hierarchy of federal authorities (e.g., Code, regulations, subregulatory guidance, and cases) as well as the importance of state law in federal tax matters. That latter point is somewhat challenging for students who have not studied law, and who sometimes view the law as a monolith. Theft law cases are very helpful in this regard, because to establish entitlement to a theft loss a taxpayer must prove that the actions amounted to a theft under the jurisdiction where the loss occurred. It is not necessary that there is a conviction under state law (and in many cases the courts have allowed the deduction even absent a prosecution and plea or conviction), but the person alleging that she is entitled to the theft loss deduction has to show that under the relevant state law the actions amount to a theft.

In this case, there was no prosecution, but Riley claimed that Frank’s actions amounted to theft by false pretenses under California law. The opinion gets into the elements of theft by deception under the California penal code and cases that have interpreted that code. To that end, the opinion notes that in California “the elements of [theft by false pretenses] are (1) a false representation, (2) made with intent to defraud, (3) that causes the owner of property to part with it in reliance on the false representation.”

Riley came up short because she offered little in the way of evidence with respect to the first two elements. As the opinion explains, in 2010 Riley began to get suspicious about what was happening to her money when one of her friends went to work for Frank and told her “that things were not right” and that Frank had not “used the money properly.” After learning from her friend about the misuse of the money, Riley took some action. The opinion lays it out:

Riley began asking for her money back, and she hired an attorney, Nina Yablok, to assist her. Yablok wrote a letter to Nemirofsky in June 2010 to argue that he breached his fiduciary duties and disclosure obligations and request immediate repayment of $280,000 along with information about the future prospects of Exphand. Riley also consulted with the law firm Fitzgerald, Abbott & Beardsley, where lawyers told her they would take her case against Nemirofsky on contingency, but she would need to pay $10,000 up front for expenses. She declined to retain the firm because of this retainer. Riley also told the FBI about Nemirofsky, but the government chose not to pursue the case. Throughout this time, Riley and Nemirofsky remained in contact, speaking at least eight times in December 2013 alone. Riley testified that Nemirofsky has stated he wants to return her money to her.

The Problem With the Case: Hearsay and Absence of Testimony from Anyone Who Could Corroborate the Alleged Theft

The absence of any prosecution presented some obstacles for Riley but what prevented her from establishing that Nemirofsky made a false representation with intent to defraud was the absence of any testimony from anyone other than herself or any admissible evidence that would otherwise show what the money was used for or the state of mind of Nemirofsky. Here is where Judge Holmes discusses some of the evidentiary challenges:

[M]any of the statements on which Riley bases her case–promises from Nemirofsky about the Ribbon and investment returns, reports from Wallace about lies and financial wrongdoing at Exphand–are inadmissible hearsay if used to prove the truth of the matters asserted in them. See Fed. R. Evid. 801. We admitted these statements not for their truth but for the limited use of showing Riley’s state of mind and why she grew suspicious. But Riley can’t use them to prove that Exphand had misused Riley’s loans or contributions. The reason neither party subpoenaed Nemirofsky and why Riley based most of her case on hearsay is unclear. The consequence is clear: large holes in the factual record.

The kicker was that absent evidence of Nemrofsky’s actual statements or what his state of mind was it was difficult to establish that the actions amounted to a theft under California law. As the opinion discusses, California law also requires that there be corroborating evidence if the claim “rests primarily on the testimony of a single witness that the false pretense was made.”

Despite the lack of third party testimony, the opinion does note that “the use of an out-of-court statement to show false representations doesn’t violate the hearsay ban when the statement’s probative value is independent of its truth.” Thus it was possible if there was some corroborating evidence to establish the falsity of the statements the third party testimony could have been useful to establish the existence of the statements; yet the absence of corroborating evidence was a killer for Riley and her theft loss deduction.

Parting Thoughts

The opinion also walks through the reasons why Riley was not entitled to either a nonbusiness bad loss deduction or a deduction for worthless securities. Neither of those two losses would generate the carryback necessary to offset the 2008 income; and in any event the opinion notes that she failed to establish that there was no reasonable chance of recovering her money (an issue with the theft loss too). It is possible that in a later year she would be entitled to claim a deduction though the opinion does also suggest other challenges, including the question as to whether some of the payments were gifts.

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