Investors suffered theft loss in connection with company that issued sub-prime loans
Mike Habib, EA
A Chief Counsel Advice (CCA) has concluded that a theft occurred in connection with investors’ losses on loans to a company engaged in writing sub-prime loans. However, it determined that whether and when a theft occurred for any particular investor, and what losses resulted from the theft, was a question of fact since the company had been engaged in legitimate business for many years before the theft occurred.
Facts. Taxpayers (investors) invested in notes issued by X, which had been in business as a lender for many years and later expanded into writing sub-prime mortgage loans. X sold unsecured and uninsured notes exclusively to State residents because the company wished to avoid being subject to federal securities regulations. X was a legitimate business that offered returns which were greater than those typically offered to bank depositors, but were commensurate with returns available from corporate bonds.
Later, X was acquired by Y, which was primarily engaged in the business of mortgage lending. X continued to exist, but its direct lending activities were curtailed. Most of the proceeds of X’s borrowings were loaned to Y. The market for high-risk mortgages subsequently crashed, and Y suffered significant losses. Y’s business deteriorated as the losses mounted, and it was only able to stay in business by using the cash X generated from the sale of its notes to the public for operating capital. When X distributed annual prospectuses to its investors (as required by State securities law), they represented that X continued to conduct substantial business of its own and showed X to be solvent by virtue of its loans to Y. Y’s financial condition wasn’t disclosed. Further, X and Y officers and directors made public statements misrepresenting X’s financial condition.
In a few years, Y owed more to X’s investors than the company was worth. The losses forced Y and its subsidiaries to cease operations and file for bankruptcy. Under a liquidation plan approved by the Bankruptcy Court, investors received a payout. Thousands of investors affected by the bankruptcy suffered losses. Several people associated with X were convicted of securities violations under State law. X’s president pled guilty to a number of counts of securities fraud, while another insider was convicted of a number of counts of securities fraud in connection with X. One officer was indicted on criminal charges, including obtaining signature or property by false pretenses and breach of trust with fraudulent intent.
Background. A taxpayer can deduct a loss suffered during the tax year and not compensated for by insurance or otherwise. For an individual, a loss deduction is limited to losses incurred in a trade or business, or a transaction entered into for profit, or arising from fire, storm, shipwreck, or other casualty or from theft. ( Code Sec. 165(c) ) IRS broadly defines “theft” for purposes of Code Sec. 165(c)(3) so that a taxpayer need only prove that his 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 CB 60)
A loss that is the direct result of fraud or theft is deductible under Code Sec. 165 , even though the theft is accomplished through a purported borrowing or offer to sell a security. (Vietzke, 37 TC 504 (1961) acq., 1962-1 CB 4) IRS ruled that where a taxpayer was induced to lend money to a corporation by fraudulent financial statements that didn’t reflect large liabilities which made the corporation insolvent, the taxpayer was entitled to a theft loss deduction. The money was obtained by false representations constituting a misdemeanor under state law. IRS reached this conclusion based on the taxpayer’s reliance on the misrepresentations and the specific intent to separate the taxpayer from his money through fraud. (Rev Rul 71-381, 1971-2 CB 126) However, the worthlessness of valid debt is not a theft loss. (Spring City Foundry Co. v. Comm. 13 AFTR 1164 , 292 U.S. 182)
Theft found. In X and Y’s situation, the CCA concluded that the facts established that a theft had occurred. While IRS initially based its assessment on X and Y being in a legitimate business and suffering losses in the ordinary course of that business, the CCA reasoned that later facts revealed the nature of the insider’s fraudulent statements: various insiders’ statements downplayed X’s true financial difficulties; financial statements issued to the investors presented X as a solvent enterprise; the statements didn’t contain Y’s balance sheet (which would have shown its insolvency); and X’s financial statements treated the loans to Y as assets at face value. In addition the financial statements also indicate that X was engaged in the mortgage business on its own behalf, while, in fact, after its acquisition by Y, it existed only to raise capital for Y. Further, there were securities violations cases and an insider was indicted on criminal charges requiring a misappropriation of property as an element of the crime.
The CCA noted that not every securities violation is a theft of property, and a loss or taking of property is generally not a required element of securities fraud. Thus, losses on open market transactions are not theft losses even if the market values of the securities were inflated by insiders’ fraud. However, in this case, criminal charges were brought against at least one Y’s officers.
Deductible loss. The CCA, however, concluded that it remained a question of fact whether and when a theft occurred with regard to any particular investor, and what losses resulted from theft. The CCA found that a determination had to be made as to whether, or at what point, loans to X no longer represented bona fide debti.e., both parties intending that the money advanced be repaid. X had conducted substantial legitimate business for many years, issuing notes and repaying debts as they came due. It was a question of fact when a loan to X was no longer bona fide debt, but a theft, or when the officers’ conduct with regard to the money entrusted to X by the investors amounted to an arrogation of those funds with the intent to deprive the investors of their enjoyment.
To the extent that IRS determines that an investor’s losses were the result of the worthlessness of a security under Code Sec. 165(g), the CCA concluded that the loss occurred when the security was wholly worthless. (Reg. § 1.165-5(c)) To the extent that IRS determined an investor’s loss resulted from theft, the loss was treated as sustained during the tax year in which the taxpayer discovered the loss. (Code Sec. 165(e), Reg. § 1.165-8) Where there is a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no part of the loss for which reimbursement may be received is sustained under Code Sec. 165 until the tax year in which it can be ascertained with reasonable certainty.
The CCA also concluded that the open transaction doctrine (treating payments to taxpayers as a return of capital and not ordinary income) was only proper for amounts actually or constructively received after the fraud was discovered. Thus, payments made by X in the year the fraud was discovered weren’t income unless the taxpayer’s basis was exceeded. While returns may be amended if an amount was reported as income but wasn’t in fact actually or constructively received, the open transaction doctrine should not be applied retroactively. The proper remedy for taxpayers who have suffered a loss is a deduction.
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