                        T.C. Memo. 2008-212



                      UNITED STATES TAX COURT



         ELECTRIC PICTURE SOLUTIONS, INC., Petitioner v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket No. 14156-05.               Filed September 8, 2008.



     Herman H. Pettegrove, for petitioner.

     Aely K. Ullrich, for respondent.



             MEMORANDUM FINDINGS OF FACT AND OPINION


     THORNTON, Judge:   Respondent determined a $35,450 deficiency

in petitioner’s Federal income tax for the taxable year ended

September 30, 1998.   The issue is whether petitioner is entitled

to a theft loss deduction under section 165 for an investment in
                              - 2 -

corporate shares that became worthless because of alleged fraud

by the issuer and the stockbroker.1

     The parties have stipulated some facts, which are so found.

When the petition was filed, petitioner’s principal office was in

California.

                        FINDINGS OF FACT

     At the heart of this case is petitioner’s investment in

common stock of Novatek International, Inc. (Novatek).

Petitioner purchased Novatek shares on six occasions in 1995 and

1996, most recently on October 2, 1996.    Petitioner purchased the

shares through a stockbroker, Joseph Roberts & Co., Inc.

(Roberts), with which petitioner had a history of doing business.

Novatek’s common stock was traded on the National Association of

Securities Dealers Automated Quotations Small Cap Market System

until October 14, 1996, when trading in the stock was suspended.

On October 28, 1996, Novatek filed a voluntary petition for

protection pursuant to chapter 11 of the Bankruptcy Code.   When

petitioner later attempted to sell its Novatek shares, there was

no market for them.

     On June 18, 1998, the U.S. Securities and Exchange

Commission (SEC) filed a civil enforcement action against

Novatek’s successor in interest and Novatek’s principals and


     1
       Unless otherwise indicated, section references are to the
Internal Revenue Code in effect for the year at issue, and Rule
references are to the Tax Court Rules of Practice and Procedure.
                                 - 3 -

officers.     The complaint alleged that the defendants had

committed a massive fraud on investors by, among other things,

orchestrating a series of sham transactions, announcing highly

profitable nonexistent contracts, and filing materially false and

misleading financial statements.     Subsequently, without admitting

or denying the SEC allegations, one of the individual defendants

consented to the entry of a final judgment that imposed civil

sanctions against him for his role in the Novatek matter and in a

related fraud action.2

         On its Form 1120, U.S. Corporation Income Tax Return, for

the year ended September 30, 1998, petitioner claimed a $115,616

“fraud and embezzlement loss” under the category “Other

deductions”.3    Petitioner reported no capital gain net income on

its Form 1120 and did not attach a Schedule D, Capital Gains and

Losses.     In a notice of deficiency dated May 6, 2005, respondent

disallowed the claimed theft loss deduction.4


     2
       The record does not establish the consequences, if any, of
the U.S. Securities and Exchange Commission’s enforcement action
as to any of the other defendants.
     3
       On brief petitioner concedes that the $115,616 figure
reflected a computational error in its cost basis for the Novatek
stock and contends that the correct amount of loss is
$110,583.55. We deem petitioner to have conceded a corresponding
amount of its claimed theft loss.
     4
       The notice of deficiency is silent as to the proper
characterization of the loss and provides for no tax benefit
related to the loss. The parties have stipulated, however, that
“Respondent characterized the loss as a capital loss that may be
                                                   (continued...)
                               - 4 -

                              OPINION

     Section 165(a) permits a deduction against ordinary income

for “any loss sustained during the taxable year and not

compensated for by insurance or otherwise.”   For this purpose,

any loss arising from theft is treated as sustained during the

taxable year in which the taxpayer discovers the loss.    Sec.

165(e).   Petitioner has the burden of proving it has sustained a

theft loss.5   See Rule 142(a); Welch v. Helvering, 290 U.S. 111

(1933).




     4
      (...continued)
deducted in the year of loss, carried back three years and
carried forward five years.” On brief, respondent calculates the
loss to be $110,512.10. As previously noted, petitioner contends
that the amount of the loss is $110,583.55. Neither party has
expressly addressed the amount, if any, of capital loss that is
deductible in 1998. The record before us does not establish that
petitioner is entitled to deduct any amount of capital loss in
1998, inasmuch as petitioner reported no capital gains in that
year and the record does not otherwise establish that petitioner
had any capital gains for that year. See sec. 1211(a).
Consequently, we do not take literally the stipulation that
respondent has characterized petitioner’s loss as a capital loss
“that may be deducted in the year of loss”. Because we do not
have before us the preceding or subsequent tax years in which
petitioner might be eligible to claim a capital loss carryback or
carryover, and because, as discussed infra, we hold that
petitioner has not established that it sustained a theft loss, we
need not and do not in this proceeding undertake to resolve the
parties’ relatively small difference as to the amount of the
loss.
     5
       Petitioner does not claim and has not established that the
conditions of sec. 7491(a) have been met to shift the burden of
proof to respondent with regard to any factual issue as to
petitioner’s liability for tax.
                               - 5 -

     Whether a theft loss has been sustained depends upon the law

of the State where the loss was sustained.     Bellis v.

Commissioner, 540 F.2d 448, 449 (9th Cir. 1976), affg. 61 T.C.

