The Bernard Madoff situation is just the most notorious of dozens of Ponzi schemes that have surfaced since the current recession made it more difficult for the operators of those schemes to keep covering payouts and redemptions with money from new investors.
Tax issues that have arisen for victims of Ponzi schemes include whether a theft loss can be claimed, whether the claimed loss can include not only the investment but also income that had been reported in prior years' tax returns that has now proved to be fictitious, and in what year the loss should be claimed - when the theft was discovered or after any chance of recovery is decided. Investors have also been concerned about whether they should amend prior years' tax returns that are still open to amendment to remove reported income from the scheme that has now proved to be fictitious.
On March 17, 2009, the IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20 to provide some guidance on these issues.
REV. RUL. 2009-9
Revenue Ruling 2009-9 provides guidance on theft losses. The guidance focuses on an individual who is on the cash method of accounting. It also focuses on an investment with an individual or entity that holds itself out as an investment advisor and securities broker. If the investment also meets the definition of a tax shelter, it is excluded from the guidance. An investor who did not invest directly with the fraudulent investment advisor but only through a third party would not appear to be addressed in this guidance.
Within this framework, the ruling holds that a loss from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss, not a capital loss, under Code Section 165, despite the taxpayer's original intention of making an investment.
However, this original intention to invest does bear on placing the invested funds under the general umbrella of "a transaction entered into for profit." As such, the IRS observed that a theft loss from a transaction entered into for profit is not subject to the percentage of adjusted gross income and floor limits normally applicable to personal casualty and theft losses. The theft loss is also not subject to the phase-out of itemized deductions.
The amount of the theft loss is the amount invested in the arrangement, less any amounts withdrawn, reduced by reimbursements or recoveries and claims as to which there is a reasonable prospect of recovery. The amount of the theft loss also includes amounts included as income on a prior tax return that were reported to the investor as income from the investment.
Such a theft loss, by its classification as "a transaction entered into for profit," also may create or increase a net operating loss under Code Section 172 that can be carried back up to three years and forward up to 20 years. In the case of a 2008 net operating loss, the carryback may be three, four or five years pursuant to the American Recovery and Reinvestment Act of 2009.
The theft loss does not qualify for the Code Sec. 1341 protections arising from possible mismatching of tax benefits due to including an item in gross income in one tax year and taking a deduction in a different tax year when, due to rate changes or other factors, the deduction may not provide a full offset for the income inclusion.
The theft loss also does not qualify under the mitigation provisions of Code Sections 1311 to 1314 to adjust tax liabilities for prior open years because, in the view of the IRS, the inclusion of income in those years was still the proper treatment at that time.
Finally, Revenue Ruling 2009-9 holds that a theft loss in a transaction entered into for profit is deductible in the year that the loss is discovered, provided that the loss is not covered by a claim for reimbursement or recovery with respect to which there is a reasonable prospect of recovery.
However, because establishing the year that the loss is discovered and whether there is a reasonable prospect of recovery can involve difficult questions of fact, the service also provided a safe harbor for taxpayers to follow in Revenue Procedure 2009-20.
REV. PROC. 2009-20
Revenue Procedure 2009-20 follows the same definitional framework as Revenue Ruling 2009-9. It provides a safe harbor, however, with respect to when a theft loss is deductible and the amount of the deduction. Under the safe harbor, a qualified investor's discovery year is the tax year in which the indictment, information or complaint against a lead figure is filed. For purposes of the Madoff scheme, this would be the 2008 calendar year.
The amount that can be deducted under the safe harbor as a theft loss is 95 percent of the qualified investment for a qualified investor that does not pursue any potential third-party recovery, or 75 percent of the qualified investment for a qualified investor that is pursuing or intends to pursue any potential third-party recovery.
From this amount, the sum of any actual recovery and any potential insurance or Securities Investor Protection Corporation recovery must be subtracted. Subsequent events could require additional income or deductions in subsequent years based on the actual amount of the loss that is eventually recovered.
Revenue Procedure 2009-20 includes a form statement to be completed and signed by the taxpayer and filed with the tax return setting forth the computation of the theft loss claimed and making certain representations as to supporting documentation, status as a qualified investor, potential third-party recoveries, and tax returns that have been filed inconsistent with the requirements of the safe harbor. Form 4684, Casualties and Thefts, to be attached to the return, is also to include an added heading of "Revenue Procedure 2009-20" at the top of the form.
For taxpayers not utilizing the safe harbor, the revenue procedure states that they must establish that the loss was from theft and that it was discovered in the year of the claimed deduction. The taxpayer must also establish, through documentation, the amount of the claimed loss and that no claim or reimbursement of any portion of the loss exists with respect to which there is a reasonable prospect of recovery in the tax year for which the loss is claimed.
The new revenue procedure does state, however, that the claimed loss may include income from tax years for which the statute of limitations has otherwise expired.
Revenue Ruling 2009-9 helps to clarify the IRS's preference that Ponzi losses be claimed as theft losses in the year of discovery, rather than attempting to file amended refund claims to pull out fictitious income reported on prior-year open returns.
Revenue Procedure 2009-20 provides a helpful safe harbor to taxpayers who have difficulty determining the year in which to claim the theft loss and whether the amount of the theft loss is sufficiently certain to claim or too uncertain due to possible recoveries. The safe harbor should help Madoff investors claim theft losses in 2008, when net operating loss carrybacks can go back as far as five years under current law, and should help other Ponzi scheme investors deduct theft losses sooner and in larger amounts than they might otherwise have been able to justify.
Ironically, for at least some of those who entrusted their money to a Ponzi scheme only within the past few years, there is even the possibility that recoveries through SIPC insurance and theft-loss deductions, as further enhanced by five-year NOL carryback treatment, may leave them in a better financial situation than many of those who invested in certain legitimate sectors of the crashing stock market.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a Wolters Kluwer business.
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