DocketNumber: Docket No. 18774-11.
Citation Numbers: 2014 T.C. Memo. 177, 108 T.C.M. 226, 108 Tax Ct. Mem. Dec. (CCH) 226, 2014 Tax Ct. Memo LEXIS 173
Judges: WHERRY
Filed Date: 8/28/2014
Status: Non-Precedential
Modified Date: 4/17/2021
Decisions will be entered under
Ps claimed a deduction for a bad debt loss on their 2006 Schedule A, Itemized Deductions. Ps subsequently filed a Form 1040X, Amended U.S. Individual Income Tax Return, and characterized the claimed bad debt loss as a theft loss on their Schedule C, Profit or Loss From Business. R determined that Ps were not eligible for a theft loss or bad debt loss deduction for the 2006 tax year and issued a notice of deficiency disallowing a current deduction for the claimed loss.
WHERRY,
The only issues for decision are (1) whether petitioners may claim a bad debt deduction of $4,044,0962014 Tax Ct. Memo LEXIS 173">*174 for the 2006 tax year, and if not, (2) whether petitioners may claim a theft loss of $4,011,6962 for the 2006 tax year.
According to their 2006 Federal income tax return, petitioner Delbert M. Bunch is a broker, and petitioner Ernestine L. Bunch a consultant. At the time the petition was filed, Mr. and Mrs. Bunch resided in Las Vegas, Nevada.
In 2000 petitioners discovered an opportunity in a newspaper advertisement to invest in U.S.A. Commercial Mortgage Co. (Mortgage Co.). Mortgage Co. raised money from investors and made loans to developers for the construction of real estate. In May 2000 Mortgage Co. created the Diversified Trust Deed Fund (Diversified Fund), an unregistered investment fund. Joseph D. Milanowski, then Mortgage Co.'s president, was actively involved in the Diversified Fund.
On June 26, 2000, petitioners and some of their family members loaned Mortgage Co. $10 million, of which petitioners contributed $4,044,096, in exchange for a promissory note (note). According to the note, petitioners and their colenders were to2014 Tax Ct. Memo LEXIS 173">*175 be paid interest at a rate of 20% per annum, with the principal due one year after the final interest payment. The note provided that the loan was secured by "one or more collateral assignments of deeds of trust." The note contained an acceleration clause which stated that "[u]pon the occurrence of an Event of Default, Lender may declare the entire principal balance of the note then *180 outstanding * * * to be due and payable immediately." Mr. Milanowski signed the Note on Mortgage Co.'s behalf in his capacity as its president.
In 2001 several loans in Mortgage Co.'s portfolio apparently went into default. Petitioners were not aware of these defaults. They never received any monthly or quarterly statements with respect to their loans. They never knew what Mortgage Co. did with the principal from their note. Petitioners and their family members received their regular interest payments according to the note until March 31, 2006.
On April 13, 2006, Mortgage Co. filed for bankruptcy under chapter 11 of the United States Bankruptcy Code. According to its bankruptcy petition, Mortgage Co. had $50-$100 million in assets and $10-$50 million in outstanding liabilities2014 Tax Ct. Memo LEXIS 173">*176 at the time of filing. When Mr. Milanowski pleaded guilty to wire fraud on August 4, 2009, in connection with the Diversified Fund, his plea agreement with the United States stated more specifically that, as of April 13, 2006, when it filed for bankruptcy, Mortgage Co. had approximately $962 million in assets under its management.
On November 17, 2006, Mr. Bunch and a group of unsecured nonpriority claimants related to him filed a proof of claim for $11,358,662 against Mortgage *181 Co. in the U.S. Bankruptcy Court for the District of Nevada (bankruptcy court). Petitioners allege they filed the proof of claim in order to "prove * * * [their] loss and get tax refunds."
Nearly three years later, on July 9, 2009, the bankruptcy court allowed petitioners' claim against Mortgage Co. as a general unsecured claim in the amount of $11,358,662. The claim's allowance occurred before a $20 million interim distribution to creditors approved by the bankruptcy court on October 27, 2009. Petitioners received at least one distribution from Mortgage Co.'s bankruptcy estate though the record does not clearly establish its timing.
In a 2006 disclosure statement submitted to the court, Mortgage Co. estimated2014 Tax Ct. Memo LEXIS 173">*177 that it would have sufficient funds to pay 8%-33% of all general unsecured claims after payments to higher priority creditors. And at a 2007 meeting petitioners were advised that they could expect to recover around $500,000 of their loaned funds. In November 2012 the chapter 11 bankruptcy trustee reported that the first interim distribution, in late 2009, had covered 4.92% of allowed unsecured claims, on a pro rata basis, and that a second interim distribution in January 2012 had raised the aggregate percentage to 8.8%.
*183 Donald R. Walker, a member of the Unsecured Creditors' Committee (committee) for Mortgage Co.'s bankruptcy proceeding, testified that the committee learned of "the loss" in the latter part of 2006, just before the bankruptcy plan was confirmed. During 2006 the committee discussed bringing criminal charges against Mr. Milanowski, and attorneys for some creditors communicated with the Federal Bureau of Investigation (FBI) about prosecuting him.
