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ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – THEFT LOSSES AND TAX REFUNDS IN CALIFORNIA – THE FELIPE CASE
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ASK THE CALIFORNIA EMPLOYMENT TAX AND PAYROLL TAX ATTORNEY – THEFT LOSSES AND TAX REFUNDS IN CALIFORNIA – THE FELIPE CASE

By Robert S. Schriebman

2021

Introduction

Mr. and Mrs. Felipe paid the huge sum for the preparation of phony tax returns that initially generated substantial refunds. When the FTB audited these returns they disallowed the refunds and assessed the Felipe’s substantial deficiencies together with penalties. The Felipe’s wanted to offset the assessments by claiming a theft loss for the fee paid to the crooked return preparer. The case was brought before the Office of Tax Appeals (OTA). The decision spelled out the rules required for deductions or refunds based upon a casualty or theft loss. 2021-OTA-026, OTA Case No. 18053219

This article will discuss the Felipe case and set forth the rules relating to the FTB’s allowance of a casualty loss based upon theft.

The Felipe Case

C. Felipe Jr. and T. Felipe were born and educated in the Philippines. They were not well versed in matters of US taxation. Prior to the tax year 2009, they had hired a reputable tax return preparer who charged them only a few hundred dollars to prepare their annual FTB and IRS income tax returns. When these returns were prepared, they paid substantial additional taxes over and above their withholdings. They did not receive any refunds.

They had real estate investments in California and Nevada, but during the Great Recession in 2008 and 2009, their Nevada property went into foreclosure and they loss quite a bit of money. In 2010 they retained a new tax advisor, Ms. S., who was recommended by a friend and co-worker. They did not undertake any other kind of due diligence to investigate the bona-fides of Ms. S. Ms. S. charged them a fee of 20% of any tax refunds received. Ms. S. prepared tax returns for the years 2009 through 2014. Each return was filed late. Each return prepared by Ms. S. claimed phony theft/casualty losses totaling over $1.5 million. In each of the returns that Ms. S prepared she did not sign any of the returns as the preparer. This should have raised a red flag with the Felipe’s, but they ignored it.

Instead of paying Ms. S. 20% of the amount of refunds, the Felipe’s paid about $26,000 in 2014, but made the check payable to Ms. S’s son at her request

The FTB audited the Felipe’s for the years 2009-2014 and in each year assessed an average of $20,000 in additional taxes together with an average of $4,000 in accuracy-related penalties. The FTB allowed only a foreclosure loss for 2009 in the amount of $156,000,

The Felipe’s challenged these assessments before the OTA but limited their argument to a deduction of the $26,000 paid in 2014 as either a theft/casualty loss or a fee paid for the preparation of tax returns.

Basic Rules for Casualty Loss

The rules for deducting losses are set forth in IRC §165.  This section was part of the 1954 tax law.  The rules have not changed much since they were enacted.  Losses are divided into the following categories:

    1. Losses incurred in a trade or business;
    2. Losses incurred in any transaction entered into profit, but not connected with a trade or business;
    3. Casualty and theft losses.

Casualty losses have several key factors:

    1. The loss results from an event that is sudden, unusual, and unexpected.
    2. The loss is not fully covered by insurance.
    3. You have to deduct $100 from the amount of the loss.
    4. A theft loss is only allowed in the year the theft was discovered.

In California the rules for the deduction of losses are set forth in R&TC § 17201.  This section simply says that the FTB will follow the rules set forth in the Internal Revenue Code.

The OTA’s Decision

The Felipe’s contended that they were entitled to a miscellaneous itemized deduction of the $26,000 paid to Ms. S.’s son in 2014 as a theft loss under IRC §165.  The check, made out to Ms. S’s son noted that it was for an “audit reconciliation.”

In order to deduct a theft loss, one has to prove: (1) the occurrence of a theft; (2) the amount of the theft loss; and (3) the year in which the theft loss was discovered. (IRC §165(a)(c)(e)).  The IRS has defined the term “theft” to include, but not necessarily be limited to, larceny, embezzlement and robbery (Tres.Reg.Sec.1.165-8(d)).

The Felipe’s argued that Ms. S. committed theft by depriving them of their funds by misrepresenting that she was qualified to prepare their returns.  The OTA refused to allow a deduction for the year 2014 because the Felipe’s continued to make payments to Ms. S. until 2016.  The judge also noted that the Felipe’s neither filed a police report nor did they bring a civil suit against Ms. S. for theft.  The check made payable to Ms. S.’s son, on its face, stated that the payment was for an audit reconciliation.  The judge correctly pointed out that there is no such thing as an audit reconciliation.  The Felipe’s had no clue either.

The judge disallowed the deduction because the Felipe’s could not show what year they discovered the theft, nor could they prove that they actually paid for tax return preparation.

Conclusion

The Felipe’s case had two arguments for the deduction of the $26,000 paid to Ms. S. They lost the casualty/theft loss argument. They also argued that they should be allowed the deduction as a fee for years of tax return preparation. My next article will discuss this aspect of their case.

***

Robert Schriebman has a successful practice in the Rolling Hills Estates area of Los Angeles County serving clients throughout California and the United States. He has successfully dedicated more than 50 years to helping individual taxpayers, business owners, CPAs, Enrolled Agents, and tax attorneys navigate the complicated tax systems of the federal and state governments. Mr. Schriebman is in private practice. He is not affiliated in any way with the EDD and he is not employed by the EDD or any other agency of the State of California.

Robert Schriebman has written the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House.

Robert Schriebman has written over 20 books including the major manual used nationally by practitioners and the IRS, “IRS Tax Collection Procedures – A Manual for Practitioners” published by Commerce Clearing House in addition to the only 2 books ever published dealing with how California Employment Development Department (EDD) operates. See “California Tax Collection Practice and Procedures” and “California Taxation Practice and Procedure,” both published by Commerce Clearing House.

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