Theft loss eligibility is broader for estates than for individuals.

• Author: Chambers, Valrie

If an individual taxpayer buys a security in a company through a stockbroker who is not a conduit for the company issuing the security and the company commits fraud, a theft loss is generally not allowed. However, if an individual taxpayer buys a security directly from a company that commits fraud, he or she may be allowed a theft loss. Similarly, if an LLC buys a security directly from a company that commits fraud rather than through an intermediary, it may be allowed a theft loss that, if the LLC elected to be taxed as a partnership, would flow through as a theft loss to the partners.

But how would an estate be taxed if its gross estate holdings included an interest in an LLC that held investments that became worthless because of fraud? According to the Tax Court, in a case of first impression, the estate was entitled to a theft loss deduction (.Estate of Heller, 147TC.No.11 (2016)).

In this case, the taxpayer, the estate of James Heller, held a 99% interest in a family LLC, the only asset of which was an account with Bernard L. Madoff Investment Securities LLC. Between the time of the decedent's death and the discovery that Madoff was running a Ponzi scheme, the estate received distributions of more than two-thirds of the alleged account assets, but the remaining account assets became worthless when the Ponzi scheme was discovered. The estate then claimed a theft loss deduction for the balance that remained in the account immediately prior to the discovery of the fraud. The IRS took the position that the LLC itself incurred the loss, not the estate. The court, in a summary judgment, sided with the estate.

The difference in taxpayer treatment stems from the IRS's and court's interpretations of different sections of the Internal Revenue Code.

Theft Losses for Individuals

The courts have traditionally relied on state law to define theft (see, e.g., Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956)) in cases where the propriety of a theft loss deduction is at issue. In most states, to prove a theft occurred, it must be shown that the perpetrator of the theft had a specific intent to deprive the victim of the property, and for this intent to exist there must be direct privity between the perpetrator and the victim (see Chief Counsel Advice 201213022). In cases of securities fraud, in which an investor makes an investment through a stockbroker who was not a party to the fraud, there is no direct privity between the investor who gave money to a...