Premji v. Commissioner

T.C. Memo. 1996-304

UNITED STATES TAX COURT

ZAHIRUDEEN PREMJI AND CAROL M. PREMJI, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

CARL JOHN NORBY, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent

Docket Nos. 8372-94, 10353-94. Filed July 3, 1996.

Declan J. O'Donnell, for petitioners.

Virginia L. Hamilton, for respondent.

MEMORANDUM FINDINGS OF FACT AND OPINION

DAWSON, Judge: In these consolidated cases respondent

determined the following deficiencies in petitioners' Federal

income taxes:
 - 2 -

Petitioners Docket No. Year Deficiency

Zahirudeen and
Carol M. Premji 8372-94 1990 $ 18,501

Carl John Norby 10353-94 1990 $ 15,959

In an Amendment to Answer filed in docket No. 8372-94 respondent

asserted an increased deficiency of $4,448 based on the

allegation that petitioners Premji failed to report interest

income of $29,329 actually or constructively received in 1990.

Petitioners and respondent have made concessions with respect to

the amount of the interest income received by the Premjis, and

those concessions should be reflected in the computations for

entry of the decision.

The primary issue in both of these cases is whether

petitioners Premji and Norby are entitled to theft loss

deductions in 1990 resulting from their investment of funds with

M&L Business Machine Company, Inc., which, through its officers

and shareholders, operated a ponzi scheme. The resolution of

this issue depends on whether there existed a reasonable prospect

of recovery in that year.

Secondary issues in the Premji case are whether petitioners

constructively received certain amounts of interest income in

1990 and whether certain amounts of interest actually received in

1990 constitute taxable income to them in that year.
 - 3 -

Unless otherwise stated, all section references herein are

to the Internal Revenue Code in effect for 1990, and all rule

references are to the Tax Court Rules of Practice and Procedure.

FINDINGS OF FACT

Some of the facts have been stipulated and are so found.

The stipulation of facts, supplemental stipulation of facts, and

attached exhibits are incorporated herein by this reference.

At the time they filed their petitions in these cases,

Zahirudeen Premji (Mr. Premji), and Carol M. Premji, and Carl

John Norby (Mr. Norby), resided in Boulder, Colorado.

Mr. Premji and Mr. Norby invested funds in M&L Business

Machine Company, Inc. (M&L).

M&L Business Machine Company, Inc.

M&L was a closely held Colorado corporation formed in the

1970's to repair office machines and business equipment. During

the 1980's, Robert Joseph, Daniel Hatch, and David Parrish

acquired all of M&L's stock. Thereafter, M&L was used to operate

a ponzi scheme.1 M&L also continued to repair office machines

and business equipment, but that activity generated little

income.

The M&L ponzi scheme collected funds from investors. In

return, M&L promised investors exceptionally high interest rates.

1
The first ponzi scheme surfaced in 1920, instigated by
Charles Ponzi. It is the subject of Cunningham v. Brown, 265
U.S. 1 (1924).
 - 4 -

Investors were told that the funds were used to purchase business

equipment for resale. No equipment was purchased. Instead,

funds obtained from later investors were used to pay early

investors their promised interest rates. Later investors often

received no payments.

All of M&L's equipment, inventory, accounts, chattel paper,

and general intangibles were subject to a security agreement,

dated September 11, 1989, in favor of Capitol Federal Savings and

Loan (Capitol Federal). Subsequently, when the Resolution Trust

Corporation (RTC) was appointed Capitol Federal's receiver, RTC

succeeded to Capitol Federal's security interest.

On October 1, 1990, M&L filed a petition with the United

States Bankruptcy Court for the District of Colorado under

Chapter 7 of the Bankruptcy Code. 11 U.S.C sec. 701 (1994). The

Chapter 7 filing was due to a clerical error, and the case was

converted to a Chapter 11 proceeding on October 9, 1990. 11

U.S.C. sec. 1101 (1994).

M&L notified private investors by letter dated October 4,

1990, that it had filed the bankruptcy petition ostensibly to

prevent RTC from seizing the assets covered by the September 1989

security interest. M&L sent private investors a second letter

dated October 30, 1990, purporting to inform them as to M&L's

status and indicating that M&L would shortly obtain a loan from a

European lender, Manns Haggerskjold, which would enable M&L to

remove itself from the Chapter 11 bankruptcy proceeding. In
 - 5 -

fact, there was no loan commitment from Manns Haggerskjold. Both

letters contained additional false representations, notably that

M&L's assets exceeded liabilities.

M&L filed original bankruptcy schedules on October 25, 1990,

and an amendment on November 15, 1990. Both the original

schedules and the amendment falsely showed that assets exceeded

liabilities.2

At some point not specified in the record, the Colorado

Division of Securities began to investigate M&L's operations. As

a result of its investigation, on December 3, 1990, the Colorado

Securities Commissioner filed an ex parte motion to oust M&L as

debtor in possession and to have a trustee appointed.3 In

support of the ex parte motion, the Securities Commissioner

alleged the following: (1) M&L executed a security interest in

2
M&L's Oct. 25, 1990, bankruptcy schedules listed assets
in the amount of $29,865,909 and liabilities in the amount of
$5,505,875. These schedules also state that M&L had promissory
note obligations to numerous private investors that were not
listed due to claimed lack of information. The Nov. 15, 1990,
amendment lists assets in the amount of $29,865,909 and
liabilities in the amount of $15,251,956. This amendment also
indicates an additional amount of unsecured claims in an unknown
amount.

