Washington, D.C.-In the wake of several high-profile Ponzi schemes - most notably, the $65 billion fraud perpetrated by the now-jailed Bernard Madoff - the Internal Revenue Service has issued new guidance for victims of these types of schemes and their tax preparers.
In recent testimony before the Senate Finance Committee and also at a conference from IRS headquarters, Commissioner Doug Shulman announced the guidance for those affected by Ponzi schemes in the form of a revenue ruling and a revenue procedure.
However, the commissioner stressed that the guidance was not specific to the Madoff case.
"Clearly the Madoff case is tragic, as so many people were victims of this fraud, but the case also raises a staggering array of tax issues for the victims," he said. "We worked hard to reduce the burden on taxpayers and provide a straightforward way for people to deduct their losses."
The ruling clarifies the income tax law governing the treatment of losses in such schemes, while the revenue procedure provides a safe-harbor method of computing and reporting the losses.
"The revenue ruling is important because determining the amount and timing of losses from these schemes is factually difficult and dependent on the prospect of recovering the lost money, which may not become known for several years," Shulman noted.
"The revenue procedure simplifies compliance for taxpayers, and administration for the IRS, by providing a safe-harbor means of determining the year in which the loss is deemed to occur and a simplified means of computing the amount of the loss," he said.
Under Revenue Ruling 2009-9, the investor is entitled to a theft loss, which is not a capital loss. In other words, a theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments - which typically limit the loss deduction to $3,000 per year when it exceeds capital gains from investments.
Ponzi-type theft losses are not subject to limitations that are applicable to personal casualty and theft losses, and are deductible in the year the fraud is discovered, except to the extent that there is a claim with a reasonable prospect of recovery. Determining the year of discovery and applying the "reasonable prospect of recovery test" is highly fact-intensive and can be the source of controversy, observed Shulman.
The revenue ruling determines that the amount of the theft loss includes not only the investor's unrecovered investment, but also the phantom income that the promoter of the scheme credited to the investor's account and which the investor reported as income on their tax returns for years prior to discovery of the theft.
"Some taxpayers have argued that they should be permitted to amend tax returns for years prior to the discovery of the theft to exclude the phantom income and receive a refund of tax in those years," said Shulman. "The revenue ruling does not address this argument, and the safe-harbor revenue procedure is conditioned on taxpayers not amending prior-year returns."
Although the law does not require a criminal conviction of the promoter to establish a theft loss, it is often difficult to determine how extensive the evidence of theft must be to justify a claimed theft loss. Revenue Procedure 2009-20 provides that the IRS will deem the loss to be the result of theft if: the promoter was charged under state or federal law with the commission of fraud, embezzlement or a similar crime that would meet the definition of theft, or was the subject of a state or federal criminal complaint alleging the commission of such a crime, and either there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.
The revenue procedure generally allows taxpayers to deduct in the year of discovery 95 percent of their net investment, less the amount of any actual recovery in the year of discovery and the amount of any recovery expected from private or other insurance. For those investors suing persons other than the promoter, the ruling says that they compute their deduction with a 75 percent limit.
"There's no 10 percent [adjusted gross income] haircut," observed Neil Tipograph, tax partner at New York-based Imowitz Koenig & Co. LLP. "And most individuals will get a five-year NOL carryback."
"But there's a catch," he noted. "Qualified investors agree not to file amended returns excluding phantom income, and agree not to apply the claim of right credit or mitigation provisions."
Tipograph suggested that Madoff victims should, in most cases, follow the new procedure. "Taxpayers who do not use the safe harbor run the risk of having their returns, and more importantly, their refund claims, challenged by the IRS," he said. "Each victim needs to have his or her accountant run the numbers."
A possible instance where a victim might not follow the recommended procedure is where the taxpayer was completely wiped out. "If they take the loss in 2008 and carry it back five years through 2003, they're getting back taxes over a six-year period. In many cases, that will not fully compensate them for what they paid in the past," he said. "Now they have a carryforward, but if they have no prospects of any future income, that NOL carryforward does nothing for them. But if they're destitute, they need to get their hands on cash immediately, and following the ruling is the fastest way."
