Strict Substantiation and Timing for § 162 Legal Fees, § 165 Theft Losses, and § 172 NOL Carryovers (Sixth Circuit)

I. Introduction

Case: Michael H. Shaut v. Commissioner of Internal Revenue (6th Cir. Mar. 12, 2026) (unpublished).
Posture: Appeal from the United States Tax Court sustaining, after trial, an IRS deficiency determination (ultimately a $3,548 liability for 2019).

Michael H. Shaut—an attorney and entrepreneur—previously served as president of Downing Investment Partners (“Downing”) and later stepped back into a role the court characterized as essentially that of an investor. After substantial civil litigation and a criminal prosecution of other Downing principals for fraud, Shaut’s 2019 return sought to deduct (i) legal fees as business expenses, (ii) an alleged $720,000 theft loss tied to Downing, and (iii) a $570,806 net operating loss (“NOL”) carryover (variously attributed to Carbon Vision, his law practice, earlier carryovers, and Downing-related items). The IRS disallowed the losses; the Tax Court largely agreed; and the Sixth Circuit affirmed.

Key issues: (1) Whether litigation expenses were deductible under 26 U.S.C. § 162 as “ordinary and necessary” expenses of a trade or business; (2) whether a theft loss was proven and deductible in 2019 under 26 U.S.C. § 165; (3) whether the taxpayer substantiated an NOL carryover under 26 U.S.C. § 172; and (4) whether an arbitration decision was improperly admitted and, if so, whether the error was harmless.

II. Summary of the Opinion

The Sixth Circuit affirmed the Tax Court in full. It held that Shaut failed to carry his burden to substantiate:

  • § 162 legal-fee deductions, because most invoices did not relate to 2019 and the remaining expenses were not sufficiently tied to carrying on a “trade or business” as opposed to protecting an investment;
  • § 165 theft-loss deduction, because he did not prove theft under Ohio law (or that he personally was deceived into investing) and did not establish that 2019 was the proper year for the loss; and
  • § 172 NOL carryover, because tax returns alone were not enough and his claimed components were internally inconsistent or otherwise unsupported.

On the evidentiary point, the court concluded that even if the Tax Court initially erred in admitting an arbitration award, any error was harmless because the Tax Court later excluded it and substantial other evidence supported the decision.

III. Analysis

A. Precedents Cited

1. Standard of review, deference, and burden of proof

  • Oquendo v. Comm'r, 148 F.4th 820 (6th Cir. 2025): Framed appellate review—legal conclusions de novo, factual findings for clear error—setting a high bar for overturning the Tax Court’s fact-bound determinations.
  • Indmar Prods. Co. v. Comm'r, 444 F.3d 771 (6th Cir. 2006): Supplied two crucial principles: deficiency determinations are presumed correct (placing an initial burden on the taxpayer), and credibility determinations receive “even greater discretion.” This deference was central to affirming the Tax Court’s skepticism of Shaut’s self-serving testimony.
  • McGowan v. United States, 143 F.4th 686 (6th Cir. 2025) (quoting INDOPCO, Inc. v. Comm'r, 503 U.S. 79 (1992)): Reaffirmed that taxpayers must “clearly show” entitlement to deductions and noted burden-shifting if the taxpayer introduces “credible evidence” on relevant factual issues.
  • Conti v. Comm'r, 39 F.3d 658 (6th Cir. 1994) and Davis v. Comm'r, 866 F.2d 852 (6th Cir. 1989): Allowed the Tax Court to disregard testimony it finds “improbable, unreasonable[,] or questionable,” supporting the outcome where documentary and objective corroboration was missing.

2. § 162 business expense doctrine and the investor-versus-business line

  • Dargie v. United States, 742 F.3d 243 (6th Cir. 2014): Provided the four-part framework for deductibility under § 162(a), including the requirement that the expense be paid or incurred in the taxable year and arise in connection with a trade or business.
  • Comm'r v. Groetzinger, 480 U.S. 23 (1987) (quoting Higgins v. Comm'r, 312 U.S. 212 (1941)): Confirmed that “trade or business” is a fact-intensive inquiry, reinforcing the Tax Court’s case-specific approach to Shaut’s role at Downing.
  • Dietrick v. Comm'r, 881 F.2d 336 (6th Cir. 1989) (quoting Whipple v. Comm'r, 373 U.S. 193 (1963)): Anchored the rule that a shareholder (or investor) generally cannot deduct expenses incurred on behalf of a corporation, and that returns that are only “that of an investor” do not amount to carrying on a trade or business. Whipple v. Comm'r was pivotal: it supplied the conceptual boundary the court used to classify Shaut’s remaining activities as investment-protective rather than business-operational.