On Feb. 1, 1991, M&L filed another amendment to its
bankruptcy schedules. This amendment also falsely showed assets
in excess of liabilities. In July or August 1991, Christine J.
Jobin, the bankruptcy trustee, filed a further amendment adding
unsecured creditors.

3
The Securities Commissioner's motion was captioned Motion
for Ex Parte Order Allowing Appointment of Trustee, or for
Expedited Hearing.
 - 6 -

the same assets to more than one creditor; (2) M&L gave its

bookkeeper false information regarding payees of M&L checks; (3)

M&L falsely claimed that its books and records had been audited

by a certified public accountant named Jonathan Williams;4 and

(4) M&L falsely claimed to have obtained a $15 million loan

commitment from Manns Haggerskjold. The Securities Commissioner

concluded that M&L's conduct was "replete with facts indicating

fraud, dishonesty, incompetence, and gross mismanagement of its

affairs, all to the detriment of the estate creditors and past,

present, and future investors". The Securities Commissioner

concluded that this conduct would continue to the detriment of

creditors' interests. The Securities Commissioner's ex parte

motion was made part of the bankruptcy file.

On December 10, 1990, RTC joined the Securities

Commissioner's ex parte motion and further alleged that M&L's

conduct demonstrated its pattern of defrauding everyone who

crossed its financial path, including the Bankruptcy Court.5

RTC's motion was made part of the bankruptcy file.

On December 18, 1990, the Bankruptcy Court granted the

Securities Commissioner's motion and Christine J. Jobin (Ms.

4
By affidavit attached to the Securities Commissioner's ex
parte motion and made part of the record in this proceeding,
Jonathan Williams expressly denied any participation in the
preparation of M&L audit reports.
5
RTC's motion is captioned Joinder by RTC in Motion for Ex
Parte Order Allowing Appointment of Trustee.
 - 7 -

Jobin), was appointed as Chapter 11 trustee. Ms. Jobin is an

attorney who has dealt with bankruptcy matters for 13 years.

On or about December 18, 1990, Ms. Jobin met with members of

the Colorado Division of Securities and was informed of M&L's

alleged fraud and misconduct. She also received a copy of M&L's

bank records for late 1989 and 1990. In 1990, after reviewing

M&L's bank records, Ms. Jobin believed that M&L was operating a

check-kiting scheme.

Ms. Jobin also met with Robert Joseph, M&L's president, on

or about December 18, 1990. Ms. Jobin thought that Mr. Joseph

was not telling her the truth and that the Securities

Commissioner's fraud and misconduct allegations were accurate.

She also discovered that Mr. Joseph could not document M&L

receivables claimed to be $13 million to $15 million.

Between December 18, 1990, and February 2, 1991, Ms. Jobin's

suspicions as to the legitimacy of M&L's operations increased and

she continued to investigate its affairs. During that time

period, she received some information that M&L's inventory of

computers might be paving bricks packaged to resemble computers.

However, at the end of 1990, Ms. Jobin was hopeful that M&L's

unsecured creditors would recover something from the bankruptcy

estate.

On February 2, 1991, Ms. Jobin personally went to M&L's

warehouse and opened a box that was to have contained computer

inventory. She found that the box contained only paving bricks
 - 8 -

covered with hardened foam and dirt. She then concluded that M&L

was a ponzi scheme and that it had no inventory assets from which

creditors' claims could be satisfied. On February 4, 1991, she

halted the ponzi scheme.

Ms. Jobin continued to operate M&L's business machine repair

service in the hope of generating assets for creditors. It did

not perform as she hoped, and she ceased its operation in March

1991.

When Ms. Jobin discovered that M&L had no inventory in

February 1991, she believed that the only recovery for M&L

creditors would be through adversary proceedings based on the

legal theories of preferential transfers or fraudulent

conveyances. See 11 U.S.C. secs. 547 and 548 (1994). M&L's

assets were then valued at less than $100,000 and were encumbered

by RTC's security interest.

On September 26, 1991, M&L's bankruptcy case was converted

to Chapter 7.

Approximately 1,600 investors were involved in M&L's ponzi

scheme. Ms. Jobin estimated that about 540 of these investors

received promised interest payments. In September 1992, she

began filing adversary proceedings against some of these 540
 - 9 -

investors to recover assets.6 She filed additional proceedings

in September 1993.

At the time Ms. Jobin filed the adversary proceedings

against M&L's investors in 1992, there was little case law on

point within the jurisdiction of the United States Court of

Appeals for the 10th Circuit. Nonetheless, by June 1995, she had

collected approximately $8.5 million for the bankruptcy estate.

She anticipated collecting a total of $14 million at the

conclusion of all proceedings. Ms. Jobin estimated that

unsecured creditors would recover approximately 30 percent of

their claims and that distributions to unsecured creditors would

probably be made by the end of 1996.

Petitioners Zahirudeen and Carol M. Premji

The Premjis are husband and wife who filed a joint Federal

income tax return for the year 1990 on which they reported a

theft loss of $58,000 from their investment in M&L.

Mr. Premji has a degree in mechanical engineering and is a

systems engineer. He is not an accountant or financial analyst.

Mr. Premji learned about M&L from Scott Brayer, a friend of

a neighbor. He knew that Mr. Brayer had invested in M&L for

several years and thought his lifestyle supported his claimed M&L

earnings. Several other individuals, including Karen Marx and

6
Ms. Jobin was delayed in filing these proceedings because
M&L's records had been removed from its offices. The records
were recovered pursuant to a search warrant and made available to
her in July 1992.
 - 10 -

Tom Bird, also appeared to Mr. Premji to have made considerable

sums from their investments in M&L over a long period of time.

