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March 25, 2004

Treasury Notice Concerning Decrease in Stock Value
Attributable to Corporate Misconduct

Part III -- Administrative, Procedural, and Miscellaneous

Loss Deductions for Diminution in Value of Stock Attributable to Corporate Misconduct

Notice 2004-27

The Internal Revenue Service and Treasury Department are aware that sometaxpayers who acquired stock on the open market for investment have been advisedthat they may be able to deduct as a theft loss the decline in market value of their stockcaused by disclosure of accounting fraud or other illegal misconduct of the officers ordirectors of the corporation that issued the stock. The purpose of this notice is to advisetaxpayers that the Service intends to disallow such deductions and may imposepenalties under § 6662.

Section 165(a) of the Internal Revenue Code allows a deduction for any losssustained during the taxable year not compensated for by insurance or otherwise.Under § 165(c) losses for individuals are limited to (1) losses incurred in a trade orbusiness, (2) losses incurred in any transaction entered into for profit, though notconnected with a trade or business, and (3) losses of property not connected with atrade or business or a transaction entered into for profit, if such losses arise from fire,storm, shipwreck, or other casualty, or from theft. Section 1.165-1(b) of the Income TaxRegulations generally provides that, to be allowable as a deduction under section165(a), a loss must be evidenced by a closed and completed transaction, fixed by anidentifiable event or events, and actually sustained during the taxable year.

Section 1.165-4(a) provides that no deduction shall be allowed under § 165(a)solely on account of a decline in the value of stock owned by the taxpayer when thedecline is due to a fluctuation in the market price of the stock or to another similarcause. However, a deduction is allowed under § 165(a) if the stock is worthless andhas no recognizable value. A decline in the value of stock owned by the taxpayer is notallowed as a deduction under § 165(a) until the taxable year in which the loss is actuallysustained as a result o f the sale or exchange of the stock or the stock becoming whollyworthless.

Section 165(f) provides that losses from sales or exchanges of capital assetsshall be allowed only to the extent allowed in sections 1211 and 1212. Stock held forinvestment is a capital asset under section 1221. Sections 1211 and 1212 limit theamount that individual taxpayers may deduct for losses from sales or exchanges ofcapital assets and provide rules for carrying forward to subsequent years the amount ofany excess capital loss.

Under § 165(g)(1), if any stock that is a capital asset in the hands of a taxpayer, such as stock purchased as an investment, becomes worthless during a taxable year,the resulting loss is treated as a loss from the sale or exchange of a capital asset (i.e., acapital loss). Section 1.165-5(c) explains that if the stock becomes wholly worthlessduring a taxable year, the resulting loss may be deducted under § 165(a) subject to thelimitations imposed on capital losses under § § 1211 and 1212 and the regulationsthereunder.

Therefore, under § 165(a), subject to the limitations of § § 1211 and 1212, ataxpayer who owns stock that was acquired on the open market for investment and thathas declined in value is allowed a deduction for a capital loss in the taxable year inwhich the stock is sold or exchanged or becomes wholly worthless.

Sections 165(e) and 1.165-8(a)(2) provide that, in general, a loss arising from atheft shall be treated under § 165(a) as sustained d uring the taxable year in which thetaxpayer discovers the loss. Section 1.165-1(d)(3) provides that if in the year ofdiscovery there exists a claim for reimbursement with respect to which the taxpayer hasa reasonable prospect of recovery, the portion of the loss that may be reimbursed is nottreated as sustained until the tax year in which it can be ascertained with reasonablecertainty that reimbursement will not be received.

Whether a loss constitutes a theft loss is determined by examining the law of thestate where the alleged theft occurred. Edwards v. Bromberg, 232 F.2d 107, 111 (5thCir. 1956); Viehweg v. Commissioner, 90 T.C. 1248, 1253 (1988). Thus, to claim a theftloss, the taxpayer must prove that the "loss resulted from a taking of property that isillegal under the law of the state where it occurred and that the taking was done withcriminal intent." Rev. Rul. 72-112, 1972-1 C.B. 60.

In cases involving stock purchased on the open market, the courts haveconsistently disallowed theft loss deductions relating to a decline in the value of thestock that was attributable to corporate officers misrepresenting the financial conditionof the corporation, even when the officers were indicted for securities fraud or othercriminal violations. In Paine v. Commissioner, 63 T.C. 736, affÕd without publishedopinion, 523 F.2d 1053 (5th Cir. 1975), the taxpayers claimed a theft loss deduction for adecline in value of stock stemming from misrepresentations of the financial status of thecorporation by corporate officials. The court noted that the taxpayers did not purchasethe stock from the corporate officers who made the misrepresentations, but on the openmarket. In MTS International Inc. v. Commissioner, 169 F.3d 1018 (6th Cir. 1999), anindividual taxpayer sold at a loss stock that was acquired on a public stock exchangeand argued that the substantial decline in value was due to criminal conduct by thecorporationÕs officers. The Sixth Circuit concluded that the loss was not a theft loss.See also Crowell v. Commissioner, T.C. Memo. 1986-314; DeFusco v. Commissioner,T.C. Memo. 1979-230; Barry v. Commissioner, T.C. Memo. 1978-215; and Rev. Rul.77-17, 1977-1 C.B. 44.

Accordingly, the Service will disallow a deduction for a theft loss under § 165(a)relating to a decline in the value of stock that was acquired on the open market forinvestment. If the stock is sold or exchanged or becomes wholly worthless, anyresulting loss is a capital loss.