A recent Tax Court case has highlighted the importance for individual taxpayers in determining the “discovery year” for the purpose of taking a theft loss deduction. In Giambrone v. Commissioner, the Tax Court held that the taxpayers were not entitled to a theft loss deduction because they did not claim the deduction in the year they discovered the illegal scheme giving rise to the deduction. See Giambrone v. Commissioner, TC Memo 2020-145 (10/19/2020).

Pursuant to I.R.C. § 165(c), an individual taxpayer can deduct an uncompensated loss—even one not connected with a trade or business or a transaction entered into for profit—if such loss arises from a theft. Generally, a theft loss is treated as sustained during the tax year in which the taxpayer discovers such loss. See I.R.C. § 165(e).

To clarify this standard, the IRS provided a safe-harbor provision under Rev Proc 2009-20, 2009-14 IRB 749. Under this safe harbor, qualified investors that are involved in a fraudulent business scheme may treat a loss as a theft loss when certain conditions are met. This safe harbor is available to a “qualified investor” who experiences a “qualified loss.”  For the purpose of the safe harbor, the term “qualified loss” includes a loss from a specified fraudulent arrangement in which the perpetrator of the fraud was charged with the commission of fraud, embezzlement, or a similar crime that, if proven, would meet the definition of theft for purposes of § 165. The term “qualified investor” includes an individual qualified to deduct theft losses under § 165 and who did not have actual knowledge of the fraudulent nature of the investment arrangement prior to it becoming known to the general public. The safe harbor allows such taxpayers to deduct 95% of the investor’s qualified loss in the year of discovery.

Giambrone analyzed whether the taxpayers deducted their theft losses in the proper “discovery year.” This case involved an individual perpetrating a fraudulent scheme based on bank, wire, and securities fraud. He was indicted in 2010, and that individual was ultimately convicted of bank and securities fraud in 2011. The individual taxpayers affected by the illegal conduct took theft loss deductions under the safe harbor on their 2012 tax returns. The IRS disallowed the deductions because they were not taken in 2010, which the IRS alleged was the discovery year under the safe harbor.

The Tax Court agreed with the IRS. It held that, under the safe harbor, the discovery year would have been 2010—the year of the perpetrator’s indictment, rather than conviction. Thus, the taxpayers’ theft loss deductions were properly disallowed by the IRS.

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