The United States Tax Court, in Potts v. Commissioner, T.C. Memo. 2025-108, addressed a deficiency of $431,691 and an accuracy-related penalty of $86,338 under Section 6662(a) determined by the Commissioner of Internal Revenue (Respondent) against petitioners Craig K. and Kristen H. Potts for the 2014 taxable year. The predominant issue concerned the disallowance of a $2 million theft loss deduction claimed by the petitioners pursuant to Section 165.

Case Summary and Factual Background

The underlying facts relate to the petitioners’ investment in the Turks and Caicos Islands (Turks and Caicos) gaming industry. Petitioners, who resided in Arizona when the Petition was filed, purchased 25 shares (a 25% interest) of Carib Gaming, Ltd., in May 2008 for $2,500,000. The shares were acquired by CGL Investments, Ltd., as the designee of Mrs. Potts, from VT Enterprises, Ltd., an entity controlled by Jack Tatum and Rick Olson. Mr. Tatum had solicited the investment, describing a project to build a casino (the casino project) at the Airport Hotel & Plaza.

The 2008 Purchase Agreement explicitly stated that it superseded all prior agreements, whether written or oral, and did not specify any requirement for VT Enterprises to use the $2,500,000 sale proceeds for the casino project or to inject capital into Carib Gaming. Petitioners asserted that their investment was contingent on Mr. Tatum’s oral promise that the proceeds would be used to fund the casino project.

In 2014, petitioners became aware of Carib Gaming’s financial distress, including unpaid gaming taxes and rent. Petitioners’ claim for relief stemmed from an alleged admission made by Mr. Tatum to attorney Peter Karam in 2014 that $2 million of the 2008 investment had been transferred to Mr. Tatum’s and Mr. Olson’s personal bank accounts. Following this purported confession, petitioners, through CGL, acquired VT Enterprises’ remaining 52 shares of Carib Gaming for $225,000 via a 2014 Purchase Agreement. As part of this transaction, petitioners executed a Deed of Settlement and Release, absolving Messrs. Tatum and Olson of “all claims of any nature whatsoever arising out of or in relation to the business operations of Carib [Gaming]”. Petitioners never initiated a civil suit against Tatum or Olson.

Taxpayer’s Claim for Relief

On their timely filed 2014 federal income tax return, prepared by McGladrey, LLP, petitioners claimed a $2 million theft loss deduction under Section 165. They contended that the $2 million had been misappropriated by Messrs. Tatum and Olson because the funds were not used, as allegedly promised, to inject additional capital into Carib Gaming to complete the casino project.

Court’s Analysis of Applicable Law

The Theft Loss Requirement under Section 165

Section 165(a) permits a deduction for losses sustained during the taxable year and not compensated by insurance or otherwise. For individuals, this loss must arise from certain defined events, including “theft” (§ 165(c)). A loss arising from theft is deemed sustained in the year the taxpayer discovers the loss (§ 165(e); Treas. Reg. § 1.165-1(d)(3)).

Crucially, the court cited precedent requiring the taxpayer to prove, by a preponderance of the evidence, that an actual theft occurred under the law of the relevant jurisdiction. In this case, both parties agreed that the determination of theft must be made under the law of the Turks and Caicos Islands.

The relevant Turks and Caicos Theft Ordinance provides that a person is guilty of theft if they "dishonestly appropriates property belonging to another with the intention of permanently depriving the other of it" (Theft Ordinance, c. 3.10, § 3 (2009)).

The Ordinance also creates a separate offense for theft by deception, where a person "by any deception dishonestly obtains property belonging to another, with the intention of permanently depriving the other of it" (Theft Ordinance, c. 3.10, § 24.1). Deception is defined as "any deception (whether deliberate or reckless) by words or conduct as to fact or as to law, including deception as to the present intentions of the person using the deception" (Theft Ordinance, c. 3.10, § 2.1).

Burden of Proof

Taxpayers bear the burden of proving that the Commissioner’s determinations in the Notice of Deficiency are erroneous (Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115 (1933)). Petitioners failed to introduce credible evidence to shift the burden of proof to the Commissioner under Section 7491(a).

Application of Law to the Facts and Conclusions

Failure to Prove Theft Under Turks and Caicos Law

The court required petitioners to establish three elements for either theft or theft by deception: (1) appropriation of property belonging to another, (2) through dishonesty or deception, and (3) with the intent to permanently deprive.

Appropriation of Property Belonging to Another

The court concluded that the petitioners failed to establish that the $2 million belonged to them or to Carib Gaming when it was allegedly misappropriated. Petitioners purchased existing shares from VT Enterprises, which was the seller, rather than making a direct capital contribution to Carib Gaming through the purchase of newly issued shares. Neither the MOU, the 2008 Purchase Agreement, nor the Shareholder Agreement imposed a legal obligation on VT Enterprises to reinvest the sale proceeds into Carib Gaming or the casino project. Since the funds belonged to VT Enterprises after the sale transaction was completed, the court could not conclude that Messrs. Tatum and Olson misappropriated funds "belonging to another" (i.e., belonging to the petitioners) within the meaning of the Turks and Caicos Theft Ordinance.