354 (1973); Luman v. Commissioner, 79 T.C. 846, 860 (1982); Paine

v. Commissioner, 63 T.C. 736, 740 (1975), affd. without published

opinion 523 F.2d 1053 (5th Cir. 1975).    The parties agree that

California law applies in determining whether a theft occurred

with respect to petitioner’s investment in Novatek stock.     Cal.

Penal Code sec. 484(a) (West 1999) provides:

     Every person who shall feloniously steal, take, carry,
     lead, or drive away the personal property of another,
     * * * or who shall knowingly and designedly, by any
     false or fraudulent representation or pretense, defraud
     any other person of money, labor or real or personal
     property * * * is guilty of theft. * * *

     This criminal statute encompasses various larcenous

offenses, including at least two varieties of theft involving

alleged fraud.   See People v. Ashley, 267 P.2d 271, 279 (Cal.

1954) (distinguishing theft by false pretenses and theft by trick

or device).   We need not concern ourselves with the technical

distinctions among these larcenous offenses.    Inasmuch as

petitioner appears to allege theft involving fraud, for present

purposes it is sufficient to observe that the following elements

are essential under California law:    (1) The perpetrator made a

false pretense or representation which materially influenced the

owner to part with his property, (2) the perpetrator did so

knowingly with the intent to defraud the property owner, and
                                 - 6 -

(3) the owner was actually defrauded.     Id. at 279, 282; People v.

Traster, 4 Cal. Rptr. 3d 680, 686-687 (Ct. App. 2003); People v.

Sanders, 79 Cal. Rptr. 2d 806, 810-811 (Ct. App. 1998).      Implicit

in these elements is a relationship of privity between

perpetrator and victim.     Crowell v. Commissioner, T.C. Memo.

1986-314.6

     Generally, a taxpayer who purchases securities on the open

market cannot support a claim of theft under California law

because there is no privity between the perpetrator and the

victim.    Marr v. Commissioner, T.C. Memo. 1995-250; Crowell v.

Commissioner, supra; De Fusco v. Commissioner, T.C. Memo. 1979-

230; cf. First Chicago Corp. v. Commissioner, T.C. Memo. 1995-109

(holding that the taxpayer was entitled to a theft loss with

respect to an investment in newly issued shares of a foreign

company where the stock purchase was not on an open market but

from the company itself).    Petitioner has not alleged or

established a purchaser-seller relationship between itself and

Novatek.     Instead, at trial and on brief petitioner contends that

it was defrauded by Roberts.    On brief petitioner argues:


     6
       In certain narrow circumstances a theft loss deduction has
been allowed where the taxpayer suffered a loss which arose
indirectly from a theft between other parties. See Boothe v.
Commissioner, 768 F.2d 1140 (9th Cir. 1985) (allowing a theft
loss deduction with respect to the taxpayer’s purchase of
nonexistent rights to land, even though the taxpayer was not the
immediate purchaser from the fraudulent vendor), revg. 82 T.C.
804 (1984). Petitioner has not alleged or established that it
suffered a loss which arose from a theft between other parties.
                               - 7 -

“Clearly, Roberts was aware that it was making claims about the

company in order to sell its stock.”   To support this allegation,

petitioner asserts that statements made by Roberts’s

representative were “breaches of the stockbroker’s duty of truth

and fitness for his customer’s portfolio.”   Petitioner alleges

that Roberts was sued and lost in two separate arbitrations held

before the National Association of Securities Dealers (NASD) with

respect to complaints made by other investors.

     The evidence is inadequate, however, to establish that

Roberts or its agents had “guilty knowledge or intent”.     Bellis

v. Commissioner, 61 T.C. at 357.   Similarly, the evidence is

inadequate to establish that Roberts or its agents made any false

pretense or representation to petitioner with intent to deceive.

See People v. Ashley, supra at 282.    Neither the filing of the

SEC complaint against Novatek and its principals nor the entry of

judgment against one of these defendants establishes criminal

intent on the part of Roberts or its agents.   Similarly,

petitioner’s allegation that Roberts was unsuccessful in NASD

arbitration proceedings involving other investors, even if true,

does not establish that Roberts or its agents had the requisite

criminal intent with respect to petitioner’s investment in

Novatek.   See, e.g., Schmidt v. Commissioner, T.C. Memo. 1989-188

(judgment rendered in a civil proceeding was insufficient to
                                 - 8 -

establish a theft loss), affd. without published opinion 891 F.2d

283 (3d Cir. 1989).

     Moreover, petitioner has not shown that it was actually

defrauded by Roberts or its agents, as required under Cal. Penal

Code sec. 484(a), because it has not established that Roberts

appropriated petitioner’s property.      See Crowell v. Commissioner,

supra; De Fusco v. Commissioner, supra; cf. First Chicago Corp.

v. Commissioner, supra.   On brief petitioner alleges that the

shares petitioner purchased were owned or controlled by Roberts,

possibly as the lead underwriter or as the so-called market maker

of the Novatek stock.   Petitioner has failed to prove this

allegation by competent evidence.    Even if we were to assume, for

purposes of argument, that Roberts was the lead underwriter or

market maker of the Novatek shares, the evidence in the record

would still be inadequate to establish the essential elements for

theft under Cal. Penal Code sec. 484(a).

     In sum, petitioner has failed to establish that a theft

occurred under California law.    As a result, we hold that

petitioner is not entitled to a theft loss deduction under

section 165.

     To reflect the foregoing,


                                             Decision will be entered

                                         for respondent.