3. § 165 theft losses—state-law theft and timing

  • Alioto v. Comm'r, 699 F.3d 948 (6th Cir. 2012): Controlled two key points: theft is determined by reference to the criminal law of the relevant jurisdiction, and the taxpayer must prove existence of theft, amount, and year of discovery.
  • Ohio v. Edmondson, 750 N.E.2d 587 (Ohio 2001) and Ohio Rev. Code § 2913.02(A): Supplied the elements of theft (including theft by deception), which the court applied to find the record lacked proof that Shaut transferred property due to deception, threat, or intimidation directed at him.
  • Roth Steel Tube Co. v. Comm'r, 800 F.2d 625 (6th Cir. 1986): Foreclosed Shaut’s attempt on appeal to reframe the timing theory (arguing a “reasonable prospect of recovery” ended in 2019) when that explanation was not presented to the Tax Court.

4. § 172 NOL carryovers—substantiation beyond returns

  • United Dominion Indus., Inc. v. United States, 532 U.S. 822 (2001): Cited for the general carryforward concept, but did not help Shaut on proof; it functioned as background authority rather than a dispositive rule.
  • Wilkinson v. Comm'r, 71 T.C. 633 (1979) and Sparkman v. Comm'r, 509 F.3d 1149 (9th Cir. 2009): Supported the Tax Court’s refusal to treat returns as conclusive evidence of an NOL; additional evidentiary support is required.
  • Simpson v. Comm'r, 23 F. App'x 425 (6th Cir. 2001) (per curiam): Reinforced that the taxpayer must prove both entitlement to and amount of the carryover.

5. Evidentiary rulings and harmless error

  • Craddock v. FedEx Corp. Servs. Inc., 102 F.4th 832 (6th Cir. 2024): Supplied the abuse-of-discretion standard and the “clear error of judgment” formulation for reviewing evidentiary rulings.
  • Barnes v. City of Cincinnati, 401 F.3d 729 (6th Cir. 2005): Provided the harmless-error principle: even improper evidence does not warrant reversal if other evidence sufficiently supports the outcome.

B. Legal Reasoning

1. § 162: Legal fees were not shown to be (a) incurred in 2019 or (b) tied to carrying on a trade or business

The court’s § 162 analysis proceeded in two steps.

  1. Tax-year requirement: Relying on Dargie v. United States, the court emphasized that expenses must be “paid or incurred” in the relevant year. The Tax Court found, and the Sixth Circuit agreed was supported by the record, that most invoices related to years other than 2019; and Shaut failed to prove any permissible carryover mechanism for those fees into 2019.
  2. Trade-or-business nexus (investor vs. operator): Using Whipple v. Comm'r and Dietrick v. Comm'r, the court treated Shaut’s Downing-related litigation posture as investor-protective rather than business-operational. Critically, the court accepted the factual finding that by the time the litigation arose, Shaut was not engaged in Downing’s day-to-day operations and was not receiving salary—facts that pushed his activities to the “investment” side of the line.

2. § 165: Theft loss failed on proof of theft and on year-of-deduction timing

The court rejected the theft-loss deduction for multiple independent reasons.

  1. No proven theft as to Shaut: Following Alioto v. Comm'r, the court required proof of theft under Ohio law, including (for theft by deception) that deception caused the property transfer as described in Ohio v. Edmondson. Even though other Downing principals pleaded guilty to fraud in separate proceedings, the court held Shaut still had to prove his own theft-loss elements—particularly that he invested due to deception directed to him. The Tax Court’s adverse credibility finding (that Shaut’s story was implausible given his sophistication and prior leadership role) was insulated by Indmar Prods. Co. v. Comm'r deference.
  2. Wrong year: The governing regulations (cited by the court) require that a theft loss be deducted in the year discovered, but not if there exists a “reasonable prospect of recovery” until that prospect ends with reasonable certainty. The court held Shaut failed to provide objective evidence that discovery (or the end of a reasonable prospect of recovery) occurred in 2019; the record suggested discovery earlier (late 2017/early 2018). The Sixth Circuit also invoked Roth Steel Tube Co. v. Comm'r to reject Shaut’s attempt to introduce a new timing theory on appeal.

