During tax audits and appeals, taxpayers typically bear the burden of proving that they are entitled to a tax benefit or favorable tax treatment. In some instances, the tax law provides a safe harbor rule where, if a taxpayer can demonstrate that certain preconditions are met, then the taxpayer receives the tax benefit or favorable tax treatment without further inquiry from the taxing authority. However, taxpayers should remember that, even if they do not satisfy the preconditions of a safe harbor rule, they can still meet their burden to prove their entitlement to the tax benefit or favorable tax treatment. If a state taxing authority denies a tax benefit or favorable tax treatment solely because a safe harbor rule does not apply, taxpayers who believe they have the facts on their side should be ready to fight back.
A recent taxpayer victory at the Alabama Tax Tribunal ("Tribunal") in Cornelius v. Alabama Department of Revenue, Docket No. 26-0155-RC (Ala. Tax Trib. Aug. 25, 2026), is a good example of why taxpayers who do not satisfy a safe harbor rule should not necessarily lose heart. Unfortunately, the facts of the case are terrible. A married Alabama couple was the victim of a scam that led to them liquidating over one million dollars of their assets held in their investment accounts, converting those assets into gold bars, and handing those gold bars off to a scammer in a grocery store parking lot, with the scammer and the gold bars riding off together never to be seen again. The couple had been convinced by a scammer, posing as an investigator employed by the United States Bureau of Alcohol, Tobacco, Firearms, and Explosives, that the husband’s identity had been stolen, drug traffickers had access to all of the couple’s investment accounts, and the only way to keep the assets safe was to withdraw them, convert them to gold, and hand them over to the scammer for safekeeping.
The liquidation of the couple’s retirement accounts created taxable income for the couple that they offset on their federal and Alabama income tax returns with a miscellaneous theft loss deduction under Section 165 of the Internal Revenue Code. Section 165(c)(2) provides for a deduction for “losses incurred in any transaction entered into for profit, though not connected with a trade or business.” The Internal Revenue Service (“IRS”) has issued guidance establishing a so-called “Ponzi Scheme Safe Harbor” whereby if a taxpayer can demonstrate that certain preconditions are met demonstrating that their losses were incurred in a Ponzi scheme, the taxpayer qualifies for the deduction under Section 165(c)(2). Here, while the couple had undisputably been victims of a scam, there was no dispute that the form of the scam was not a Ponzi scheme and, therefore, the Ponzi Scheme Safe Harbor did not apply. Based on the foregoing, the Alabama Department of Revenue determined that the couple could not qualify for the deduction under Section 165(c)(2) and disallowed the couple’s theft loss deduction.
On appeal, the Tribunal determined that the Department of Revenue was wrong to stop its analysis after determining that the Ponzi Scheme Safe Harbor did not apply. The Tribunal explained that safe harbor rules “operate as exemptions carved out of broader legal obligations” and, even if a safe harbor rule does not apply, a taxpayer may still “endeavor to bear evidentiary or procedural burdens it might otherwise avoid through use of safe harbor provisions.” Here, relying on a 2025 IRS Chief Counsel Memorandum explaining the applicable tax treatment of “five hypothetical fraud victims,” the Tribunal concluded that the Memorandum “reads as if it was drafted for these Taxpayers specifically,” and that the couple met their burden of demonstrating that they qualified for the Section 165(c)(2) deduction through application of the Memorandum to their facts. IRS Chief Counsel Memorandum 202511015 (Jan. 17, 2025).
Finally, the Tribunal summed up this very sad case well, explaining that “[t]axpayers may have lost a substantial amount of their life savings; they will not in addition be indebted to the state for taxes on gold bars last seen speeding away in the trunk of a white 2020 Lexus from the Chelsea Winn-Dixie.”
This update is one in a series of updates written for the September 2026 edition of The BR State + Local Tax Spotlight.
© 2026 Blank Rome LLP. All rights reserved. Please contact Blank Rome for permission to reprint. Notice: The purpose of this update is to identify select developments that may be of interest to readers. The information contained herein is abridged and summarized from various sources, the accuracy and completeness of which cannot be assured. This update should not be construed as legal advice or opinion, and is not a substitute for the advice of counsel.