                               T.C. Memo. 2019-39



                         UNITED STATES TAX COURT



  DONNOVAN M. McNELY AND BETTY J. CRUZ-McNELY, Petitioners v.
       COMMISSIONER OF INTERNAL REVENUE, Respondent



      Docket No. 30415-15.                          Filed April 18, 2019.



      Cindy L. Ho, for petitioners.

      Cameron W. Carr and Thomas R. Mackinson, for respondent.



            MEMORANDUM FINDINGS OF FACT AND OPINION


      NEGA, Judge: Respondent determined a deficiency in petitioners’ 2011

Federal income tax, a late filing addition to tax under section 6651(a)(1),1 and an


      1
       Unless otherwise indicated, all section references are to the Internal
Revenue Code in effect for the taxable year at issue, and all Rule references are to
the Tax Court Rules of Practice and Procedure. All monetary amounts are
rounded to the nearest dollar.
                                         -2-

[*2] accuracy-related penalty under section 6662(a) of $133,779, $37,323, and

$26,755, respectively.

      After stipulations,2 the issue before the Court is whether petitioners are

entitled to deduct theft losses passed through M & M Properties, Inc. (M & M),

totaling $418,283 for their tax year 2011.3

                                FINDINGS OF FACT

      Some of the facts are stipulated and are so found. The stipulation of facts

and the attached exhibits are incorporated herein by reference. Petitioners resided

in California when they timely filed the petition.


      2
        The parties have stipulated: (1) an adjustment of $10,956 to income for
gambling losses claimed as other miscellaneous deductions on Schedule A,
Itemized Deductions; (2) liability for the sec. 6651(a)(1) late filing addition to tax;
and (3) liability for the sec. 6662(a) accuracy-related penalty. Further, we note
that the record contains evidence, in the form of a civil penalty approval form, that
respondent complied with the requirements of sec. 6751(b)(1). See Graev v.
Commissioner, 149 T.C. 485, 493 (2017), supplementing and overruling in part
147 T.C. 460 (2016).
      3
        In the notice of deficiency, respondent disallowed any deduction for the
theft loss. Respondent has conceded that the S corporation described below
incurred a theft loss but argues that petitioners were not entitled to deduct any of
that loss for 2011 for lack of proof that the loss was incurred during that year. The
only year before this Court is 2011. Additionally, we find the record lacks facts
sufficient to enable us to consider the implications of the theft loss for years
outside 2011 with respect to our redetermination of the deficiency properly before
this Court. See Hill v. Commissioner, 95 T.C. 437, 439-440 (1990). Accordingly,
our jurisdiction over this loss extends only to the claim made on petitioners’ 2011
tax return.
                                        -3-

[*3] I.        M & M Properties, Inc.

          Petitioner Donnovan McNely and Jeffery McKay incorporated M & M on

October 23, 2008, as 50% shareholders. M & M was an S corporation at all

relevant times. M & M was involved in the real estate business in northern

California exclusively until Mr. McKay’s cousin, Justin Sinnott, presented M & M

with an investment opportunity in southern California.

          Mr. Sinnott’s proposed opportunity to M & M involved M & M’s

purchasing distressed real estate properties which had immediate renters who

could not qualify for loans to purchase the homes. This would create immediate

rental income for M & M before it later sold the property to the renter for a

premium. The purchases would take place through First Investments, JoCal

Investments, Eternity Escrow, and Salem Abbadi. (We will refer to the actors and

the proposed opportunity collectively as the fraud scheme.) The truth behind the

opportunity was a complex real estate fraud transaction which, generally, faked a

short sale of property to a cash buyer (e.g., M & M) and issued a grant deed to the

cash buyer (e.g., M & M). No one paid the bank holding the note on the property.

Thus, after the bank foreclosed on the property, the cash buyer (e.g., M & M)

would no longer have ownership of the property. In some transactions the fraud
                                        -4-

[*4] scheme would use real title companies which had title insurance, but in other

transactions they would use fake title companies created under the fraud scheme.

