Take-Away: Currently there is no income tax deduction for theft losses. The inability to deduct a theft loss can cause enormous hardship on the victims of a theft.

Background: We know that a distribution taken from an IRA is taxable. But what if the distribution was part of an orchestrated plan to fraudulently take the account owner’s IRA funds. Can the victimized account owner avoid paying income taxes on the distribution the owner did not receive or benefit from? No, says a federal District Court decision. The Court  reached this conclusion while sympathizing with the IRA owner, but in the end found that their participation in the IRA distribution, i.e., there was no forgery, was sufficient to warrant taxing the IRA owner.

2017 Tax Act: Once again we stumble across one of those provisions of the 2017 Tax Act that we have either forgotten, or tend to overlook while being fixated on the benefits of lower income tax rates, broader income tax brackets, a doubling of the Standard Deduction, or being mesmerized by the doubling of the transfer tax applicable exemption amounts. Historically, victims of theft were entitled to deduct their theft loss in the year the theft was discovered. [IRC 165(e).] However, that changed with the 2017 Tax Act, which suspended the theft loss deduction for tax years 2018 through 2025. [IRC 165(h)(5).] The impact of this suspension of the theft loss deduction was profoundly on display in a recent federal District Court decision.

Gomas v. United States, U.S. District Court for the Middle District of Florida, No. 8:22-CV-01271 (July 19, 2023)

Facts: The underlying facts are pretty complicated but they will be tersely summarized. Mr. Gomas ran a business before his retirement years. When he moved to Florida he hired his wife’s daughter to run the day-to-day business in his absence. Over time this daughter induced her stepfather and mother to give to her greater and greater authority over the business. Mr. Gomas ultimately decided to close the business in 2015; he even took steps in 2016 to dissolve the corporation, and he retired to Florida. However, in 2017, the stepdaughter told the Gomases that she thought she could continue run the business from her home, they agreed, and she moved the business into her Florida home. The daughter also convinced the Gomases to give her $20,000 to build a fence around her home and a shed to assist in her operating the business from her home. But this was just the start. The stepdaughter began to manipulate the elderly Gomases by suggesting that they faced imminent incarceration arising from earlier business merchant service accounts that used Mr. Gomas’s personal information, e.g. his Social Security information. The daughter told him that former employees had used these subaccounts to defraud internet customers and that the main account holder (Mr. Gomas) would held personally liable. To carry out this ‘story’ she then told Mr. Gomas that he had to hire an attorney to protect him from being arrested for the fraudulent transactions. The daughter claimed to have  hired an attorney for the Gomases (who they never met over the years, the daughter handling all communications with him on their behalf) and induced them to pay ‘their’ attorney $125,000. The daughter went so far as to open an email address in the name of the attorney [unbeknownst to him] which she used to correspond to the Gomases. Of course, the attorney never knew any of this was going on. The daughter forged numerous legal and business documents to perpetuate her fraud. She used the fake email address for the ‘hired’ attorney, which directed all communications from the Gomases to the daughter and not to the attorney, who never opened a file on behalf of the Gomases. As part of this scheme, the Gomases ultimately withdrew $1,133,250 from their retirement accounts in 2017, handing about $700,000 to the daughter in 2018 to ‘deal’ with the fabricated claims and continuing attorney fees to presumably keep  Mr. Gomas from becoming incarcerated. Only in 2020 were the Gomases made aware of the daughter fraudulent scheme (she had apparently scammed others who started the investigation into her activities.)

Criminal Charges: There was ultimately limited justice for the Gomases. In June, 2022 the daughter pled guilty to multiple theft and fraud charges and she was sentenced to 25 years in prison for her multiple felonies.]

Income Tax Problems: As noted, in 2018 the Gomases took significant distributions from their retirement accounts as part of the daughter’s scheme to defraud them. They reported the taxable distributions ($1,175,799) and paid a tax liability of $412,259. The IRS then imposed a penalty of $758.14 because they did not prepay the income tax on the IRA distribution! Later, the Gomases were rewarded with a tax refund of (a whole!) $659.86. In 2020, after the fraud was fully discovered,  the Gomases then filed a claim for the refund of their 2018 income tax liability claiming a tax loss since the distributed funds had been used to pay expenses,  fictious invoices, fake attorney’s fees, and other ‘fraudulent mechanisms’ use by the daughter, all warranting the conclusion that they were the victims of an elaborate theft. The IRS rejected their claim for an income tax refund. The Gomases then filed suit in the federal District Court seeking a tax refund of the $412,259 paid.

