Taxpayer Snared In Fraudulent Investment Scheme Denied Theft Loss And Hit With Penalty

Vincentini v. Comm., (CA 6 7/12/2011) 108 AFTR 2d ¶ 2011-5060

The Court of Appeals for the Sixth Circuit, affirming the Tax Court, has concluded that an individual who claimed a theft loss failed to show that there was no reasonable prospect of recovery in a fraudulent investment scheme. In addition, the Court found that the taxpayer's reliance on an advisor associated with the scam was insufficient to establish a good faith defense against a Code Sec. 6662 penalty for the false losses he claimed under the scheme.

Background. A taxpayer can deduct a loss suffered during the tax year and not compensated for by insurance or otherwise. For an individual, a loss deduction is limited to losses incurred in a trade or business, or a transaction entered into for profit, or arising from fire, storm, shipwreck, or other casualty or from theft. (Code Sec. 165(c))

Any loss arising from theft is treated as being sustained during the tax year in which the taxpayer discovers the loss. (Code Sec. 165(e)) However, if there exists a claim for reimbursement (i.e., a claim for compensation) for which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until it can be determined with reasonable certainty whether or not reimbursement will be received. 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 an examination of all facts and circumstances. (Reg. §1.165-1(d)(2)(i))

Theft losses qualify as net operating losses (NOLs) and can be carried back up to three tax years. (Code Sec. 172(a), Code Sec. 172(b)(1)(F)(ii)(I))

Facts. In '99, Dominick Vincentini invested in two programs offered by Anderson Ark & Associates (AAA), which marketed itself as an investment company with offices in the U.S. and Costa Rica. Under one program, he made a $800,000 investment in factoring commissions for high-end consumer goods. Under the other, he entered into a joint venture (Birdlane Marketing Venture, i.e., Birdlane) with AAA, which would use the proceeds from a business loan to underwrite the marketing of books, electronic media, and audio tapes. On behalf of the partnership, Vincentini executed a promissory note for $950,000 from a purported Costa Rican corporation. To effectuate the loan, Vincentini had to pay $76,000 in origination fees. The majority of the loan was paid to an entity operated by AAA. While the transaction purportedly generated a NOL for the partnership in '99 (which was passed on to Vincentini), in reality the loans were illusory. AAA simply used the fake loans to generate and then steal from investors the fees needed to obtain the fictional capital.

On his '99 return, Vincentini claimed a partnership loss of $907,470 due to Birdlane, which offset a $796,629 early distribution from his IRA. Vincentini's return was prepared by Gary Kuzel, who represented himself as a Certified Public Accountant and was recommended by AAA. Kuzel had previously drawn up the legal documents for Birdlane, explained the partnership framework to Vincentini, and provided him with documents relevant to his investment.

On Feb. 28, 2001, law enforcement officials from the U.S. and Costa Rica raided AAA's offices on the suspicion that the investment programs were in fact elaborate Ponzi schemes. Four of the principals for AAA were arrested and indicted in California. By 2002, a number of them had been convicted on federal criminal charges in the U.S. That same year, these criminal defendants, along with two other employees (i.e., the AAA principals), were also indicted in Washington on a variety of federal crimes that also ended in convictions in 2004, with the court ordering them to pay restitution to their victims and forfeit a substantial amount of personal and real property.

On Mar. 6, 2003, IRS sent a statutory notice of deficiency to Vincentini stating that the partnership loss deduction he took in '99 for Birdlane was inappropriate and assessing an Code Sec. 6662 accuracy-related penalty against him. He eventually conceded that the deduction was improper since the AAA principals had revealed during their trials that the loans had never existed. On April 13, 2003, he filed an amended return for '99 and claimed a theft loss deduction of $835,000 (purportedly carried back from 2001 or 2002), which was eventually adjusted downward to $511,500.

Tax Court decision. The Tax Court concluded that Vincentini hadn't met his burden of proof in showing that there was no reasonable prospect of recovery in 2001 for his theft loss from the AAA principals. The only evidence offered was his uncorroborated testimony that he made some attempts to recover his money. He didn't offer into evidence the forms that he supposedly filled out and submitted to AAA or call any witnesses who could testify to his attempts to recover his money. More importantly, the Tax Court noted that he did not testify that he believed at the end of 2001 that he had no reasonable prospect of recovering his money. The Tax Court also upheld the Code Sec. 6662 penalty, rejecting Vincentini 's claim that under Code Sec. 6664(c)(1) the penalty shouldn't be imposed because he relied in good faith on Kuzel's advice. The Court found that since Vincentini knew of Kuzel's affiliation with AAA, any reliance upon him was misplaced and unreasonable.

Taxpayer's position on appeal. On appeal of the Tax Court decision, Vincentini argued that the Court overlooked two important facts: (1) that by 2002 convictions against the AAA principals had been handed down in California; and (2) that during this criminal trial the AAA principals were represented by court-appointed counsel. Vincentini argued that this conclusively demonstrated that there was no reasonable prospect for recovery since the AAA principals were facing substantial terms of imprisonment and could not afford attorneys.

Appellate decision. The Sixth Circuit found that the Tax Court had properly concluded that Vincentini did not meet his burden. At trial he declined to offer anything more than his own uncorroborated and self-serving testimony to show that at the end of 2002, there was no reasonable prospect of recovery. The fact that Vincentini did not say that he subjectively believed that there was no reasonable prospect of recovery further supported the Tax Court's ultimate conclusion. The Tax Court also found that portions of Vincentini's testimony weren't credible.

While the Sixth Circuit found that the two pieces of evidence argued on appeal were somewhat supportive of Vincentini's position, it wasn't persuaded that the Tax Court's decision was clearly erroneous. Notwithstanding the convictions, in 2002 the California and Washington courts hadn't decided whether the AAA principals would be subject to property forfeitures or restitution orders. Recovery from these parties could have been obtained through these avenues or through the civil suit already contemplated by some investors. Accordingly, the impact of the convictions was altogether unclear to Vincentini in 2002. As for the use of court-appointed counsel for the criminal trial, Vincentini declined to investigate the AAA principals' solvency before his own trial, and thus there was no evidence on the issue presented to the Tax Court before its decision. While the use of court-appointed counsel was probative of whether the AAA principals could satisfy a judgment against them, the Court agreed with the Tax Court's implicit finding that it wasn't dispositive.

Penalty issue. The Sixth Circuit also found that the Tax Court had not clearly erred in rejecting Vincentini's argument that he relied in good faith on Kuzel's advice. Vincentini conducted no research on Kuzel's professional background or the extent of his ties with AAA. Despite Kuzel's open affiliation with AAA, Vincentini did not solicit help from another financial professional to create the Birdlane partnership or prepare his taxes for '99. Vincentini's claim at trial that he consulted his personal investment advisor was unsubstantiated, and the Tax Court properly discarded it.

The Sixth Circuit found that Vincentini put his faith in a biased professional who was affiliated with the organization promoting the investments. The Court reasoned that the fact that Vincentini did not question Kuzel about his professional background indicated that he either errantly omitted important investigatory steps or chose to ignore the telltale signs of an investment that was too good to be true. Either way, Vincentini did not act in good faith to determine his tax liability.

References: For deductible theft losses, see FTC 2d/FIN ¶M-2100; United States Tax Reporter ¶1654.351; TaxDesk ¶367,001; TG ¶17001.