Internal Revenue Service
Revenue Ruling
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smRev. Rul. 77-18
1977-1 C.B. 46
Section 165
IRS Headnote
Losses; stock; theft. Shareholders who voted to merge their corporation into another corporation on the basis of the latter's false financial statements, which the corporation specifically warranted all material facts to be true and fully disclosed, experienced a theft loss under State law in the year of discovery from the exchange of stock. A deduction is allowable in the year of discovery unless a reasonable prospect of recovery exists.
Full Text
Rev. Rul. 77-18
Advice has been requested whether, under circumstances described below, the taxpayer is entitled to a theft loss deduction under section 165 of the Internal Revenue Code of 1954.
The taxpayer, an individual who is a resident of State N, purchased 100x shares of stock of the G corporation in 1967. In 1973, G's board of directors approved an agreement and plan for the merger of G into the X corporation. Pursuant to the agreement, X provided G with detailed information about its financial condition that was included in the proxy statements sent to G's stockholders for voting upon the merger plan. A specific warranty by X to G with respect to that financial information was set forth in the agreement, stating that the information did not contain any untrue statement of material fact nor did it omit any material facts.
Final approval of the agreement required the votes of stockholders owning at least two-thirds of the stock of each corporation. The agreement was approved and the merger consummated in 1973. The transaction was a reorganization within the meaning of section 368(a)(1)(A) of the Code. The taxpayer received shares of X's stock in exchange for the taxpayer's G stock.
In 1975, information about irregular activities led the authorities to suspend 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.
The reorganization plan provided that certain of X's assets, including G's former assets, would be transferred to a newly created corporation. Under the plan, those stockholders who acquired their X stock in exchange for G stock at the time of the merger would be entitled to receive one share of the new corporation's stock for each share of their X stock. However, the reorganization plan cannot be implemented unless it is approved by X's creditors.
Under section 167 of the Bankruptcy Act, 11 U.S.C. section 567(3) (1970), the trustee was required to report to the court any facts the trustee 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 primary goal of the fraud participants 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 trustee estimated that the fictitious income reported by X for 1972, which was included in the proxy statements sent to G's stockholders, was greater than the net earnings reported by X for that year. Therefore, X had sustained a substantial loss in 1972 while reporting large net earnings. This was also the situation for many years preceding 1972.
During 1975, a number of lawsuits were initiated on behalf of all former stockholders of G as a class that seek to rescind the 1973 merger agreement because of the fraudulent inducements involved. Because it is not feasible to reorganize X if the new entity does not own G, the reorganization plan has been made contingent upon all the suits for rescission being either dismissed with prejudice or enjoined. The reorganization plan states that, if all such suits are dismissed or enjoined, the shares of stock of the new corporation received by the former stockholders of G will be the consideration for settlement and dismissal of the actions or be deemed the allowance for the claims enjoined.
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 theft. The applicable definition of 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 laws of State N, persona person who shall by false pretenses obtain from another person any chattel, money or valuable security, with intent to defraud any person of the same, shall be guilty of a theft.
The above crime is committed under the laws of State N when a person: (1) makes a false representation of a past or existing fact; (2) with intent to defraud; and, (3) knowledge of its falsity; and (4) obtains any chattel, money or valuable security from an owner; (5) who relies upon the false representation; (6) to that owner's detriment.
In the instant case, false representations about the financial condition of X were made to G's stockholders with the intent to induce them to vote for the merger. The responsible X officials knew of the falsity of the financial statements they issued. The stockholders of G relied upon the false financial statements at the time they decided to exchange their stock for X stock which was worth substantially less than was represented. The exchange was a theft by false pretenses under the laws of State N and therefore, meets the definition of theft for Federal income tax purposes.
Section 165(e) of the Code provides that for purposes of section 165(a) any loss arising from theft shall be treated as sustained during the taxable year in which the taxpayer discovers such loss. In the instant case, the fraud at X was discovered, and therefore sustained, in 1975.
However, section 1.165-8(a)(2) of the Income Tax Regulations states, in part, that if in the year the taxpayer discovers the loss arising from a theft there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained, for purposes of section 165, until the taxable year in which it can be ascertained with reasonable certainty whether or not such reimbursement will be received.
Section 1.165-1(d)(2)(i) of the regulations states, in part, that whether a reasonable prospect of recovery exists with respect to a claim for reimbursement of a loss is a question of fact to be determined upon examination of all facts and circumstances.
In the instant case, the taxpayer has a reasonable prospect of recovery for any loss caused by the theft sustained in 1975. One such prospect is the claim for rescission of the G-X merger and the consequent restoration of G stock to its former owners. The taxpayer has another prospect of recovering a substantial portion of the taxpayer's investment through participation in the bankruptcy reorganization.
Accordingly, in the instant case, the taxpayer is not entitled to a theft loss deduction pursuant to section 165 of the Code since there exists a reasonable prospect of recovery.