In July or August of 1990, Mr. Premji reviewed a book that

Mr. Brayer gave him explaining M&L's programs, finances, and the

equipment M&L claimed to sell. Mr. Brayer told him that M&L was

soliciting investors to finance its purchase of used fax machines

for resale to a private company in Russia. Mr. Premji understood

he could obtain a 10 percent return every 8 days (456 percent

annually) if he invested in M&L. He did not speak with a

representative of M&L.

Based on newspaper reports of returns on real estate

transactions in Central City, Colorado, and on his experiences

growing up in Tanzania, Africa, Mr. Premji thought there were

legitimate ways for an investor to receive an annual return of

456 percent. He concluded that an investment in M&L would be a

reasonable investment. Therefore, he invested a total of $58,000

in M&L as follows:

Date Amount
July 31, 1990 $20,000
August 30, 1990 4,000
September 5, 1990 14,000
September 13, 1990 20,000
$58,000

He gave Mr. Brayer cashier's checks for the amounts listed above

and Mr. Brayer delivered them to M&L.

During August 1990, Mr. Premji received four checks from M&L

in the amount of $2,000 each that represented promised interest
 - 11 -

payments. The checks were dated August 6, August 14, August 22,

and August 30, 1990, and were drawn on M&L's account with the

Bank of Boulder. Each time he received an interest check, Mr.

Premji also received a $20,000 check representing his current

principal balance.

Mr. Premji cashed the four $2,000 checks at the Bank of

Boulder in August 1990. He did not report the $8,000 as interest

income received for that year. He did not cash the $20,000

checks. Instead, he returned them to M&L.

On two occasions Bank of Boulder personnel refused to cash

the checks because they were postdated. Mr. Premji was told to

return in a day or two. He did so and was able to cash the

checks.

Mr. Premji received six additional checks from M&L as

follows:

Check Number Amount Date Issued

100416 $64,440 9/23/90
100417 6,444 9/23/90
94062 70,884 10/1/90
94063 7,088 10/1/90
96092 77,972 10/9/90
96093 7,797 10/9/90

The checks for $64,440, $70,884, and $77,972 represented Mr.

Premji's total principal advanced to M&L as of the date of the

check. The checks for $6,444, $7,088, and $7,797 represented his

ten percent interest on that principal as of the date of each

check.
 - 12 -

Mr. Premji did not obtain cash for any of the above-listed

checks. He voluntarily returned the September 23 and October 1,

1990, principal and interest checks to M&L to maintain and

increase his investment.7 He attempted to cash the October 9,

1990, principal and interest checks after he learned that M&L had

filed its bankruptcy petition. He was unable to do so.

Mr. Premji did not report the $6,444 and $7,088 checks as

interest income on his 1990 Federal income tax return.

Mr. Premji learned of M&L's bankruptcy filing on October 5,

1990, from Mr. Brayer. His remarks as to the status of

investors' funds struck Mr. Premji as "sketchy", and he

understood that it would be some time before the payments would

resume, if at all. Mr. Premji did not consult an attorney,

accountant, or financial analyst in 1990 after he learned that

M&L had filed the bankruptcy petition.

Mr. Premji met with Karen Marx, another M&L investor, on or

about October 9, 1990, but he did not state the content of their

conversation.

In 1990, Mr. Premji attempted to review M&L's bankruptcy

file but was unable to do so. He attended the first meeting of

M&L creditors held on or about November 30, 1990. There is no

7
By returning the larger checks representing his total
investment Mr. Premji chose not to liquidate the investment. By
returning the smaller checks, he increased the total principal
advanced to M&L.
 - 13 -

evidence of the substance of the meeting. He did not speak with

Ms. Jobin, the bankruptcy trustee.

Based on M&L's October 1990 letters, his conversations with

Mr. Brayer and Karen Marx, and his attendance at the November

creditors' meeting, Mr. Premji concluded that M&L's investment

materials he had reviewed in August 1990 were not accurate. He

questioned why M&L was having difficulty securing financing if

its net worth was as claimed. He interpreted the October 1990

letters as nothing more than excuses for why money was not

available and an attempt by M&L to cover its tracks.

Consequently, he believed that the funds he had invested with M&L

would not be repaid.

Mr. Premji consulted an attorney in late February 1991. He

was told that a suit against the Bank of Boulder (Amazing

Enterprises suit) was planned and that several other

possibilities for investor recovery were being considered.

Shortly thereafter, in March 1991, he signed a retainer agreement

with the attorney's firm. As a result, Mr. Premji was one of the

68 Amazing Enterprises suit plaintiffs seeking to recover losses

from their M&L investments. The Amazing Enterprises suit was

commenced on or about July 1, 1991. It was settled in January

1993. Mr. Premji received $29,205 in settlement of his claim in

late 1994. His legal fees and costs associated with the suit

were $9,772.
 - 14 -

Mr. Premji filed his 1990 Federal income tax return on April

15, 1991. Prior thereto, Mr. Premji knew of his forthcoming

involvement in the Amazing Enterprises lawsuit.

Mr. Premji filed a proof of claim in the M&L bankruptcy

proceeding on May 16, 1991.

In the notice of deficiency dated February 16, 1994,

respondent disallowed Mr. Premji's claimed theft loss of $58,000

on the ground that no deductible loss was sustained in 1990.

