Last week, the IRS provided detailed guidance regarding the tax treatment of losses from fraudulent “Ponzi” investment schemes, such as those operated by Bernard Madoff. Rev. Rul. 2009-9 (March 19, 2009) addresses seven specific tax issues that victims of fraudulent schemes may confront when claiming theft losses. Rev. Proc. 2009-20 (March 17, 2009) provides an optional safe harbor alternative under which victims may deduct losses. The IRS’s guidance is generally pro-taxpayer, clarifying the allowability and calculation of theft loss deductions for victims of such investment schemes.

Rev. Rul. 2009-9 – Guidance for Deducting Theft Losses

Rev. Rul. 2009-9 addresses seven specific tax issues regarding when and how to deduct losses from fraudulent investment schemes under the Internal Revenue Code (the “Code”). The following guidance applies to fraudulent arrangements that take the form of so-called Ponzi schemes.

  • Theft Loss. Losses from fraudulent investment schemes may be treated as theft losses, rather than less-favorable capital losses, because the investment manager specifically intended to, and did, deprive the investor of money by criminal acts.
  • Theft Loss Deduction Limitations. Because investments were entered into for profit, theft losses are deductible under I.R.C. § 165(c)(2), rather than § 165(c)(3) (relating to losses not connected with a business or for-profit activity). Thus, victims’ theft loss deductions are not subject to the various stringent limitations on the amount of § 165(c)(3) losses that may be deducted.
  • Year of Deduction. Victims may deduct the theft loss in the year the theft loss is discovered, provided the loss is not covered by a claim for reimbursement or other recovery as to which the victim has a reasonable prospect of recovery. To the extent that the deduction is reduced by such a claim, amounts eventually recovered pursuant to such claim are not includible in gross income. If the victim recovers a greater amount in a subsequent year, or an amount that was not covered by such a claim for recovery, the recovery is includible in gross income to the extent the earlier deduction reduced the victim’s income tax. The victim may ultimately deduct a loss not currently deductible, once the amount of recovery is ascertained with reasonable certainty.
  • Amount of Deduction. The amount of the theft loss deduction is (i) the amount invested, less amounts withdrawn; (ii) plus amounts reported on federal income tax returns as gross income from the investment; (iii) minus investment distributions; and (iv) minus any amounts under claim for reimbursement where there is a reasonable prospect of recovery.
  • Net Operating Loss Carryback. To the extent the theft loss deduction creates a net operating loss in the year the loss is deducted, the victim may carry back such loss up to three years and forward up to 20 years. The American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, § 1211 (February 17, 2009) provides that eligible small businesses may elect a carryback period of up to five years for certain 2008 net operating losses. Individual theft losses may qualify as a “sole proprietorship” eligible for the increased carryback period if the individual has $15 million average annual gross receipts.
  • Amounts Not Held Under Claim of Right. Victims of fraudulent investment schemes may not utilize the alternative tax computation formula under I.R.C. § 1341. The benefits under that section are only available where the loss deduction arises from an obligation by the taxpayer to restore the income based on a mistaken claim of right to the income.
  • Mitigation Provisions Not Applicable. Victims cannot use the mitigation provisions of I.R.C. §§ 1311-1314 to correct errors made in tax years for which the statute of limitations has closed. The mitigation provisions under those sections are only available where the IRS makes a determination that is inconsistent with the erroneous prior tax treatment. The IRS’s determination under Rev. Rul. 2009-9 that victims are entitled to a theft loss in the year of discovery is consistent with the IRS’s position that income from the investment was properly included in the victims’ closed tax years.

Rev. Proc. 2009-20 – Safe Harbor for Theft Losses

Rev. Proc. 2009-20 provides an optional safe harbor treatment for losses incurred pursuant to Ponzi-like investment schemes that are determined to be criminally fraudulent. The IRS created the safe harbor for victims meeting certain conditions because it recognized that eligibility to claim a theft loss under the Code and Rev. Rul. 2009-9 is a highly factual and uncertain determination. Accordingly, the safe harbor under Rev. Proc. 2009-20 provides a means by which many victims of fraudulent investment arrangements may deduct their theft losses while avoiding potentially difficult problems of proof.

The safe harbor is generally available to “qualified investors” with a “qualified loss” from a “specified fraudulent arrangement.” A “specified fraudulent arrangement” is an arrangement in which a party (the “lead figure”) receives cash or property from investors; purports to earn income for the investors; reports income amounts that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investors’ cash or property.

A “qualified investor” is a U.S. person (including citizens, residents, domestic partnerships and corporations, and certain trusts and estates) (i) that generally qualifies to deduct theft losses; (ii) that did not have actual knowledge of the fraudulent nature of the investment arrangement prior to the general public; (iii) with respect to which the fraudulent arrangement is not a tax shelter under federal tax law; and (iv) that transferred cash or property to a “specified fraudulent arrangement.” A “qualified investor” does not include a person that invested solely in a fund that invested in the arrangement; however, the fund may itself be a qualified investor.

A “qualified loss” is a loss resulting from a “specified fraudulent arrangement” in which the lead figure or figures of the scheme (i) are charged by indictment or information with the commission of fraud, embezzlement, or a similar crime; or (ii) were the subject of a state or criminal complaint alleging the commission of fraud, embezzlement, or a similar crime, and either (a) the complaint alleged an admission by such lead figure, or the execution of an affidavit by that person admitting the crime; or (b) a receiver or trustee was appointed to the arrangement or the assets were frozen.

An investor who meets the foregoing qualifications may take a theft loss deduction for 95 percent of the amount of the “qualified investment” (75 percent for investors that will pursue any potential third-party recovery), less the sum of any actual recovery and any potential insurance recovery. The deduction amount is not reduced by potential direct recovery from the fraudulent parties or by third-party non-insurance recovery. The investor may have income or an additional deduction in a subsequent year, depending on the actual amount of the loss that is eventually recovered.

The amount of “qualified investment” is generally the same as the amount of deduction calculated under Rev. Rul. 2009-9. However, Rev. Proc. 2009-20 expressly excludes (i) amounts borrowed from the fraudulent party and reinvested in the scheme, to the extent not repaid; (ii) amounts such as fees that were paid to the fraudulent party and deducted for federal tax purposes; (iii) amounts reported to but not included as gross income on the investor’s federal income tax returns; and (iv) cash or property invested in a fund or other entity that invested in a fraudulent arrangement.

The Rev. Proc. provides detailed procedures for participation in the safe harbors, and includes as an appendix a form that may be used for filing with the taxpayer’s federal income tax returns. The safe harbor applies to losses which are discovered in a taxable year beginning after December 31, 2007. Losses are “discovered” upon filing of an indictment, information or complaint against the lead person. Finally, the Rev. Proc. notes that taxpayers that choose not to participate in the safe harbor are subject to the more rigorous evidentiary requirements for theft losses under I.R.C. § 165 and Rev. Rul. 2009-9.