On March 17, 2009, the Internal Revenue Service ("IRS") issued Revenue Ruling 2009-9, which describes the IRS position with respect to the tax consequences associated with losses incurred by taxpayers who are victims of a "Ponzi" scheme. On the same date, the IRS also issued Revenue Procedure 2009-20, which provides certain taxpayers with an optional safe harbor for determining their theft loss amount in connection with such investment losses. The guidance set forth in Revenue Ruling 2009-9 and Revenue Procedure 2009-20 generally should have a favorable tax effect (including a level of certainty) regarding losses incurred by victims of fraudulent investment schemes. The following is a summary of Revenue Ruling 2009-9 and Revenue Procedure 2009-20.

Revenue Ruling 2009-9

In Revenue Ruling 2009-9, the IRS sets forth its legal position on the treatment of losses incurred pursuant to certain criminally fraudulent investment arrangements. In general, the IRS' legal position regarding such losses is as follows:

  • A loss from criminal fraud or embezzlement is a theft loss rather than a capital loss. An investor who is a victim of a fraudulent scheme is entitled to claim theft loss (which can reduce or offset ordinary income) under Code §165, rather than a capital loss (the deductibility of which is subject to significant limitations).
  • A theft loss is not subject to the limitations applicable to "personal" casualty losses under Code §165(h) or to itemized deductions under Code §§67 or 68. An investor's loss in connection with a fraudulent arrangement generally is not subject to (1) the limitations that are applicable to "personal" casualty and theft losses (e.g., the 10 percent of adjusted gross income floor) and (2) the 2 percent limitation on miscellaneous itemized deductions under Code §67, or the overall limit on itemized deductions under Code §68.
  • A theft loss is deductible in the taxable year that the loss is discovered. The investor can claim a deduction for the theft loss in the year such losses are discovered.
  • The amount of the theft loss is generally equal to the taxpayer's unrecovered investment—including "fictitious income" taxed in prior years. An investor's theft loss deduction generally is equal to the excess of (1) the investor's investment, plus amounts included in the investor's gross income as income with respect to such fraudulent arrangement prior to the discovery of the fraud, over (2) amounts previously withdrawn, plus any recoveries and claims for reimbursement (e.g., insurance recoveries from the Securities Investor Protection Corp. ("SIPC")) as to which the investor has a reasonable prospect of recovery.
  • A theft loss that creates or increases a net operating loss may be carried back up to three (and possibly up to five) years, and carried forward up to 20 years. An investor's theft loss deduction that creates or increases a net operating loss ("NOL") may be carried back up to three years and carried forward up to 20 years. For losses discovered in 2008, an investor may elect to carryback the related NOL up to five years if, generally speaking, such investor's average gross receipts for the prior three taxable years does not exceed $15 million.

Revenue Procedure 2009-20

Revenue Procedure 2009-20 provides an optional safe harbor for losses in certain criminally fraudulent investment arrangements, such as "Ponzi" schemes and similar arrangements (the "Safe Harbor"). If a taxpayer follows the rules and procedures set forth in the Safe Harbor, the IRS will not challenge (1) the characterization of the loss as a theft loss, (2) the timing of the taxable year in which the taxpayer is deemed to discover the fraudulent nature of the scheme, and (3) the amount of the theft loss deduction.

Revenue Procedure 2009-20 generally includes the following rules and requirements with respect to the Safe Harbor:

  • Taxable year of the theft loss. For purposes of the Safe Harbor, the taxable year in which an investor can take the theft loss generally is the taxable year in which, with respect to such loss, the lead figure in the arrangement is (1) charged with the commission of fraud, embezzlement or similar crime, or (2) subject to a criminal investigation alleging such crime, coupled with an actual or alleged admission of the crime by such lead figure, the appointment of a receiver or trustee, or the assets of the arrangement being frozen.
  • Amount of the theft loss. The amount of the theft loss deductible under the Safe Harbor is equal to 95 percent (if the taxpayer does not pursue any potential third-party recovery) or 75 percent (if the taxpayer is pursuing or intends to pursue any potential third-party recovery) of the taxpayer's "qualified investment" (described below), reduced by the amount of any actual recovery and any potential insurance/SIPC recovery.
  • "Qualified Investment" defined. The taxpayer's "qualified investment" generally equals the excess of (1) the sum of (i) the aggregate amount invested by the taxpayer in the fraudulent arrangement in all years and (ii) the aggregate net income taken into account by the taxpayer for federal income tax purposes for all years (whether closed or open) prior to the discovery year, over (2) the aggregate amount of cash or property that the taxpayer withdrew in all years from the fraudulent arrangement.
  • Administrative Requirements. In order to utilize the Safe Harbor, the taxpayer generally must comply with certain administrative provisions, including providing a written statement agreeing to not filing amended returns that are inconsistent with the Safe Harbor treatment.

Technically, the Safe Harbor applies only to direct investors in the fraudulent arrangement. Thus, a taxpayer who invested in an investment partnership that itself invested in the fraudulent arrangement may not make a Safe Harbor election. However, the investment partnership itself may apply for Safe Harbor treatment, in which case each partner in the investment partnership generally would take into account its allocable share of the loss determined under the Safe Harbor.

Taxpayers who do not follow the Safe Harbor usually are subject to all of the generally applicable provisions governing the deductibility of theft losses, including establishing the year the theft was discovered, the amount of the claimed loss, and that there was no claim for reimbursement for any portion of such loss for which there was a reasonable prospect of recovery. Whether such a reasonable prospect of recovery exists is a fact-intensive inquiry, the determination of which may not be entirely certain. Therefore, the Safe Harbor eliminates the need for taxpayers to address this issue and provides taxpayers with a level of certainty in this regard.

Furthermore, a taxpayer not following the Safe Harbor may file amended tax returns for prior years, excluding amounts previously reported as income with respect to the fraudulent arrangement, if such taxpayer can establish that such amounts were not income actually or constructively received. In addition, if a taxpayer can establish the amount of net income from the fraudulent arrangement that was reported in closed taxable years, the IRS will not challenge including such amount any allowable theft loss (whether or not the income was genuine) in the year such loss is discovered. Certain taxpayers (e.g., taxpayers who reported income with respect to the fraudulent arrangement in prior taxable years, but did not receive any distributions from the arrangement) may find it more advantageous to not apply the Safe Harbor and file amended returns for open taxable years. In such cases, the taxpayer may be entitled to receive interest for any tax refund with respect to such amended returns, and may be able to establish a theft loss deduction that is greater than that available under the Safe Harbor.

Taxpayers should be aware that the state tax treatment of losses incurred with fraudulent investment arrangements may not follow the federal tax treatment of such losses. For example, Massachusetts has announced that, due to certain differences between federal and Massachusetts tax law regarding theft loss deductions, it does not adopt the Safe Harbor treatment set forth in Revenue Procedure 2009-20.

This Tax Alert is intended only to provide a general summary of certain tax provisions in Revenue Ruling 2009-9 and Revenue Procedure 2009-20. Many questions were still not answered by this IRS guidance. If you have questions or would like additional information on the material covered in this Tax Alert, please contact one of the authors, or the Reed Smith attorney with whom you regularly work.