Petitioner Carl John Norby

Mr. Norby has a degree in mechanical engineering. He was

employed by IBM developing business machines until his retirement

a few years ago. He is not an accountant or financial analyst.

Mr. Norby invested in M&L to increase his retirement income.

Celetha Reyos, one of M&L's sales representatives, gave him M&L's

financial statements, history, resumes of the three principals,

and a description of investment programs in August 1990. After

reviewing the information, Mr. Norby and an IBM co-worker, Larry

E. Rittenhouse, met with Dale Krug, M&L's vice-president, on

September 20, 1990. Mr. Krug showed Mr. Norby and Mr.

Rittenhouse M&L's 1988 and 1989 financial statements and a

partial financial statement for 1990. Mr. Norby asked various

questions about M&L's operations, including how M&L was able to

pay investors the promised high rates of return and whether the

company had any problems. Based on the financial statements and

Mr. Krug's responses to his questions, Mr. Norby invested $50,000
 - 15 -

in M&L on September 20, 1990. He received a promissory note

stating that his interest would be $3,500 per month for 12 months

(84 percent per year).

On October 2, 1990, Mr. Norby again met with Mr. Krug and

asked additional questions about M&L's operations. He did not

know and Mr. Krug did not tell him that the M&L bankruptcy

petition had been filed on October 1, 1990. Mr. Norby was

satisfied with Mr. Krug's replies that M&L was doing fine and

invested an additional $10,000 on October 2, 1990. He received a

second promissory note stating that his interest would be $700

per month for 12 months (84 percent per year).

On October 11, 1990, Ms. Reyos told Mr. Norby that M&L had

filed the bankruptcy petition. He did not receive M&L's October

4, 1990, letter and did not know about it until he received the

October 30, 1990, letter. In view of his October 2, 1991,

conversation with Mr. Krug, Mr. Norby thought both letters looked

suspicious.

Mr. Norby spoke with Ms. Reyos approximately once a week

during the remainder of 1990 in an attempt to determine what

M&L's intentions were regarding its investors. He also spoke

with Mr. Joseph, M&L's president, several times during 1990 after

he learned that M&L had filed for bankruptcy. He did not find

the information he obtained from these conversations to be

positive.
 - 16 -

On or about December 27, 1990, Mr. Norby, accompanied by Mr.

Rittenhouse, reviewed M&L's bankruptcy file. He did so because

he anticipated claiming a theft loss for his M&L investment on

his 1990 Federal income tax return, and he wanted to obtain

documentation to support his claim.

Mr. Norby read and believed that the fraud allegations made

by the Colorado Securities Commissioner and RTC were true. He

discovered that the Manns Haggerskjold loan commitment M&L

professed to have secured in its October 30, 1990, letter to

investors did not exist. He also reviewed the bankruptcy

schedules. Because of Mr. Krug's failure to tell him about M&L's

bankruptcy petition on October 2, 1990, and based on his

understanding of the contents of the bankruptcy file, Mr. Norby

did not believe M&L's assets exceeded liabilities. He concluded

that his investment would not be repaid.

Mr. Norby also learned from the bankruptcy file that Ms.

Jobin had been appointed trustee, but he did not contact her. He

received two creditor's notices from Ms. Jobin and filed a proof

of claim in the bankruptcy proceeding on November 5, 1991. He

did not file a claim in 1990 because he did not believe that

there would be assets remaining after secured creditors' claims

were satisfied. He did not contact an attorney in 1990 or in

1991. He was not involved in collateral suits to recover his M&L

investment.
 - 17 -

Mr. Norby sustained a loss in connection with his placement

of funds with M&L.

In the notice of deficiency dated March 15, 1994, respondent

disallowed Mr. Norby's claimed theft loss of $60,000 on the

ground that no deductible loss was sustained in 1990.

OPINION

1. Claimed Theft Loss Deductions in 1990

The parties agree that Mr. Premji and Mr. Norby sustained

theft losses.8 Sec. 165(a) and (e). They also agree that Mr.

Premji and Mr. Norby incurred losses in transactions entered into

for profit. Hence, section 165(c)(2) controls the reporting of

their theft losses. The dispute is whether deductible theft

losses were sustained in 1990.

Petitioners have the burden of proving that they are

entitled to the deductions claimed. Rule 142(a); Welch v.

Helvering, 290 U.S. 111, 115 (1933). This includes the burden of

proving that a deductible loss occurred in the year claimed. See

Burnet v. Houston, 283 U.S. 223, 227 (1931); Citron v.

Commissioner, 97 T.C. 200, 207 (1991).

The appropriate year for a loss deduction is the year in

which the loss is sustained. Sec. 165(a); sec. l.165-1(d)(1),

8
See Muncie v. Commissioner, 18 T.C. 849,851 (1952)
(whether a theft occurred depends on the law of the jurisdiction
where the loss was sustained); see also Edwards v. Bromberg, 232
F.2d 107 (5th Cir. 1956). The applicable provisions of the
Colorado theft statute are sections 18-4-401 and 18-4-403, Colo.
Rev. Stat. (1986 and 1995 Supp.).
 - 18 -

Income Tax Regs. A theft loss is sustained during the taxable

year in which the taxpayer discovers the loss. Sec. 165(e); Sec.

1.165-1(d)(3), 1.165-8(a)(2), Income Tax Regs. The loss is not

deductible for the year in which the theft actually occurs unless

that is also the year in which the taxpayer discovers the loss.

Sec. 1.165-8(a)(2), Income Tax Regs.; see Alison v. United

States, 344 U.S. 167, 170 (1952); Marine v. Commissioner, 92 T.C.