      Between 2008 and 2011, M & M purchased between 14 and 16 properties.

While the record is unclear on how many of these properties were purchased as

part of the fraud scheme, at least six properties (six Southern California properties)

were subject to the fraud scheme.

II.   The Six Southern California Properties

      Between January 28 and November 30, 2010, M & M acquired the six

Southern California properties. Of the six Southern California properties, at least

four used real title companies.

      A.     M & M’s Fraud Suspicion

      Mr. McKay acted as the point of contact, both through Mr. Sinnott and

directly, for M & M’s dealings with the fraud scheme. On February 24, 2011, Mr.

McKay learned of the possible issues with M & M’s real estate investments

concerning the six Southern California properties through an email from Mr.

Sinnott. In approximately May 2011, Mr. McKay drove to southern California to

speak with members of the fraud scheme but was unable to find anyone associated

with it. After the May trip but at a time not in the record, Mr. McKay spoke with a

member of the fraud scheme and attempted to recoup some of M & M’s
                                       -5-

[*5] investment by fabricating a story involving a rich aunt who was seeking to

invest in commercial real estate the fraud scheme owned. Mr. McKay told the

fraud scheme that his aunt would invest only after M & M had received some of

its investment back. Mr. McKay’s attempt to scam the fraud scheme did not work,

and M & M did not receive any money from the fraud scheme at any time.

      Subsequently, at a time not in the record, but in 2011 after concern arose

with M & M’s potential loss on the six Southern California properties, Mr. McKay

spoke briefly with a fellow country club member, an attorney named Richard

Struck, about the fraud scheme. After their conversation at the country club, Mr.

McKay had a one-hour meeting with Mr. Struck at his office. In that meeting Mr.

McKay described his dealings with the fraud scheme but did not provide any

documentation. Mr. Struck, who was not retained, advised Mr. McKay that the

best recourse would be restitution after litigation. Neither Mr. McNely, Mr.

McKay, nor M & M filed a lawsuit.

      B.    Police Investigation

      Investigator Donald Willie, with the Orange County district attorney’s

office, became involved in the investigation of the fraud scheme in 2012.4 On

      4
       On May 9, 2013, Investigator Willie contacted the Federal Bureau of
Investigation (FBI) for their notes when he began his investigation. The FBI had
                                                                      (continued...)
                                         -6-

[*6] February 25, 2015, Investigator Willie conducted his only interview with

M & M, speaking with Mr. McKay, to gather information related to M & M’s

investments in the fraud scheme. During the interview Mr. McKay asked whether

there was a chance M & M would recover any of its investment, to which

Investigator Willie answered that it was highly unlikely. Other parties had

recovered some or all of their investments through title insurance as some of the

title companies used by the fraud scheme were legitimate. Neither Mr. McNely,

Mr. McKay, nor M & M filed title insurance claims.

III.   Petitioners’ 2011 Tax Return

       Petitioners untimely filed their Form 1040, U.S. Individual Income Tax

Return, for the tax year 2011, claiming a $407,327 Schedule A deduction under

section 165 for a theft loss related to the six Southern California properties.

M & M’s return, filed on September 6, 2012, did not report the theft losses.5




       4
       (...continued)
been investigating the fraud scheme for two years but never spoke to Mr. McNely
or Mr. McKay. The first criminal indictments were filed in 2014.
       5
       The Court is unclear as to why petitioners believed they were entitled to a
deduction for a theft loss when M & M did not claim a theft loss deduction on its
2011 return.
                                        -7-

[*7]                                 OPINION

I.     Burden of Proof

       The Commissioner’s determinations in a notice of deficiency are generally

presumed correct, and the taxpayer bears the burden of proving those

determinations erroneous. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115

(1933). Deductions are a matter of legislative grace. Deputy v. du Pont, 308 U.S.

488, 493 (1940). Taxpayers must comply with specific requirements for any

deductions claimed. See INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84

(1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934).

