No Sympathy for the Pump-and-Dump

Pump and Dump schemes can empty your pocketsIn case you needed another reason to avoid getting scammed, here you go.

A district court has ruled that two investors that lost $569,000 in a “pump-and-dump” scam have a capital loss and not theft-loss.  The difference in the two is huge.

First of all, what is a “pump-and-dump” scam?  In a pump-and-dump scam investors are encouraged to purchase shares of a company that may not be as attractive as it seems.  In the case of taxpayers Robert and Penny Greenberger, a family “friend” encouraged them to buy shares of Spongetech Delivery Systems, Inc.  The “friend”, Douglas Furth, was an investment advisor and one of Spongetech’s largest shareholders.  From 2007 through 2009 Spongetech reported large revenue gains, which pumped up their stock price.  The problem?  The revenue was bogus sales to nonexistent customers.  Bogus sales to existent customers is bad, but nonexistent customers…. Well, that’s just as bad.  Executives at Spongetech began dumping (see the pump and dump!) their shares and made millions.  Based on sales that looked too good to be true and some missed SEC filings, the media began to scrutinize Spongetech’s stock price.  In July 2010 Spongetech filed for bankruptcy and all trading of its stock ceased.  Not good for shareholders.  In a little bit of good news, executives at Spongetech were indicted on criminal securities fraud charges in December of 2010, so that’s cool.

Unfortunately for the Greenbergs they held 7.5 million (worthless) shares of Spongetech stock, which resulted in a loss of $569,000.  In 2012 the Greenbergs amended their 2010 tax return and claimed a theft-loss deduction and requested a $177,000 refund.  According to Code section 165(c )(3) and Regulation section 1.165-8, taxpayers can deduct losses from taxable income that arise from “larceny, embezzlement, and robbery.”  The IRS disallowed the theft-loss and the Greenbergs sued the IRS.  The IRS would allow the loss under capital loss rules, but not under theft-loss regulations.

The IRS argued that the theft must have resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred (in this case Ohio) and was done with criminal intent.  According to the Greenbergs, even if they weren’t victims of a theft, they were victims of a “theft-offense”.

The court ruled that because the taxpayers purchased the shares on the open market, they could not demonstrate that the executives acted with specific intent to defraud the Greenbergers, one of the requirements for a theft-loss. In addition, the Court ruled that while the Greenbergers were victims of a theft-offense, this terms was too broadly defined and that this term would not fit the IRS’ theft-loss regulations.  In the end, the Court ruled the Greenbergers were not eligible for the refund that resulted from claiming the theft-loss.  They will be eligible to deduct the worthless securities, but that’s a whole different ball game