On March 17, the IRS released Revenue Ruling 2009-09 and Revenue Procedure 2009-20 regarding the deduction of theft losses from criminally fraudulent investment arrangements that take the form of “Ponzi” schemes. Revenue Procedure 2009-20 provides an optional safe harbor method for eligible taxpayers to deduct such losses and a simplified method for eligible taxpayers to determine the amount and timing of their theft loss deductions. Revenue Ruling 2009-09 addresses the tax treatment of such types of losses. The ruling categorizes the losses as theft losses and provides guidance on the character, timing and amount of the deduction. The procedure and ruling will be published in Internal Revenue Bulletin 2009-14 on April 6, 2009.
Revenue Procedure 2009-20
Rev. Proc. 2009-20 provides both an optional safe harbor treatment for taxpayers that have experienced criminally fraudulent theft losses and guidance with respect to the deduction of such losses when the safe harbor treatment is not utilized. The Rev. Proc. shows that the IRS is aware of fraudulent “Ponzi” arrangements that have resulted in significant losses to taxpayers. In these arrangements, the party perpetrating the fraud receives cash or property from investors, appropriates it and reports fictitious income amounts to the investors. Any payments that are made to investors are made from cash or property that other investors invested in the fraudulent arrangement. The requirements for claiming a theft loss for an investment in a Ponzi scheme involve a factual determination that often cannot be made by taxpayers with certainty in the year the loss is discovered. Rev. Proc. 2009-20 provides an optional safe harbor under which qualified investors may deduct a theft loss when certain conditions are met. If a qualified investor follows the proper procedures, the IRS will not challenge the treatment as a theft loss. The revenue procedure applies to losses for which the discovery year is a taxable year beginning after December 31, 2007. A taxpayer that chooses not to apply the safe harbor treatment provided by the procedure remains subject to all the generally applicable provisions governing the deductibility of losses under § 165.
A qualified loss is a loss resulting from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss:
(1) the lead figure was charged by indictment or information under state or federal law with the commission of fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for purposes of §§ 165 and 1.165-8(d) under the law of the jurisdiction in which the theft occurred; and
(2) the lead figure was the subject of a state or federal criminal complaint alleging the commission of a crime, and either – (a) the complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or (b) a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.
Qualified investment means the excess, if any, of: (a) the sum of – (i) cash or the basis of property that the qualified investor invested in the arrangement in all years; plus (ii) the income with respect to the specified fraudulent arrangement that the investor included in income for federal tax purposes for all taxable years prior to the discovery year; over (b) the total amount of cash or property that the qualified investor withdrew in all years from the arrangement. The amount to be deducted is calculated as follows: (i) multiply the amount of the qualified investment by: (a) 95 percent, for a qualified investor that does not pursue any potential third-party recovery; or (b) 75 percent, for a qualified investor that is pursuing or intends to pursue any potential third-party recovery; and (ii) subtract from this product the sum of any actual recovery and any potential insurance/SIPC recovery.
A taxpayer that chooses not to apply the safe harbor treatment and who files or amends federal income tax returns for years prior to the discovery year to exclude amounts reported as income to the taxpayer from the investment arrangement must establish that the amounts sought to be excluded in fact were not income that was actually or constructively received (or accrued) by the taxpayer. However, provided a taxpayer can establish the amount of net income from the arrangement that was reported in the taxpayer’s gross income consistent with information received from the arrangement in taxable years for which the period of limitation on filing a claim for refund has expired, the IRS will not challenge the taxpayer’s inclusion of that amount in basis for determining the amount of any allowable theft loss.
Revenue Ruling 2009-09
Rev. Rul. 2009-9 (April 6, 2009), describes the proper income tax treatment for losses resulting from these “Ponzi” schemes. This treatment provides qualified investors with a uniform manner for determining their theft losses. In addition, the treatment avoids potentially difficult problems of proof in determining how much income reported in prior years was fictitious or a return of capital, and it eases compliance and administrative burdens on both taxpayers and the IRS.
The holdings of Rev. Rul. 2009-09 include the following:
(1) a loss from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss rather than a capital loss, under § 165;
(2) a theft loss in a transaction entered into for profit is deductible under § 165(c)(2) rather than § 165(c)(3), as an itemized deduction that is not subject to the personal loss limitations under § 165(h) or the limitations on itemized deductions under §§ 67 and 68;
(3) a theft loss in a transaction entered into for profit is deductible in the year the loss is discovered provided the loss is not covered by a claim for reimbursement or recovery;
(4) the amount of a theft loss in a transaction entered into for profit is generally the amount invested in the arrangement, less amounts withdrawn reduced by reimbursements, recoveries or claims as to which there is a reasonable prospect of recovery (moreover, where an amount is reported to the investor as income prior to discovery of the arrangement and the investor includes that amount in gross income and reinvests this amount in the arrangement, the amount of the theft loss is increased by the purportedly reinvested amount); and
(5) a theft loss in a transaction entered into for profit may create or increase a net operating loss under § 172 that can be carried back up to three years and forward up to 20 years.