958, 976 (1989), affd. without published opinion 921 F.2d 280

(9th Cir. 1991); Ramsay Scarlett & Co. v. Commissioner, 61 T.C.

795, 808 (1974), affd. 521 F.2d 786 (4th Cir. 1975).

However, if in the year the taxpayer discovers the loss

there is a claim for reimbursement for which there is a

reasonable prospect of recovery, "no portion of the loss with

respect to which reimbursement may be received is sustained, for

purposes of section 165, until the taxable year in which it can

be ascertained with reasonable certainty whether or not such

reimbursement will be received". Sec. 1.165-1(d)(3), Income Tax

Regs.

It is clear that the loss must be actual and sustained in

fact. Boehm v. Commissioner, 326 U.S. 287, 291-292 (1945);

Ismert-Hincke Milling Co. v. United States, 246 F.2d 754, 757

(10th Cir. 1957); Lapin v. Commissioner, T.C. Memo. 1990-343,

affd. without published opinion 956 F.2d 1167 (9th Cir. 1992);

sec. 1.165-1(b), Income Tax Regs.
 - 19 -

The requirement that the taxpayer's right of recovery be

considered demonstrates that a theft loss must be evidenced by a

closed and completed transaction. See Marine v. Commissioner,

supra at 980; Ramsay Scarlett & Co. v. Commissioner, supra at

810-811; secs. 1.165-1(d)(1), 1.165-8(a)(2), Income Tax Regs.

Whether there is a reasonable prospect of recovery is a

question of fact, determined by examining all facts and

circumstances. Sec. 1.165-1(d)(2)(i), Income Tax Regs.; see

Boehm v. Commissioner, supra at 292-293 (1945); Dawn v.

Commissioner, 675 F.2d 1077, 1078 (9th Cir. 1982), affg. T.C.

Memo. 1979-479; Ramsay Scarlett & Co. v. Commissioner, supra at

811-812.

A reasonable prospect of recovery exists when the taxpayer

has a bona fide claim for recoupment from third parties or

otherwise, and when there is a substantial possibility that such

claims will be decided in the taxpayer's favor. Ramsay Scarlett

& Co. v. Commissioner, supra at 811 (citations omitted). The

taxpayer is not, however, required to be an "incorrigible

optimist", and claims with only remote or nebulous potential for

success will not postpone the deduction. United States v. White

Dental Manufacturing Co., 274 U.S. 398, 403 (1927); Ramsay

Scarlett & Co. v. Commissioner, supra at 811. Thus, the

deduction need not be postponed where the financial condition of

the party against whom the claim is filed is such that no

recovery could be expected. Jeppsen v. Commissioner, T.C. Memo.
 - 20 -

1995-342; see also Jensen v. Commissioner, T.C. Memo. 1993-393,

affd. without published opinion 72 F.3d 135 (9th Cir. 1995).

The standard to be applied is primarily objective, but the

taxpayer's subjective attitude and beliefs are not to be ignored.

Boehm v. Commissioner, supra at 292-293; Ramsay Scarlett & Co. v.

Commissioner, supra at 812. The standard is to be applied with

foresight. Ramsay Scarlett & Co. v. Commissioner, supra at 811.

One of the relevant factors is whether the taxpayer has

filed a lawsuit to recoup the loss. Dawn v. Commissioner, supra

at 1078; Scofield's Estate v. Commissioner, 266 F.2d 154, 159

(6th Cir. 1959), affg. in part and revg. in part 25 T.C. 774

(1956). Filing the lawsuit soon after the end of the tax year in

which the loss was claimed suggests that the taxpayer did not

consider the loss a closed and completed transaction. Dawn v.

Commissioner, supra at 1078; see also National Home Products,

Inc. v. Commissioner, 71 T.C. 501, 525-526 (1979).

Unless litigation is speculative or without merit, where the

taxpayer deems the chance of recovery sufficiently probable to

warrant bringing a lawsuit and pursuing it with reasonable

diligence to a conclusion, the taxpayer should postpone the loss

deduction until the litigation is terminated. Scofield's Estate

v. Commissioner, supra at 159; see also Gale v. Commissioner, 41

T.C. 269, 276 (1963).

Another fact which we may consider is whether the taxpayer

ultimately recovered as a result of a lawsuit. Gale v.
 - 21 -

Commissioner, supra at 276; Huey v. Commissioner, T.C. Memo.

1985-348.

However, filing a proof of claim in a bankruptcy proceeding

has been held to be a ministerial act that does not require the

same degree of effort as pursuing a lawsuit. Jensen v.

Commissioner, supra.

The burden is on the taxpayer to show there was no

reasonable prospect of recovery in the year the theft loss is

claimed. Gale v. Commissioner, supra at 276.

For the reasons stated below, we hold that neither Mr.

Premji nor Mr. Norby sustained a deductible theft loss in 1990.

Both Mr. Premji and Mr. Norby contend that their theft

losses were discovered in 1990. To the contrary, respondent

contends that the losses were not discovered until 1991 when Ms.

Jobin, the trustee in bankruptcy, first ascertained that M&L was

operating an illegal ponzi scheme and that its inventory did not

exist. Regardless of the year in which the theft losses were

discovered, the crucial issue here, as we see it, is whether

petitioners had a reasonable prospect of recovery in 1990 when

they claimed the theft loss deductions. Based on the evidence

presented, we conclude that there was a reasonable prospect in

1990 that petitioners would subsequently recover some of their

losses.

