Unknowingly engaging in fraudulent transactions or learning you are the victim of a scam is never a good thing. When you’ve lost some of your hard-earned money due to theft, fraud, or a scam, you may be able to deduct the amount at tax time. However, state laws have three criteria that must be met to deduct losses resulting from these situations, as the taxpayer in the next situation unfortunately had to learn.

The Situation

At a local swap meet, the taxpayer met Eugene McCullough when interested in his gold clubs and accessories. After forming a quick friendship, McCullough mentioned an old Navy-mate, known as Lawyer Stanley, and claimed he had a troubled past. However, according to McCullough, Stanley was currently doing well in the diamond industry. Since the taxpayer wanted a small pair of diamond earrings, McCullough contacted Stanley, who could not make a sale because he only did wholesale.

Within a few weeks, McCullough told the taxpayer that Stanley had contacted him with an interesting offer, and that the taxpayer should consider. With an adequate initial investment, Stanley could offer her $1 million after he had acquired the diamonds and resold them. Because of her friendship and trust of McCullough, the taxpayer didn’t sign any contracts or documents, and was expecting a ROI within 10 to 30 days.

The taxpayer sent $320,000 via wire transfer to Africa World Trade, LLC, and within days McCullough told her that Stanley emailed him, excited about the millions she could make if she continued to provide capital. She could own a bank! She reacted to the immediacy of the emails, and wired $60,000 more.

That’s when the delays started. First, a bank wouldn’t let Stanley pay the taxpayer, then it was the holiday season, and the final delay revolved around the inland revenue taxes. Stanley emailed McCullough a desperate plea for more money, as the revenue taxes were raised to 1.0025% and he required an additional $25,000 – which the taxpayer sent.

Once in court, it was determined that this is a common scam that has been claiming victims since the internet began. It was a textbook case: delays to excuses to more delays and more excuses.

Seventy-four days after the first wire transfer, the taxpayer became suspicious. After emailing both parties, she learned that Stanley needed a probate document for the deal to be complete. When the taxpayer threatened to go to the police, Stanley didn’t seem concerned. Instead, she received forged documents from a group called the Foreign Credit Commission (FCC), with incorrect numbers, and when she questioned it, Stanley accused her of causing more delays.

Then he stopped answering emails and phone calls. She realized she’d been had. McCullough talked to authorities on her behalf, and contacted both the FBI and district attorney, even going as far as Congress, but it had zero impact. The local police in Stanley’s last known address determined he’d skipped town, and no lawyers wanted to touch her case. The only thing she has was the emails between her and Stanley, which documented the transactions over the course of the year. She hadn’t pressed charges or filed a case against Stanley because she couldn’t find him.

As a result, the taxpayer opted to deduct $405,000 on her tax return as a loss resulting from theft. The IRS denied the deduction, under the concept that since police made no determination and she didn’t file a suit or claim against the con artist, it was not theft.

The court stated that a case is not required for a to be proven, however the taxpayer has to prove through evidence that theft did occur according to state law. Theft by false pretense has three elements as per state law:

  1. The concoction of false pretense or misrepresentation by the defendant
  2. Intent to defraud property from its owner
  3. Reliance in parting with his property by the owner, under the false pretenses

In this situation, the taxpayer had to prove that Stanley’s failure to deliver were not the result of legitimate commercial default. Commercial default occurs when the taxpayer has agreed to a contract with a legal business. In a separate case, the courts determined that purchased stocks from a business that underwent bankruptcy later on does not count as theft loss. The same is true for a bad business deal – the court determined no theft loss occurred.

However, in this case, the court agreed that Stanley was not running a legitimate business. The taxpayer never received contracts or other documents, and what was sent to her was falsified. She received zero written confirmation that her expectations of doubling her investment in 10 to 30 days was accurate. The court claimed the taxpayer was a victim of fraud and Stanley had scammed her because he did not represent himself correctly.

Secondly, the court determined that the next criteria of theft by false pretense was met, stating: “we can think of no plausible intent on Stanley’s part other than to defraud her of her money and never perform the deal he promised.”

In meeting the last criteria, it was evident that the taxpayer did rely on the false pretense set forth by Stanley. State courts have reiterated that we can think of no plausible intent on Stanley’s part other than to defraud her of her money and never perform the deal he promised.”

There is no proof or evidence to suggest that the taxpayer was suspicious of Stanley from the beginning, and even if she was, she didn’t have any warning suggesting the transaction was fraudulent. Because of this, the court allowed her $405,000 theft loss deduction.