Deducting business theft losses

Whether it’s unauthorized payroll payments, pilfered inventory, stolen equipment or forged checks, theft can be a devastating blow for a small business. Once the fraud is discovered, many business owners focus on stopping the losses and recovering what they can. But there’s another important question to consider: Can the loss be deducted? The answer is often yes, but qualifying for a theft loss deduction isn’t always straightforward. Here’s a closer look at the federal tax rules for claiming theft loss deductions.

The basics

For purposes of deducting theft losses, the term “theft” is broadly defined to include larceny, embezzlement and robbery. In general, a loss is regarded as arising from theft only if the appropriation of a taxpayer’s property involves a criminal element.

You can generally deduct business theft losses sustained during the tax year that aren’t compensated by insurance or other means. A theft loss is treated as sustained in the year you discover the theft, not necessarily the year it actually occurred. However, you must defer any portion of the deduction for which there’s a reasonable prospect of recovery through insurance claims, lawsuits or guarantees.

Only the unreimbursed amount is deductible. If you subsequently recover part of a previously deducted theft loss, the recovery is income in the year received, but only up to the amount that produced a prior tax benefit.

Loss calculations

The deductible theft loss for business or income-producing property is generally the lesser of: 1) the property’s adjusted basis immediately before the theft, or 2) its fair market value (FMV) immediately before the theft. Adjusted basis generally equals its cost minus depreciation.

The loss (after reimbursement) must be computed, item by item, for each identifiable stolen asset. Then you must combine the net losses from all your business assets affected by the theft to arrive at the total theft loss for that event.

Stolen inventory may instead be accounted for through cost of goods sold. The same loss can’t be deducted twice.

Suppose you discovered on November 1, 2026, that an employee stole equipment from your business. You bought the asset for $12,000 in 2024 and had claimed $6,000 in depreciation deductions through the loss date, resulting in an adjusted basis of $6,000 ($12,000 − $6,000). You obtained an appraisal that estimates the equipment was worth $7,000 on the loss date. If your insurance provider reimburses you $2,000 for the stolen asset, and you have no reasonable prospect of further recovery at the end of 2026, your deductible loss would be $4,000 for 2026 ($6,000 − $2,000). If you later recover $1,000 in a lawsuit, you’d report that amount as income in the year you receive it, to the extent the earlier deduction reduced your tax.

Reporting rules

Business theft losses are computed on Form 4684, “Casualties and Thefts.” Business and investment property losses then typically flow to Form 4797, “Sales of Business Property.” This form is used to complete the appropriate line on your tax return.

Where you actually report the loss deduction depends on how your business is structured. C corporations claim theft losses on Form 1120. The rules for “pass-through” entities are as follows:

• Sole proprietorships and limited liability companies (LLCs) taxed as sole proprietorships claim theft losses on Schedule C of the owner’s personal return.
• Partnerships and LLCs taxed as partnerships report theft losses on Form 1065, and the partners deduct their shares of the loss on their personal returns.
• S corporations report theft losses on Form 1120S, and the shareholders deduct their shares of the loss on their personal returns.

Owners’ deductions for their shares of pass‑through theft losses may be subject to applicable loss limitations, including at-risk and excess business loss rules. If theft losses will create a tax loss for your business, contact us to learn whether these limitations apply to your situation.

Documentation requirements

When claiming a business theft loss, you’ll need to gather records to substantiate your deduction. These records may include:

• A police report, insurance claim or other credible evidence that a theft occurred under applicable state law and when you discovered it,
• Invoices, asset registers, depreciation schedules or other business records that identify the stolen property, establish ownership (or contractual liability for leased assets) and support the adjusted basis of each item,
• Appraisal reports estimating each item’s FMV immediately before the theft, if applicable, and
• Records indicating the amount of insurance or other reimbursement received or reasonably expected.

For employee embezzlement or payroll fraud, supporting documentation may also include payroll records, bank statements and other evidence showing how the funds were misappropriated.

Proper documentation is essential. The IRS may deny or limit theft loss deductions if you can’t substantiate the adjusted basis or FMV for the stolen items or can’t clearly prove the theft occurred.

We can help

If your business is victimized by theft or fraud, you may be able to deduct the loss. But you must comply with the tax rules and keep detailed records in case the IRS questions your deduction. Although a tax deduction won’t make your business whole, it may help offset at least part of the loss. Contact us for guidance on calculating, reporting and substantiating theft loss deductions for your small business.