Several facts support our conclusion. First, Ms. Jobin, the

trustee in bankruptcy, testified that she was "hopeful" in 1990
 - 22 -

that she would be able to recover the investors' principal from

either the assets or the operations of M&L, which was then in a

Chapter 11 corporate reorganization proceeding.

Second, when Ms. Jobin discovered the ponzi scheme, she saw

other avenues for recovering assets for the bankruptcy estate.

Those avenues indeed proved fruitful. In particular, Ms. Jobin

instituted adversary proceedings against certain recipients of

M&L transfers on the basis of preferential transfers and

fraudulent conveyances. These proceedings were not filed until

September 1992, because the trustee encountered difficulties in

obtaining data pertaining to the transfers and conveyances from

M&L. As a result of these suits, the trustee had already

recovered $8.5 million for the M&L bankruptcy estate by the time

the instant cases were tried, and she estimated that

approximately $14 million will eventually be recovered. She also

estimated that the total recovery will result in the general

unsecured creditors, including petitioners, receiving about one

third of their M&L losses, probably sometime in late 1996.

Although at the end of 1990 none of the relevant information

for bringing the adversary proceedings had been obtained, this is

not the issue for Federal income tax purposes. The facts and

events which formed the bases of these adversary suits and upon

which the recovery could be based under Federal and State law

existed at the end of 1990. Therefore, the existence of such
 - 23 -

claims precludes the allowance in 1990 of petitioners' deductions

for Federal income tax purposes with respect to their M&L losses.

Mr. Premji argues that case law as to some issues raised by

Ms. Jobin in the adversary proceedings was unsettled within the

jurisdiction of the Court of Appeals for the 10th Circuit. We

disagree. The law was not so uncertain as to render the

prospects of success remote or nebulous or to presume that no

actual recovery could be expected. Various other courts had

decided similar issues. See Cunningham v. Brown, 265 U.S. 1

(1924); In re United Energy Corp., 944 F.2d 589 (9th Cir. 1991);

In re Agricultural Research & Technology Group, Inc., 916 F.2d

528 (9th Cir. 1990); First Federal of Michigan v. Barrow, 878

F.2d 912 (6th Cir. 1989); In re Bullion Reserve of North America,

836 F.2d 1214 (9th Cir. 1988); Conroy v. Shott, 363 F.2d 90 (6th

Cir. 1966); Eby v. Ashley, 1 F.2d 971 (4th Cir. 1924); In re

Baker & Getty Financial Services, Inc., 98 Bankr. 300 (Bankr.

N.D. Ohio 1989), affd. 974 F.2d 712 (6th Cir. 1992); In re

Independent Clearinghouse Co., 77 Bankr. 843 (D. Utah 1987).

Moreover, the trustee has been successful in the adversary

proceedings.

Mr. Premji's prospect of recovering some of his losses is

even stronger than that of Mr. Norby. Mr. Premji was one of 68

plaintiffs in the Amazing Enterprises lawsuit against the Bank of
 - 24 -

Boulder. Although the lawsuit was filed in July 1991, the facts

that formed the basis of that suit existed in 1990.9

The success of the lawsuit may have depended on further

investigation, but that does not negate Mr. Premji's prospects of

recovery in 1990. The test is whether the taxpayer had a

reasonable prospect of recovery at the end of the taxable year in

which the loss is claimed, not whether the taxpayer had collected

enough information to successfully prosecute legal action.

Qureshi v. Commissioner, T.C. Memo. 1987-153, affd. without

published opinion 843 F.2d 1388 (4th Cir. 1988); see also Geisler

v. Commissioner, T.C. Memo. 1988-404, affd. without published

opinion 955 F.2d 47 (9th Cir. 1992).

Mr. Premji discussed the Amazing Enterprises suit and

several other possibilities for investor recovery with an

attorney in late February 1991. He chose to pursue those avenues

of recovery and signed the attorney's retainer agreement in March

1991. That he was willing to diligently pursue the lawsuit

indicates that his prospects of recovery were reasonable rather

than remote or nebulous. Mr. Premji embarked on his course to

recoup his investment before he filed his 1990 Federal income tax

return on April 15, 1991. Hence, before he claimed his theft

9
A copy of the Amazing Enterprises suit complaint was made
part of the record. The suit was based on the Bank of Boulder's
alleged improper conduct in dealing with M&L's investors and in
handling checks presented for payment during the operation of the
ponzi scheme.
 - 25 -

loss, he was pursuing at least one avenue of recovering that

loss.

The Amazing Enterprises suit, commenced on or about July 1,

1991, was settled in January 1993. In late 1994, Mr. Premji

received $29,205 from the settlement. That is approximately 50

percent of his claimed theft loss.

In addition, Mr. Premji filed a proof of claim in the

bankruptcy proceeding on May 16, 1991. The sole bankruptcy

estate assets available to satisfy creditors' claims are moneys

obtained as a result of Ms. Jobin's adversary proceedings to

avoid preferences and fraudulent conveyances. Ms. Jobin

testified that she concluded in February 1991 that such

proceedings would be her only avenue to satisfy creditors'

claims. Hence, in early 1991 Ms. Jobin clearly had formulated a

plan to attempt to bring assets into the bankruptcy estate.

Even though Ms. Jobin did not begin to file the adversary

proceedings until September 1992,10 the facts that formed the

basis of those proceedings existed at the close of 1990, i.e.,

M&L had made the payments in 1990 that Ms. Jobin sought to avoid.