3. § 172: NOL carryover failed for lack of coherent, corroborated computation

The court’s NOL analysis was fundamentally evidentiary. Under the regulations cited, a taxpayer must establish both the existence of the NOL and the amount available to carry to the year at issue. Invoking Wilkinson v. Comm'r (and Sparkman v. Comm'r), the court refused to treat prior returns as conclusive proof. It then identified concrete gaps and inconsistencies:

  • Carbon Vision: Shaut offered no substantiation explaining how entity-level items translated into his personal NOL position, especially with missing personal returns for key years.
  • 2017 carryover inconsistency: The 2018 return’s claimed carryover did not match the prior year’s stated remaining balance.
  • Law-practice and Downing components: Claimed amounts were unclear or untraceable to admissible evidence; and Downing legal fees were independently non-deductible under the court’s § 162 analysis.

Citing Simpson v. Comm'r, the court concluded Shaut did not meet his burden on entitlement or amount.

4. Evidence: Any initial admission of arbitration decision was harmless

Applying Craddock v. FedEx Corp. Servs. Inc. and Barnes v. City of Cincinnati, the Sixth Circuit held that even if the arbitration opinion was improperly admitted initially, the Tax Court later excluded it and expressly stated it did not consider related testimony. Given that other evidence supported the key findings (particularly regarding credibility and lack of objective substantiation), any error did not affect the outcome.

C. Impact

  • Reinforces documentation discipline for deduction litigation: The decision underscores that Tax Court trials are won with contemporaneous, year-specific proof—paid/incurred dates, clear allocation, and tie-outs from invoices and ledgers to the precise line items claimed.
  • Strengthens the investor-versus-business boundary for founder/executive taxpayers: Even a former president/founder figure may be treated as an investor once operational involvement and compensation cease; litigation expenses that “defend the investment” rather than “carry on the business” risk non-deductibility under Whipple v. Comm'r.
  • Clarifies theft-loss limits in fraud-adjacent contexts: Criminal fraud by others is not automatically “theft” as to a particular taxpayer; the taxpayer must still prove state-law elements and a proper deduction year, including the “reasonable prospect of recovery” timing rule.
  • Signals appellate reluctance to revisit Tax Court credibility findings: The court’s reliance on Indmar Prods. Co. v. Comm'r indicates that taxpayers should assume credibility battles are largely decided at trial, not on appeal.
  • Unpublished but instructive: While “NOT RECOMMENDED FOR PUBLICATION,” the opinion provides a practical roadmap for how the Sixth Circuit evaluates proof problems in § 162, § 165, and § 172 disputes.

IV. Complex Concepts Simplified

  • “Ordinary and necessary” (§ 162): A business can deduct common, appropriate costs of running that business. But the expense must be tied to operating the business, not merely protecting an investment in someone else’s business.
  • “Trade or business” vs. investing: Running a business typically involves regular, continuous activity aimed at earning income from operations (often with compensation like salary/fees). Investing—even if time-consuming—usually produces returns like dividends, interest, or appreciation, and is treated differently for deduction purposes.
  • Theft loss (§ 165): You must show (1) there was a “theft” under the relevant state’s criminal law, (2) the amount taken, and (3) when you discovered it. A general fraud scandal does not automatically prove that you personally were tricked into transferring your money.
  • “Reasonable prospect of recovery” (timing rule): Even if you discover a theft, you generally cannot deduct the loss while there is a realistic chance you will recover money through litigation, insurance, bankruptcy distributions, settlements, or similar means. The deduction is tied to when the recovery prospect becomes reasonably certain to be absent.
  • NOL carryover (§ 172): If deductions exceed income in one year, the unused loss can sometimes offset income in later years. But you must prove the loss existed, was computed correctly, and was not already used up—usually with more than just a prior tax return.
  • Harmless error (evidence): A court mistake about admitting evidence does not require reversal if the outcome would be the same based on other, proper evidence.

V. Conclusion

Michael H. Shaut v. Commissioner of Internal Revenue affirms a rigorous, proof-centered approach to contested deductions: (1) § 162 litigation expenses must be clearly tied to carrying on a trade or business and to the correct tax year; (2) § 165 theft losses require state-law proof of theft as to the taxpayer and careful timing based on discovery and recovery prospects; and (3) § 172 NOL carryovers demand coherent, corroborated computations beyond prior return entries. The opinion’s broader significance is its practical warning that in tax litigation—especially where credibility and substantiation are contested—documentary precision and consistent year-by-year tracing are often decisive.