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S Corporation Owner Not Entitled to Theft Loss Deduction for Embezzlement Loss

(Parker Tax Publishing June 2021)

The Tax Court held that a taxpayer, who cofounded an S corporation with another individual whom he subsequently accused of embezzling funds from the S corporation, could not take a theft loss deduction for that embezzlement while his civil suit against the individual was still pending. The court also held that the S corporation was not entitled to deduct as compensation $166,494 of unauthorized withdrawals from the S corporation but did find that the taxpayer was not liable for late filing penalties because he had reasonable cause for the late tax return filings. Torres, T.C. Memo. 2021-66.


Michael Torres and Elizabeth Ruzendall cofounded Water Warehouse, an S corporation, in California. During 2016, Torres was the sole shareholder, president, and chief executive officer. Around 2010, Ruzendall was no longer an owner, but she continued to manage Water Warehouse's books and records. During 2016, Torres suffered from an illness that left him unable to work for Water Warehouse for most of the year. At this time, Torres was unable to read and relied upon others to handle the taxes of Water Warehouse. Pursuant to the advice of a bookkeeper, Water Warehouse issued to Ruzendall a Form 1099-MISC, Miscellaneous Income, reporting $166,494 in nonemployee compensation for 2016. In 2018, Torres learned to read and started handling Water Warehouse's tax matters. In July of 2018, he filed a civil suit against Ruzendall alleging that Ruzendall had misappropriated funds from Water Warehouse. In his complaint, Torres alleged that he had discovered Ruzendall's actions on October 1, 2017.

Torres filed his 2016 Form 1040 in July of 2018. On this Form 1040, he reported flowthrough income from Water Warehouse of $319,214. Water Warehouse did not file its 2016 Form 1120S, U.S. Income Tax Return for an S Corporation, until July of 2018. The IRS issued Torres a notice of deficiency on April 1, 2019. On April 16, 2019, Water Warehouse submitted an amended 2016 Form 1120S, on which it reported an additional $166,494 in expenses for "outside services" for Ruzendall's alleged embezzlement. On April 16, 2019, Torres submitted Form 1040X, Amended U.S. Individual Income Tax Return, for 2016, in which he reduced his reported flowthrough income from Water Warehouse to take into account the $166,494 alleged theft loss.

Under Reg. Sec. 1.165-1(c) and Reg. Sec. 1.165-1(d)(1), a taxpayer can take a theft loss deduction if the taxpayer can prove there was a theft and establish the amount of the loss and the year in which the loss was sustained. Pursuant to California law, embezzlement requires that the following elements be proven: (1) the owner entrusted his or her property to the defendant; (2) the owner did so because he or she trusted the defendant; (3) the defendant fraudulently converted that property for his or her own benefit; and (4) when the defendant converted the property, he or she intended to deprive the owner of its use. Code Sec. 165(e) provides that a loss arising from theft is generally treated as sustained during the tax year in which the taxpayer discovered the loss.

Torres took his case to the Tax Court, arguing that he was entitled to a theft loss deduction on his 2016 tax return. He also contended that, under Code Sec. 162(a)(1), Water Warehouse was entitled to deduct the $166,494 that Ruzendall withdrew as a business expense. Ruzendall testified that she took funds without Torres's authorization. Finally, Torres argued that he was not liable for the late filing penalties which the IRS had assessed against him.


The Tax Court held that Torres was not entitled to a theft loss deduction because he did not provide evidence that he had discovered the loss in 2016. The court noted that Torres had testified that near the end of 2017 he had become suspicious of Ruzendall's accounting for Water Warehouse. In addition, in his civil suit against Ruzendall, Torres provided October 1, 2017, as the date of his discovery. Nor, the court said, did he provide evidence that Water Warehouse had no reasonable prospect of recovery in 2016. Torres' civil suit against Ruzendall was filed in 2018 and was still pending in 2020.

With respect to Water Warehouse's business expense deduction of $166,494, the court noted that, under Code Sec. 162, such an expense is deductible only if it is an ordinary and necessary business expense. An expense is "ordinary" if it is "normal, usual, or customary" in the taxpayer's trade or business or it arises from a transaction "of common or frequent occurrence in the type of business involved." The amended complaint, the court observed, did not mention whether Ruzendall was entitled to compensation for services performed on behalf of Water Warehouse. Torres, the court noted, produced no evidence showing that Ruzendall was entitled to compensation. Accordingly, the court held that Water Warehouse was not entitled to a business expense deduction for the amounts withdrawn by Ruzendall.

Finally, the court held that Torres was not liable for the late filing penalties because he showed reasonable cause for the late filings. The court found that Torres testified credibly that he was not capable of handling his business because of his illness and not being able to read during 2016 and that he relied upon others. Torres's illness, the court found, affected his ability to file a timely tax return for 2016. And the court noted, once he learned of problems regarding his 2016 taxes, Torres sought a new tax preparer and also learned to read in 2018.

For a discussion of the general rules for deducting a theft loss, see Parker Tax ¶84,503.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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