As to Mr. Norby's prospects of recovery, we have considered

his subjective beliefs. His actions are consistent with those

beliefs. But, despite the prospect of losing his $60,000

10
Ms. Jobin did not obtain access to M&L's records until
July 1992. The records had been removed from M&L's place of
business and were obtained pursuant to a search warrant.
 - 26 -

investment, Mr. Norby did not consult an attorney in 1990 or

1991. He knew that collateral suits against third parties were

in progress but chose not to participate in them. He did not

speak with Ms. Jobin, the bankruptcy trustee, in 1990. He filed

a proof of claim in the bankruptcy proceeding on November 5,

1991, seeking recovery of his losses.

While the information Mr. Norby obtained in 1990 indicated

M&L's fraud and raised questions about its true financial

condition, the record does not support his conclusion that,

objectively, his prospects of recovering at least part of his

investment were remote or nebulous.

Mr. Norby did not offer any explanation as to why any

attempt or suit for recovery would have been futile except to

relate that his analysis and subjective feelings led him to

believe that his principal investment in M&L had been lost in

1990. That is not sufficient to meet his burden of proof that

there was no prospect of recovery. See Boehm v. Commissioner,

326 U.S. at 294.

Accordingly, because we conclude that Mr. Premji and Mr.

Norby had reasonable prospects for recovery of some of their

claimed M&L losses in 1990, we hold that they are not entitled to

theft loss deductions in that year.11

11
Petitioners may be entitled to claim theft loss
deductions in the year their claims are allowable and paid in the
bankruptcy proceeding if their recoveries are less than the
principal amounts they invested in M&L.
 - 27 -

2. Whether Mr. Premji Constructively Received Interest Income In

1990

Between August and October 1990, Mr. Premji received a total

of seven checks from M&L representing promised interest payments.

He cashed the first four checks in the total amount of $8,000,

and conceded that the $8,000 was received as interest in 1990.

After he learned that M&L had filed its bankruptcy petition,

Mr. Premji attempted to cash the final interest check, dated

October 9, 1990, in the amount of $7,797 at an unspecified bank.

The bank refused to honor the check. Consequently, respondent

has conceded that the $7,797 was not interest income in 1990.

Mr. Premji contends that the two remaining interest checks

in the amounts of $6,444, dated September 23, 1990, and $7,088,

dated October 1, 1990, are not interest income in 1990 because he

could not have cashed them. He made no attempt to do so.

Instead, he returned both checks to M&L to increase his

investment. M&L did increase his investment and, accordingly,

increased the amount of his interest checks. Mr. Premji's proof

of claim in the bankruptcy proceeding is for $77,972, which

represents his cumulative investment with M&L.

Respondent argues that the amounts of both checks constitute

interest income in 1990 because Mr. Premji, as a cash basis

taxpayer, constructively received the income in that year.

Respondent first raised this issue in her Amendment to the Answer
 - 28 -

seeking an increased deficiency. Therefore, respondent has the

burden of proof on the issue. Rule 142(a).

The amounts of both checks would be gross income derived

from interest according to the terms of Mr. Premji's arrangement

with M&L. See sec. 61(a)(4); Deputy v. DuPont, 308 U.S. 488, 498

(1940); sec. 1.61-1(a), Income Tax Regs.

An item of gross income shall be included in the taxable

year when received by the taxpayer unless under the taxpayer's

method of accounting the amount is properly reported in a

different period. Sec. 451(a). For a cash receipts and

disbursement method taxpayer, an item is includable in gross

income when it is actually or constructively received. Sec.

1.451-1(a), Income Tax Regs.

Income is constructively received in the taxable year during

which it is credited to the taxpayer's account, set apart for him

or otherwise made available so that the he may draw upon it at

any time. Sec. 1.451-2(a), Income Tax Regs. However, income is

not constructively received if the taxpayer's control of its

receipt is subject to substantial limitations or restrictions.

Id.; see also Hornung v. Commissioner, 47 T.C. 428, 434 (1967).

A check that is not subject to substantial restrictions and

that the taxpayer could have cashed is income when the check is

received. Kahler v. Commissioner, 18 T.C. 31, 34 (1952) (citing

Estate of Spiegel v. Commissioner, 12 T.C. 524, 529 (1949)). It

follows that where the payor lacked funds to make the payment,
 - 29 -

there can be no constructive receipt. Noel v. Commissioner, 50

T.C. 702, 706-707 (1968) (citing Jacobs v. Commissioner, 22

B.T.A. 1166, 1169 (1931) and Gullett v. Commissioner, 31 B.T.A.

1067, 1069 (1935)); see also Basila v. Commissioner, 36 T.C. 111,

115-116 (1961).

Whether the funds were actually available for the taxpayer

to draw on, i.e., whether a check could be cashed, is a question

of fact. Johnson v. Commissioner, 25 T.C. 499, 503 (1955). We

consider all relevant factors. Id.; see also Williams v.

Commissioner, T.C. Memo. 1994-560; Rosenberg v. United States,

295 F. Supp. 820, 823-824 (E.D. Mo. 1969), affd. per curiam 422

F.2d 341 (8th Cir. 1970).

We hold that Mr. Premji did not constructively receive the

$7,088 represented by the October 1, 1990, check because there

were substantial restrictions that would have prevented him from

cashing it. That check was dated the same day that M&L filed its

bankruptcy petition. Hence, M&L's assets became property of the

bankruptcy estate on that day and the automatic stay provided in

11 U.S.C. section 362(a) (1994) would have prevented the bank

from paying that check.

