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The IRS wins a victory over a former Worldcom employee who tried to claim a tax deduction for losses sustained when the scandal-ridden company collapsed.
Robert Willens, CFO.com | US
May 12, 2008
Here is a tale of woe, for at least one Worldcom shareholder.
Mahdi Taghadoss was employed by WorldCom for more than 17 years. During that span, he received stock options which he exercised on October 31, 2000. He also acquired Worldcom shares in the follow way: on the open market, through Worldcom's 401(k) plan, and through the company's employee stock purchase plan (ESPP).
Worldcom filed a Chapter 11 bankruptcy petition on July 21, 2002. Clearly, fraudulent accounting practices by certain Worldcom officers contributed to the company's bankruptcy filing. In fact, several of those officers pleaded guilty to charges ranging from fraud to conspiracy. The value of Worldcom's stock declined precipitously and Taghadoss claimed a loss of $1,344,863 from a "casualty" or "theft" on his 2003 federal income tax return. The Internal Revenue Service disallowed the deduction and in April, the tax court, in Taghadoss v. Commissioner, (T.C. Summ. Op. 2008-44) upheld the IRS decision.
The tax code ( provides that no deduction shall be allowed under Section 165(a) solely because the value of stock owned decline when the decline is due to a fluctuation in the market price of the stock, or to some other similar circumstance. Thus, no loss in the value of stock owned shall be allowable for an IRS deduction, except insofar as the loss is recognized upon the sale or exchange of the stock, or if the stock becomes wholly worthless.*
In the case of Taghadoss, neither a sale or exchange, nor a claim of worthlessness was made. Accordingly, the plaintiff's only hope was to demonstrate that he had suffered a casualty loss or a theft loss. In order for a loss to qualify as a casualty loss, however, the loss must be the result of physical damage to the taxpayer's property.
Obviously, there was no physical damage to Taghadoss's securities. Instead, his losses arose from the misconduct of Worldcom's officers, Worldcom's bankruptcy filing, and the liquidation of his securities pursuant to Worldcom's plan of reorganization. Thus, it was clear that the taxpayer did not sustain a casualty loss.
Under Regulation Section 1.165-8, any loss arising from theft is allowable as a deduction for the taxable year in which the loss is sustained. What's more, a loss from theft will be treated as so sustained during the taxable year in which the taxpayer discovers the loss. In these cases, the amount of the loss to be taken into account shall be the lesser of (1) the decline in the fair value of the property, or (2) the property's adjusted basis in the taxpayer's hands.
Whether admittedly fraudulent acts constitute a theft, however, is determined by the law of the state where the loss was sustained. In the instant case, Virginia law was controlling. Under Virginia law, the term larceny is defined as the willful or fraudulent taking of personal goods, of some intrinsic value, belonging to another and without his assent and most importantly, with the intent to deprive the owner thereof permanently.
In the Taghadoss case, the taxpayer failed to prove that he had, under Virginia law, suffered a theft. The court noted that there was no evidence establishing that Worldcom's officers willfully took Taghadoss's money or property with the requisite intent to "deprive him thereof permanently." In fact, Taghadoss did not purchase his securities from the Worldcom officers and those officers had had no direct dealings with Taghadoss.
Finally, there was no evidence introduced that indicated that Taghadoss relied upon the fraudulent financial statements or the memoranda circulated to employees which assured them that "everything was fine at Worldcom" when he purchased his securities. Further, there was no evidence that he relied upon such memoranda with respect to his decision to retain the securities. Accordingly, under the governing law, there was no theft perpetrated upon Taghadoss.
In the absence of showing that the Worldcom securities had become wholly worthless in 2003 (an assertion which the court also rejected), Taghadoss's tax deductions will have to await his sale or exchange of the Worldcom securities.
Moreover, his loss at that time will be classified as a capital loss. Had his loss been classified as a casualty or theft loss, Taghadoss would have enjoyed the distinct advantages of ordinary loss designation.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
* In the event of worthlessness, the loss is treated as a loss from the sale or exchange of a capital asset on the last day of the taxable year in which the worthlessness takes place.