District Court: Despite saying many nice things about the Gomases and expressing sympathy for their predicament, the Court found that they were not entitled to any income tax refund. Tax deductions are a matter of legislative grace. A taxpayer must prove his/her entitlement to the deduction. More importantly, the ability to claim a theft loss was suspended during the period in question, thanks to the Tax Act of 2017.

Gomas Argument: Since their miscellaneous deductions, like theft losses,  were suspended, the Gomases were forced to attempt to pitch their entitlement to a tax refund as part of IRA ‘common’ law. They claimed that the IRA distributions should be excluded from their income because they ‘did not enjoy the benefit of’ those distributed funds. The evil daughter enjoyed the benefit through her fraudulent scheme. While normally the distributee of an IRA is subject to taxation [IRC 408(d)(1)] some court have created an exception to that rule and have found that the ‘taxable distributee’ under the statute may be someone other than the IRA owner, or purported recipient, eligible to receive the IRA distribution

Court Response: While acknowledging that there are limited exceptions to the distributee having to pay the tax on an IRA distribution, the Court observed:

“In this case, Plaintiffs are the taxable distributees despite their attempts to characterize Anderson [the evil daughter] as such. Plaintiffs authorized and directed each stock sale from Mr. Gomas’s IRA account and each wire transfer to their personal Sun Trust account. They freely exercised their discretion over the expenses paid from those accounts, including their personal expenses and handouts to Anderson. Plaintiff’s case is readily distinguishable from Roberts, where the taxpayer’s ex-wife signed withdrawal requests and received and endorsed checks without the taxpayer’s authorization, forging his signatures… Had Anderson forged Plaintiff’s signatures and collected the money herself, there would be a very different outcome here. Unfortunately for Plaintiffs, because they were the ones who requested and received the IRA distributions , they are the payees or distributees within the meaning of IRC 408(d)(1). Anderson’s subsequent theft does not change Plaintiff’s status as distributees…The IRA distributions and pension funds are not deductible.”

The Court also rejected the argument that the distributions from the IRA were ‘business expenses’ primarily because the Plaintiffs were not then engaged in any for-profit business activity- they had retired.

Judicial Soliloquy: The District Judge went out of his way to comment on Congress’s lack of foresight when it enacted the 2107 Tax Act.

“Plaintiffs were the undisputed victims of a complicated theft spanning around two years, resulting in the loss of nearly $2 million dollars. The thief-Mrs. Gomas’s own daughter and Mrs. Gomas’s stepdaughter- was rightly convicted and is serving a lengthy prison sentence. The fact that these elderly Plaintiffs are now required to pay tax on monies that were stolen from them seems unjust.

In view of the egregious and undisputed facts presented here, it is unfortunate that the IRS is unwilling- or believes it lacks the authority- to exercise its discretion and excuse payment of taxes on the stolen funds. It is highly unlikely that Congress, when it eliminated the theft loss deduction beginning in 2018, envisioned injustices like the case before this Court. Be that as it may, the law is clear here and it favors the IRS. Seeking to avoid an unjust outcome, Plaintiffs have attempted to recharacterize the facts from what they really are- a theft loss- to something else. Established law does not support this effort. The Court is bound to follow the law, even where, as here, the outcome seems unjust.”

Observation: If the Gomases had not initially paid the income taxes, would the IRS have had the authority, under existing ‘offer in compromise’ provisions of the Tax Code, to potentially reduce or eliminate the Gomases’ tax liability, thus avoiding the hardship that they now face?

Conclusion: The facts of the Gomas case are troubling. The ugly concept of elder abuse readily comes to mind. While there might be some type of order of restitution arising from the criminal proceeding against the daughter, it is highly unlikely that it will make the Gomases whole, since their daughter will be spending the next 25 years (the balance of the Gomases’ lifetimes) in prison. Also, the District Judge was pretty restrained in his remarks about how Congress probably did not envision the injustice caused by its suspension of the theft loss deduction from 2018 through 2025. Still, let’s be honest, it is not the first time that Congress has acted, in haste, at the end of a calendar year, without foresight as to the consequences of its actions.