Although 11 U.S.C. section 362(b)(11) (1994) creates an

exception to the automatic stay for presentment of negotiable

instruments, case law interpreting that provision indicates that

the exception does not authorize a transfer of bankruptcy estate

property. Wittman v. State Farm Life Insurance Co. (In re
 - 30 -

Mills), 176 Bankr. 924, 928 (D. Kan. 1994); see also Roete v.

Smith, 936 F.2d 963, 965-966 (7th Cir. 1991). Instead, the

exception prevents presentment of the instrument from violating

the automatic stay. Id.

We also hold that respondent has failed to carry her burden

of proof that Mr. Premji constructively received the $6,444

represented by the September 23, 1990, check.

No evidence was introduced to establish M&L's bank account

balance or the amounts of outstanding obligations as of September

23, 1990, or for any relevant period. Ms. Jobin testified that

M&L's ponzi scheme collected approximately $10 million over the

12 months prior to October 1, 1990, the date the bankruptcy

petition was filed. However, there is no evidence as to what

part, if any, of this amount was available on or about September

23, 1990, to cover the $6,444 check.

Respondent relies primarily on the fact that Mr. Premji had

cashed four of M&L's interest checks in August 1990, at the Bank

of Boulder. All four checks are part of the record. That M&L

had sufficient funds in its account in August 1990, does not

support a finding that funds were available on or about September

23, 1990.

Respondent contends that Mr. Premji exercised dominion and

control over the interest income because he reinvested it rather

than obtaining cash and that he included it in his $77,972 proof

of claim filed in the bankruptcy proceeding. However, these acts
 - 31 -

do not support the conclusion that Mr. Premji could have cashed

the interest checks. Consequently, because Mr. Premji did not

constructively receive either the $6,444 or $7,088 represented by

the checks, we conclude that neither amount is includable in his

gross income for 1990.

3. Whether The $8,000 Interest Actually Received by Mr. Premji

Should Be Included in His Gross Income for 1990

Mr. Premji received $8,000 as interest in 1990 when he

cashed four M&L interest checks in August 1990. The $8,000 was

Mr. Premji's promised 10 percent return every 8 days on his

initial $20,000 investment.

Although Mr. Premji has conceded that he received the $8,000

in 1990, he contends that it is not includable in his gross

income for that year because the open transaction doctrine

applies, thus allowing him to recover the full amount of his

principal before including any amount of interest in income. He

argues that his placement of funds with M&L constituted a risky

and speculative investment.12 He relies on Burnet v. Logan, 283

U.S. 404 (1931); Underhill v. Commissioner, 45 T.C. 489 (1966);

and Liftin v. Commissioner, 36 T.C. 909, affd. 317 F.2d 234 (4th

Cir. 1963). Respondent counters that Mr. Premji's circumstances

are distinguishable from those cases, and, therefore, the open

12
Mr. Premji has not argued that the amount of interest
he was to receive was uncertain.
 - 32 -

transaction doctrine is inapplicable. Mr. Premji bears the

burden of proof on this issue. Rule 142(a).

The open transaction doctrine permits a taxpayer who

receives installment payments on the sale or other disposition of

property to recover his basis prior to recognizing gain where the

amount realized is not susceptible to valuation. See Burnet v.

Logan, supra at 413. It has been applied to purchasers of

installment obligations at a discount to enable the taxpayer to

recover the cost and a major portion of the discount before

recognizing gain where there was no reasonable certainty that all

payments on the obligation would be made. See Liftin v.

Commissioner, supra at 911; cf. Underhill v. Commissioner, supra

at 492-496. Thus, the essence of the open transaction doctrine

is uncertainty that the taxpayer will recover the full amount of

his basis or cost.

Mr. Premji invested $58,000 with M&L on four separate

occasions by cashier's check as follows:

July 31, 1990 $20,000
August 30, 1990 4,000
September 5, 1990 14,000
September 13, 1990 20,000
$58,000

Of the $58,000 total amount, we are here concerned with only

the $20,000 invested on July 31, 1990, because that is the

principal that gave rise to the $8,000 in interest Mr. Premji

actually received.
 - 33 -

It is our view that this situation does not fall within the

parameters of the open transaction doctrine, which is limited to

rare and extraordinary circumstances. Estate of Wiggins v.

Commissioner, 72 T.C. 701, 708 (1979). Here we find that Mr.

Premji has failed to carry his burden of proof that it was

uncertain he would recover his principal.

Mr. Premji overlooks the fact that M&L returned the full

amount of his principal during August 1990. He conceded that he

received a $20,000 check representing the full amount of his

principal each time he received a $2,000 interest check.

Although he cashed the $2,000 checks, he voluntarily chose not to

liquidate his investment by cashing any one of the $20,000

checks. Instead, Mr. Premji chose to reinvest that amount by

returning each $20,000 check to M&L.

The record contains no bank account statements for M&L or

other evidence that any one of these $20,000 checks would not

have been honored on presentment during the month of August.

Contrary to Mr. Premji's assertion that his principal might not

be repaid, it was made available to him. He voluntarily chose to

reinvest that principal rather than liquidate the investment.

Consequently, we hold that Mr. Premji has not shown that it

was uncertain he would recover his $20,000 principal and that the

open transaction doctrine applies in these circumstances. Thus,

the $8,000 interest he received in 1990 constitutes gross income

in that year.
 - 34 -

To the extent arguments made by the parties have not been

addressed, we deem them to be without merit.

To reflect concessions made by the parties and our

conclusions with respect to the disputed issues,

Decisions will be entered

under Rule 155.