II.    Section 165 Theft Loss

       Section 165 generally permits taxpayers to deduct against their ordinary

income the amount of any uncompensated loss resulting from theft for the year in

which the taxpayer discovers that loss. See sec. 165(a), (c), (e). To qualify for a

theft loss deduction, taxpayers must prove: (1) the occurrence of a theft, (2) the

amount of the theft loss, and (3) the year in which the taxpayers discover the theft

loss. Id.

       A taxpayer may deduct a theft loss for the year in which the loss is

sustained. Sec. 165(a). Any loss arising from theft is treated as sustained during

the taxable year in which the taxpayer discovers the loss and in which the loss is
                                         -8-

[*8] evidenced by a “closed and completed” transaction. Sec. 165(e); sec. 1.165-

1(d)(1), Income Tax Regs. Whether there is a closed and completed transaction

with respect to a theft loss depends on the taxpayer’s prospect of recovering the

loss. Sec. 1.165-1(d)(2)(i), Income Tax Regs. Whether there is a reasonable

prospect of recovery is a question of fact that must be determined by examining all

facts and circumstances. Id.

      The test for determining whether the taxpayer had a reasonable prospect of

recovering a theft loss is primarily an objective test. See Ramsay Scarlett & Co. v.

Commissioner, 61 T.C. 795, 811 (1974), aff’d, 521 F.2d 786 (4th Cir. 1975).

However, the taxpayer’s subjective belief as of the close of the year that there is a

reasonable prospect of recovering the loss is also an important and relevant factor.

See Boehm v. Commissioner, 326 U.S. 287, 292-293 (1945).6 The burden of

proof is on petitioners, and they must prove that it could have been ascertained

with reasonable certainty as of December 31, 2011, that the loss would never be




      6
       Boehm v. Commissioner, 326 U.S. 287 (1945), did not involve the theft
loss deduction at issue here but rather a deduction available to holders of corporate
stock that becomes worthless. However, the Court of Appeals for the Fourth
Circuit in Ramsay Scarlett & Co. v. Commissioner, 521 F.2d 786 (4th Cir. 1975),
aff’g 61 T.C. 795 (1974), analogized to Boehm in a very similar context, and we
agree that the analogy is apt. Jeppsen v. Commissioner, 128 F.3d 1410, 1418 n.6
(10th Cir. 1997), aff’g T.C. Memo. 1995-342.
                                          -9-

[*9] recovered.7 See Jeppsen v. Commissioner, 128 F.3d 1410 (10th Cir. 1997),

aff’g T.C. Memo. 1995-342; sec. 1.165-1(d)(3), Income Tax Regs. If in the year

of discovery there exists a claim for reimbursement with respect to which there is a

reasonable prospect of recovery, no portion of the loss with respect to the which

reimbursement may be received is sustained until the year in which it can be

ascertained with reasonable certainty whether such reimbursement will be

received. Jeppsen v. Commissioner, 128 F.3d at 1414; see sec. 1.165-1(d)(3),

Income Tax Regs. Further, if the prospect of recovery was “simply unknowable”

at the end of the tax year, then the taxpayer is not entitled to the theft loss

deduction for that year. See Vincentini v. Commissioner, 429 F. App’x 560, 564

(6th Cir. 2011) (“[S]peculation and conjecture will not support a taxpayer

deduction under this provision[.]”), aff’g T.C. Memo. 2009-255, supplementing

T.C. Memo. 2008-271.

III.   Actions

       Mr. McNely personally did not speak with anyone from the fraud scheme,

Mr. Struck, or Investigator Willie. All communications were through his business


       7
        The Court has jurisdiction in this proceeding to determine whether
petitioners are entitled to deduct any theft loss incurred by M & M during 2011.
See, e.g., Winter v. Commissioner, 135 T.C. 238 (2010); Powell v. Commissioner,
T.C. Memo. 2016-111, at *2 n.1, aff’d, 689 F. App’x 763 (4th Cir. 2017).
                                        - 10 -

[*10] partner, Mr. McKay. Mr. McNely testified that in 2010 “we talked to an

attorney” who advised that it would cost several hundred thousand dollars to fight

the fraud scheme and that they would not recover their money.8 The evidence in

the record fails to show that Mr. McNely personally spent any time, money, or

effort to recover his loss. A relevant factor is the amount of time and money spent

by the taxpayer investigating and prosecuting the claim. See Nat’l Home Prods.,

Inc. v. Commissioner, 71 T.C. 501, 526 (1979).