Dishonesty or Deception

Petitioners attempted to prove theft by deception based on Mr. Tatum’s alleged oral promises to reinvest the proceeds and complete the casino project. The court noted that the 2008 Purchase Agreement specifically superseded all prior oral agreements.

The court analyzed the definition of "deception" under Turks and Caicos law, which includes deception "as to fact or as to law, including deception as to the present intentions" (Theft Ordinance, c. 3.10, § 2.1). Petitioners relied on alleged promises concerning future intentions. Citing its own caselaw, the court declined to expand the definition of "as to fact" or "present intentions" to encompass future intentions, particularly without supporting Turks and Caicos legal authority.

Furthermore, the court noted that the Turks and Caicos Theft Ordinance contains a specific offense for false statements by company directors requiring a written statement or account (§ 31), which was absent from the record, thereby weakening petitioners’ claim.

The court also found the testimony of Mr. Karam, who recounted Mr. Tatum’s confession, not to be credible. However, even accepting the confession, the court maintained that the failure to reinvest the funds did not constitute an admission to theft because no binding requirement existed for VT Enterprises to use the funds in that manner.

Proper Party to Claim Any Theft Loss Deduction

The court raised a secondary point regarding the ownership of the property at the time of the purported theft. A deduction for theft loss may be claimed only by the taxpayer who was the owner of the stolen property when it was criminally appropriated (citing Malik v. Commissioner, T.C. Memo. 1995-204).

Petitioners transferred the $2.5 million to the trust account of VT Enterprises’ counsel. Once the funds were paid for the shares, any subsequent theft or embezzlement was of funds belonging to VT Enterprises. Petitioners received exactly what they contracted for—25 shares of Carib Gaming. Therefore, any theft loss deduction would properly belong to Carib Gaming, not to the petitioners. The court observed that the disallowance did not foreclose eventual recognition of a loss upon disposition of the shares, if they had diminished in value, but petitioners did not claim a loss deduction for worthless securities under Section 165(g).

Accuracy-Related Penalty Analysis

The Notice of Deficiency determined an accuracy-related penalty pursuant to Section 6662(a) and (b)(1) and (2) for negligence or a substantial understatement of income tax. The penalty is 20% of the underpayment.

Burden of Production and Substantial Understatement

The Commissioner bears the burden of production for the penalty liability, including compliance with the written supervisory approval requirement of Section 6751(b)(1). The record demonstrated, and petitioners did not dispute, the Commissioner’s compliance with Section 6751(b).

An understatement is considered substantial if it exceeds the greater of 10% of the tax required to be shown on the return or $5,000 (§ 6662(d)(1)(A)). Since the tax required to be shown was $443,918, and petitioners reported no federal income tax liability, the resulting understatement was substantial.

Reasonable Cause and Good Faith Defense

Once the Commissioner meets the burden of production, the taxpayer bears the burden of proving that the penalty determination is incorrect or that an affirmative defense, such as reasonable cause and good faith, applies (§ 6664(c); Rule 142(a); Higbee v. Commissioner, 116 T.C. 438, 446–47 (2001)). Reasonable cause requires the taxpayer to have exercised ordinary business care and prudence.

Petitioners argued they acted in good faith because McGladrey prepared their 2014 return. However, reliance on a tax advisor is reasonable only if: (1) the adviser was a competent professional, (2) the taxpayer provided necessary and accurate information, and (3) the taxpayer relied in good faith on the adviser’s judgment (Neonatology Assocs., P.A. v. Commissioner, 115 T.C. 43, 99 (2000), aff’d, 299 F.3d 221 (3d Cir. 2002)).

The court found that petitioners failed to introduce any documentation or testimony proving that McGladrey had opined on the entitlement to the theft loss deduction or that petitioners had provided the necessary information to determine its appropriateness. Given the lack of evidence supporting the defense, petitioners failed to carry their burden to prove they acted with reasonable cause and in good faith, and thus the penalty was sustained.

Final Determination

The Tax Court concluded that petitioners failed to meet their burden of proof to establish that a theft occurred under Turks and Caicos law. Furthermore, even if a theft had occurred, the petitioners were not the proper party to claim the loss, as the funds belonged to VT Enterprises at the time of the alleged embezzlement. The court upheld the disallowance of the $2 million theft loss deduction. Finally, the court sustained the accuracy-related penalty, finding that the resulting underpayment was substantial and that petitioners failed to establish the defense of reasonable cause and good faith.

Prepared with assistance from NotebookLM.