Mr. Bunch testified that petitioners learned of Mortgage Co.'s bankruptcy and that their loaned funds had been lost or stolen in 2006, through a meeting with Mr. Milanowski and examination of Mortgage Co.'s tax returns and financial statements. He also testified, however, that Mr. Milanowski did not reveal during the meeting that Mortgage Co. had fraudulently misrepresented its assets and liabilities in its bankruptcy filings,2014 Tax Ct. Memo LEXIS 173">*180 and that petitioners learned only "later" that Mortgage Co.'s reported financials were "untrue".
Petitioners filed a Form 1040, U.S. Individual Income Tax Return, for taxable year 2006. They claimed a bad debt deduction of $4,044,096. On their 2009 Form 1040X, they changed their claimed bad debt deduction of $4,044,096 to a theft loss deduction of $4,011,696.
*184 On June 29, 2011, respondent issued petitioners a notice of deficiency for taxable year 2006 determining a deficiency in income tax of $74,236.
Petitioners sought to deduct the unrecovered funds they had advanced to Mortgage Co. first as a bad debt loss and later as a theft loss. We examine both alternatives. Either way, deductions are a matter of legislative grace, and petitioners bear the burden of proving that they are entitled to the deduction claimed.
An individual taxpayer is entitled to a deduction for a debt, business or nonbusiness, that becomes wholly worthless2014 Tax Ct. Memo LEXIS 173">*181 during the taxable year.
The distinction between business and nonbusiness bad debt matters for a second reason, as well. For an individual taxpayer, a deduction may also be allowed for a business bad debt that is only partially worthless, to the extent it is charged off during the taxable year.
Because petitioners' loan to Mortgage Co. was a nonbusiness debt, petitioners must establish that the debt was wholly "worthless" within the meaning of
On November 17, 2006, petitioners filed a proof of claim in the bankruptcy court against Mortgage Co. "A proof of claim is a written statement setting forth a creditor's claim."
Even if we were to accept that the proof of claim established the amount of petitioners' loss, the document does not establish that petitioners had no hope of recovery in 2006. On the contrary, it tends to establish the reverse: By filing a proof of claim in Mortgage Co.'s bankruptcy, petitioners took the requisite step to secure a place in the order of distribution from the bankruptcy estate and thereby increased their odds of recovering at least some of the loaned funds.
Moreover, in 2006 there was no clear indication of what Mortgage Co.'s assets and liabilities were. Mortgage Co. asserted that it had excess assets, and the truth or falsity of this assertion was neither revealed in the bankruptcy proceeding nor otherwise known to petitioners until after 2006. Further,2014 Tax Ct. Memo LEXIS 173">*184 as of the end of 2006, the bankruptcy court had yet to allow or disallow petitioners' claim, so they could not know definitively what portion of their loss, if any, might be satisfied from the bankruptcy estate. Hence, the information reasonably obtainable by petitioners indicated they had some hope of at least a partial recovery as of December 31, 2006. That hope would not have been vain. Three years later, the bankruptcy court authorized partial repayment of unsecured creditors like petitioners by way of two interim distributions.
*188 Accordingly, petitioners are not entitled to deduct a bad debt loss for 2006 because they could not establish, by the end of the 2006 tax year, the amount of their loan that they were not going to recover from Mortgage Co.
A taxpayer who, like petitioners, claims a loss deduction due to theft pursuant to
The term "theft" in
In 2009 Mr. Milanowski pleaded guilty to wire fraud; however, a criminal conviction is not necessary in order for a taxpayer to demonstrate a theft loss.
Even if the Court were to accept that petitioners could have proven Mr. Milanowski a thief in 2006, they would still need to prove that they "sustained" a theft loss in 2006. Generally, a theft loss is treated as sustained during the taxable year in which the taxpayer discovers it.2014 Tax Ct. Memo LEXIS 173">*187
Petitioners attempted to establish their loss by filing a proof of claim in Mortgage Co.'s bankruptcy proceeding. For the reasons explained above, petitioners have not shown that there was no reasonable prospect of recovery as of the end of the 2006 tax year. In fact, petitioners did recover at least some portion of their claimed loss, though the record does not clearly establish whether this recovery occurred in 2007 and/or in a subsequent year. Consequently, neither the amount of the bad debt nor the amount of the theft loss was established by December 31, 2006, and no deduction under either
We have considered all remaining arguments the parties made and, to the extent not addressed, we conclude they are irrelevant, moot, or meritless. *193 To reflect the foregoing,
1. Unless otherwise indicated, all section references are to the Internal Revenue Code of 1986, as amended and in effect for the taxable year at issue. All Rule references are to the Tax Court Rules of Practice and Procedure. We round all dollar amounts to the nearest dollar.↩
2. This amount is $4,044,096 reduced to reflect statutory limitations of $100 and 10% of adjusted gross income.
3. A court may take judicial notice of appropriate adjudicative facts at any stage in a proceeding whether or not the parties request it.
As we do here, a court may take judicial notice of pleadings and court orders filed in related proceedings.
We emphasize, however, that we take judicial notice of the trustee's report only for the fact of its content, and not for the truth of that content. At trial, neither party introduced documentary evidence to substantiate whether Mr. and Mrs. Bunch in fact benefited from the interim distributions the trustee describes.↩
4. As the Court of Appeals for the Tenth Circuit explained: Under the Internal Revenue Code, a theft loss is
5. Petitioners specifically sought to deduct a theft loss pursuant to
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