Rev. Rul. 77-17

Advice has been requested whether, under the circumstances described below, the taxpayer is entitled to a theft loss or worthless stock deduction under section 165 of the Internal Revenue Code of 1954.

The taxpayer, an individual who is a resident of State M, purchased shares of X Corporation stock in 1974, through a public stock exchange. In 1975, information about irregular activities led to suspension of trading in X's stock on all public markets and trading has not been resumed.

Later, in 1975, X filed a petition for protection in bankruptcy with the United States District Court. The petition was approved and the court appointed a trustee for X. Pursuant to section 167(1) of the Bankruptcy Act, 11 U.S.C. section 567(1) (1970), the trustee investigated the property, liabilities and financial condition of X to determine the desirability of continuing the operation of X's business. The trustee concluded that X should be reorganized and should continue doing business as a new entity. A reorganization plan approved by the court provided that certain of X's assets, including two financially solvent subsidiary companies unaffected by the fraud, would be transferred to a new corporation. As a group, stockholders of X who acquired their stock through purchases on public stock markets would be allocated 1,000x shares of the new corporation's common stock. The reorganization plan will not be put into effect unless and until it is approved by X's creditors and stockholders.

Under section 167 of the Bankruptcy Act, 11 U.S.C. section 567(3) (1970), the trustee was also required to report to the court any facts discovered pertaining to fraud, misconduct, mismanagement and irregularities in the operation of X. In the report to the court, the trustee emphasized that there was essentially a "securities" fraud, rather than a theft or embezzlement of the corporation's assets. The perpetrators' goal was to inflate and keep aloft the market price of X's stock. This goal was achieved by reporting nonexistent income and assets on the corporate books and failing to record liabilities. The public was thereby induced to purchase stock in what was thought to be a large, fast-growing and solvent enterprise. The perpetrators, who owned large amounts of X stock from X's inception and who received further amounts of stock through bonuses and profit-sharing plans, were enriched when their stock was sold.

Section 165(a) of the Code provides the general rule that there is allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

Section 165(c) of the Code provides that in the case of an individual, the deduction under subsection (a) is limited to losses incurred in a trade or business; losses incurred in any transaction entered into for profit, though not connected with a trade or business; and losses of property not connected with a trade or business if such losses arise from fire, storm, shipwreck, or other casualty, or from theft.

A taxpayer who claims a theft loss deduction must first establish that the loss has actually been sustained as a result of a theft. The applicable definition of a theft for Federal income tax purposes is found in Edwards v. Bromberg, 232 F. 2d 107 (5th Cir. 1956), where the court defined theft as a word of general and broad connotation, intended to cover and covering any criminal appropriation of another's property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile. The court also stated that whether a loss from theft occurred depends upon the law of the jurisdiction where it was sustained, and the exact nature of the crime, whether larceny or embezzlement, or obtaining money under false pretenses, swindling or other wrongful deprivations of the property of another, is of little importance so long as it amounts to theft.

Under the law of State M, every person who shall knowingly and designedly, by any false or fraudulent representation or pretense, defraud any other person of money, labor, or real or personal property is guilty of theft.

The elements necessary to establish the crime of theft by false pretenses in State M are: (1) the perpetrator of the crime had the specific intent to fraudulently deprive an owner of the owner's property; (2) the perpetrator actually obtained possession and title to the property of the victim; (3) the property was obtained through the use of false pretenses; and (4) the owner of the property relied upon fraudulent representations in parting with the owner's property.

The first element enumerated above, specific intent to defraud, was considered in Lester I. Paine, 63 T.C. 736 (1975), aff'd, No. 75-2603 (5th Cir., November 3, 1975). In that case, a taxpayer who had purchased shares of stock in a corporation through a public stock exchange claimed that he was induced to do so by fraudulent financial statements issued by corporate officials. The objective of the fraudulent activities by the corporate officials was to artificially inflate the stock's market price. The United States Tax Court denied a deduction under section 165 of the Code stating that under Texas law there was no evidence that the misrepresentations in question were made by the corporate officers with the specific intent of obtaining any property or valuable right from the taxpayer and with the specific intent of criminally appropriating the taxpayer's property or right or destroying the taxpayer's right to enjoyment. (Texas law is in substance the same as the law of State M). The Court noted that the taxpayer had not purchased the stock from the persons who made the misrepresentations, but on the open market. There was no evidence that the previous owners of the stock participated in or were even aware of the misrepresentations of the corporate officers. From all that appeared in the record, they simply engaged in a standard market transaction, completely devoid of any activity amounting to a criminal appropriation of the taxpayer's property.

In the instant case, the loss in value of the taxpayer's stock does not come within the definition of theft, for Federal income tax purposes, because the perpetrators of the fraud at X did not have the requisite specific intent to defraud the taxpayer and did not obtain possession and title to the taxpayer's property.

The second question presented is whether a deduction is allowed because the taxpayer's stock became worthless at the time of, or since, the suspension of trading of X stock in 1975.

Section 165(g)(1) of the Code provides the general rule that if any security that is a capital asset becomes worthless during the taxable year, the loss resulting therefrom shall be treated as a loss from the sale or exchange, on the last day of the taxable year, of a capital asset.

Section 165(g)(2) of the Code provides, in part, that the definition of the term "security" includes a share of stock in a corporation.

Section 1.165-1(b) of the Income Tax Regulations states that, to be allowable as a deduction under section 165(a) of the Code, a loss must be evidenced by closed and completed transactions, fixed by identifiable events and, with certain exceptions, actually sustained during the taxable year.

Section 1.165-4(a) of the regulations states, in part, that no loss for a decline in value of stock owned by a taxpayer shall be allowed as a deduction except insofar as the loss is recognized upon a sale or exchange of the stock or with respect to stock which has become worthless during the taxable year.

In determining whether stock has become worthless, any potential future value as well as any present value must be considered. In Sterling Morton, 38 B.T.A. 1270, 1278 (1938) aff'd, 112 F. 2d 320 (7th Cir. 1940), the court stated:

The ultimate value of stock, and conversely its worthlessness, will depend not only on its current liquidating value, but also on what value it may acquire in the future through the foreseeable operations of the corporation. Both factors of value must be wiped out before we can definitely fix the loss.

Accord Miami Beach Shore Co. v. Commissioner, 136 F. 2d 408 (5th Cir. 1943).

The potential value of X's stock since the discovery of the fraud is evidenced by two factors. First, X's assets include two subsidiary companies in sound financial condition. Second, a reasonable prospect has existed that X would be reorganized and that its stockholders would be allocated stock in any reorganized entity. Stock in a corporation undergoing reorganization to provide for a new company with a sound financial basis cannot be assumed to be worthless where the stockholders are likely to be participants in the new entity. Edward C. Lawson, 42 B.T.A. 1103 (1940), acq., 1940-1 C.B. 7.

Accordingly, in the instant case, the taxpayer is not allowed a theft loss deduction pursuant to section 165(c) of tre Code and is not allowed a worthless stock deduction pursuant to section 165(g).