The District Court for the Northern District of Ohio denied a couple’s theft loss deduction for the worthless stock they acquired as part of a “pump and dump” scheme.

The taxpayers, Robert and Penny Greenberger, filed an amended 2010 tax return claiming the theft loss of $569,220 spent on stock in Spongetech Delivery Systems, Inc., which they said entitled them to a refund of $177,102. The Internal Revenue Service denied the deduction.

The court observed that the disagreement is not whether the Greenbergers will be able to claim a loss for their stock, but rather what kind of a loss. If the theft loss deduction is disallowed, they would still be able to claim a capital loss for the value of their shares, while a theft loss deduction is taken against ordinary income for the full amount of the loss in the year it is discovered. In contrast, non-corporate taxpayers may indefinitely carry forward capital losses, taking a $3,000 deduction against ordinary income and using the remainder of the capital loss to offset any capital gains.

“Thus, the disagreement goes to the timing of when the deduction may be taken, and how much of the loss may be deducted from ordinary income as opposed to offset against capital gains,” the court observed. “The distinction matters, since capital gains are subject to lower tax rates than ordinary income.”

The court noted that due to the lack of direct connection between wrongdoer and victim, the theft-loss deduction is generally not allowed in cases where the value of shares bought on the open market declines due to fraud. The IRS has also taken the position that stock acquired on the open market that loses value due to corporate misconduct is not eligible for the theft-loss deduction, although it can still qualify for a capital loss.

The court considered whether the aggressive promotion of the stock by the Greenbergers’ financial adviser changed the outcome. The Greenbergers suggested that the adviser, Douglas Furth, was an agent of Spongetech and told people to buy the stock to further the pump-and-dump scheme. According to the Greenbergers, if Furth specifically targeted them, there could be sufficient privity (that is, a sufficiently close relationship) to make them the victims of a theft.

Not so, said the court.

“Even if Furth were an agent of Spongetech, the fact the Greenbergers purchased their shares on the open market such that there was no direct transfer of funds [to Spongetech executives or Furth] makes the Greenbergers  ineligible for the theft-loss deduction,” the court said.

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