The taxpayer failed to substantiate that a theft occurred or, if it did, its tax year of discovery for his investments in an alleged Ponzi scheme.

The Tax Court held that a taxpayer had not substantiated the existence of a theft loss and that, in the alternative, he failed to demonstrate that his legal fees were ordinary and necessary expenses incurred in a trade or business.

Facts: Michael H. Shaut worked in various roles as an attorney and businessman throughout his career, in which he gained significant experience in business, economics, and finance. In 2014, he started investing in Downing Investment Partners LLP. His initial investment of $250,000 was followed by subsequent investments and loans to Downing from approximately 2014 through 2016. Shaut served as Downing’s president from March through September 2014. In February 2015, he became a managing director of Downing so that he could fundraise for the company. In 2016, investors determined that Downing’s principals were misleading them and mismanaging its business. Seventeen lawsuits naming Shaut as a defendant were filed and were predominantly resolved in the two years following the 2016 discoveries. In 2019, according to Shaut, two principals of Downing were sentenced to prison for their roles in the scheme. He described his own investments as a 10-year “saga related to the Downing ‘Ponzi’ scheme.”

In 2022, the IRS issued a notice of deficiency related to Shaut’s 2019 Form 1040-SR, U.S. Income Tax Return for Seniors, indicating a deficiency for 2019 and imposing an accuracy-related penalty. In response, Shaut submitted an amended return for 2019 accompanied by a letter from his CPA requesting that the IRS allow a fraud loss deduction related to Downing and a net operating loss (NOL) carryover. The amended return included Form 4684, Casualties and Thefts, claiming that Shaut was the victim of investment fraud related to his investments and loans in Downing of $720,000 and $600,000 in legal expenses. Shaut, however, was only able to produce approximately $539,000 in legal bills for 2017, 2018, 2019, and 2021. Similarly, Shaut acknowledged that he was not able to produce documentation substantiating the full $720,000 loss, stating that he was missing some of the claimed wire transfers. The amended return claimed an NOL carryforward was available from his past involvement with an unrelated business. The IRS did not process or accept this amended return.

Issues: The issues before the Tax Court were whether Shaut was: (1) entitled to a theft or casualty loss deduction; (2) in the alternative, entitled to a Sec. 162 deduction for his legal fees; (3) entitled to an NOL deduction; and (4) liable for a Sec. 6662(a) accuracy-related penalty.

Secs. 165(a) and (c) allow a deduction for losses arising from a casualty or loss, including theft, that are not compensated for by insurance or otherwise. Regs. Sec. 1.165-8(d) clarifies that theft includes, but is not limited to, larceny, embezzlement, or robbery. Furthermore, the act that results in an alleged theft loss must have been criminal under the law of the state in which the alleged theft occurred (Paine, 63 T.C. 736 (1975), aff’d without published opinion, 523 F.2d 1053 (5th Cir. 1975)). Theft losses are deductible in the year in which the taxpayer discovers the loss, in the amount of the difference between the fair market value of the property before and after the theft (Sec. 165(e); Regs. Sec. 1.165-7(b)(1)).

Applying these criteria to Shaut’s case, the court noted that, based on his testimony alone, it was evident that Shaut knew before 2019 that Downing was a “financial failure, that improper activity occurred, and that he would not recover his investment.” As a result, Shaut failed to demonstrate that he discovered the theft loss in 2019, which alone would disallow him from taking the theft loss deduction in 2019. The court further found that even if any loss could be attributed to 2019, Shaut had also failed to establish that he was the victim of theft. In particular, the court found his theft claim implausible and not credible, given his intimate involvement in Downing as president and fundraiser and his extensive business expertise gained throughout his career. Citing Seaver, T.C. Memo. 2009-270, the court concluded that Shaut’s “self-serving testimony alleging theft is insufficient in this case to meet his burden of proof.”

Even assuming Shaut had been unaware of the situation at Downing, the court noted that he had not demonstrated that his investment with Downing was anything more than a “bad business decision,” emphasizing that “[t]he casualty and theft loss provision under section 165 is not ‘designed to take care of all losses that the economic world may bestow on its inhabitants’” (quoting Billman, 73 T.C. 139 (1979)). Shaut also failed to meet his burden of proof establishing the amount of the theft loss because there was no credible evidence that he lost all his investment and was never repaid his loans. Finally, although “litigation costs may be included as ‘further or additional or collateral theft losses’ in certain circumstances,” (Ander, 47 T.C. 592 (1967)) as there was no theft loss to begin with, Shaut’s legal fees were not eligible for deduction as a theft loss. Ultimately, the court held that Shaut had not substantiated his entitlement to a theft loss deduction for 2019 or any year and sustained the IRS’s determination that the casualty loss deduction should be disallowed.

As an alternative position, Shaut argued that his legal expenses should be allowed as an ordinary and necessary business expense deduction under Sec. 162. His 2019 amended return, however, did not include legal fees on Schedule C, Profit or Loss from Business. Irrespective of the missing Schedule C, the court explained that Shaut “failed to present reliable evidence substantiating reported legal expenses associated with a business for the 2019 taxable year.” In particular, many of the invoices were for years other than 2019, making them ineligible as business expenses incurred during 2019. Similarly, the court noted that Shaut had not presented any reliable evidence that the legal bills were a business expense incurred in connection with conducting a trade or business. Instead, Shaut claimed at trial that the expenses were related to a fraud loss. Additionally, the court found his alternative position to be inconsistent with his claimed role at Downing. Shaut initially claimed to be merely a fundraiser for Downing, removed from its day-to-day operations, but in the alternative, he argued that he was engaged in a business at Downing and entitled to deduct ordinary and necessary business expenses. The court found this inconsistency to be problematic, stating that Shaut “cannot have it both ways.” Ultimately, the court found that Shaut had not met his burden of demonstrating that the legal fees were ordinary and necessary expenses incurred in a trade or business during the 2019 tax year.

With respect to the NOL carryover that Shaut claimed on his amended return, the court stated that, “beyond his own testimony and tax returns, Mr. Shaut did not offer any evidence proving the existence and amount of an NOL carryforward from the 2017 or 2018 taxable year.” Without some other credible corroborating evidence, Shaut’s tax returns and self-serving statements were insufficient to substantiate his entitlement to an NOL carryforward for 2019.

Further undermining his credibility and entitlement to an NOL carryforward was the fact that Shaut’s 2017 and 2018 tax returns were inconsistent with the claimed NOL carryforward to 2019. Specifically, his 2017 return showed a remaining carryforward of $5,894, but his 2018 tax return claimed an NOL carryforward of over $109,000 from 2017. Finding that Shaut had not established he had losses from 2017 and 2018 that could be carried forward, the court sustained the IRS’s determination that he was not entitled to an NOL deduction in 2019.

The final issue for the court to decide was whether Shaut was liable for an accuracy-related penalty for a substantial understatement of income tax under Secs. 6662(a) and (b)(2). The court found that “to the extent Rule 155 computations confirm there is a substantial understatement of income tax, we sustain respondent’s imposition of an accuracy-related penalty.”

Holding: The Tax Court held that Shaut failed to substantiate his purported theft loss, failed to substantiate that his legal fees were business expenses under Sec. 162, failed to substantiate his entitlement to an NOL carryforward, and he was liable for an accuracy-related penalty under Sec. 6662.