      Because of the vagueness and inconsistences revealed in the record, the

Court does not find Mr. McNely’s testimony credible but does find the

inconsistencies important in the Court’s determination of the year in which the

loss was sustained as compared to Mr. McNely’s subjective belief. Mr. McNely’s

uncorrobortaed and, in part, contradicted testimony shows he believed he had no

reasonable prospect of recovery in 2010, not 2011, the year for which the theft loss

deduction was claimed. Mr. McNely testified that the fraud scheme led M & M to

believe it had interests in the commercial real estate scam M & M had presented

and that it took M & M five or six months to realize that it had completely lost its




      8
        The Court has no evidence of Mr. McNely’s speaking with an attorney
other than his uncorroborated testimony.
                                         - 11 -

[*11] investment in 2010 upon the fraud scheme’s returning none of their

investment.9 He subsequently spoke with a lawyer and his accountant, who both

informed him there was no prospect of recovery in 2010.10 Further, he claims to

have filed a police report in late 2010 but did not provide any evidence of this

claim.

         Mr. McNely testified that he did not file an insurance claim because he

believed that all the titles were fake. However, Mr. McNely did not provide any

evidence other than his testimony. The Court finds credible Investigator Willie’s

testimony that other victims did recover through title insurance claims. The Court

finds that Mr. McNely had the opportunity to file a claim in 2011 with a prospect

of recovery but chose not to.




         9
      Mr. McNely testified that the conversation was probably in May or June
2010. This time line is contradicted by Mr. McKay’s testimony and
communication with Mr. Sinnott, and we decline to find the time line as fact.
         10
         Mr. McNely testified that his accountant agreed and advised Mr. McNely
that the best thing to do was to write it off on his tax return and consider it a loss.
Mr. McNely filed his 2011 tax return untimely in 2014. The Court does not find it
credible that Mr. McNely discussed the loss with and was advised by his
accountant three years before filing his tax return. Further, while the date of his
return was stipulated by the parties, Mr. McNely testified that he believed he did
not file his 2011 tax return untimely, which contradicts the stipulation, and that he
had hired people to complete his tax returns for him.
                                       - 12 -

[*12] In 2011, the year for which the deduction was claimed, the only actions by

M & M were an attempt to scam the fraud scheme and Mr. McKay’s conversation

with Mr. Struck. While M & M’s attempt to scam the fraud scheme clearly shows

it believed it might be possible to recover some of its investment, the meeting with

Mr. Struck confirmed that: Mr. Struck advised that recovery might be possible

through restitution. However, Mr. McNely and M & M failed to file a lawsuit

seeking recovery.

      Further, as late as 2015, when Mr. McKay, on behalf of M & M, was

interviewed by Investigator Willie, he inquired about the prospect of recovery.

This shows that M & M did not have a subjective belief that there was no

reasonable prospect of recovery as late as 2015.

      After reviewing both objective and subjective factors, the Court finds that

M & M’s prospect of recovery was simply unknowable and nothing more than

speculation and conjecture at the end of 2011. By the end of 2011, M & M had

not engaged an attorney, filed insurance claims, or made any effort to recoup any

of the losses. Thus, it would have been impossible for M & M to conclude, when

others had recovered and M & M had been advised of potential recovery options,

there was no reasonable prospect of recovery.
                                      - 13 -

[*13] We have considered all the other arguments made by the parties, and to the

extent not discussed above, find those arguments to be irrelevant, moot, or without

merit.

         To reflect the foregoing,


                                               Decision will be entered

                                      under Rule 155.
