In his March 17, 2009 testimony before the Senate Finance Committee on Tax Issues Related to Ponzi Schemes and an Update on Offshore Tax Evasion Legislation, the Commissioner of the Internal Revenue Service (IRS), Doug Shulman, announced the IRS’s issuance of guidance—i.e., Revenue Ruling 2009-9 and Revenue Procedure 2009-20—to help provide clarity and assist taxpayers in addressing the United States federal income tax implications of Madoff-related and other Ponzi-type investment losses. In general: (I) Revenue Ruling 2009-9 sets forth the government’s formal legal position as to United States federal income tax treatment of such losses; and (II) Revenue Procedure 2009-20 provides a “safe harbor” for taxpayers to claim a theft loss deduction for such losses.  

Revenue Ruling 2009-9  

Revenue Ruling 2009-9 sets forth a Madoff-type factual scenario, as to which the IRS concluded as follows:  

  • The taxpayer’s loss constitutes an ordinary theft loss, rather than a capital loss. The IRS noted that a “theft” covered “any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile.” The IRS further noted that although a taxpayer need not show an actual “theft” conviction to claim a theft loss, a taxpayer must prove that the “loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent.”1  
  • Since the taxpayer entered into an investment for profit, the resulting theft loss constitutes an itemized deduction not subject to either (a) the itemized deduction limitations of Sections2 67 and 68; or (b) the $100 ($500 for 2009 only) or 10%-of-adjusted gross income limitations of Section 165(h).  
  • The taxpayer may not recover any portion of the “theft loss” for which there is a “reasonable prospect of recovery.” Whether the taxpayer has a reasonable prospect for recovery is a fact-intensive determination. To this end, Revenue Procedure 2009-20 (discussed below) would allow taxpayers to claim a theft loss in the year that a criminal indictment, information or complaint is filed in respect of the arrangement, even if the taxpayer has an actual or potential claim for reimbursement or recovery.  
  • The theft loss deduction includes “fictitious income” amounts. In general, the amount of the taxpayer’s theft loss would include (in addition to the taxpayer’s original and additional investments, and less any withdrawals), any amounts reported to the taxpayer as income in prior years that the taxpayer included in gross income and which the taxpayer had “reinvested” in the arrangement.  
  • A taxpayer not having more than $15 million of gross receipts may elect 3-, 4- or 5-year net operating loss carryback for 2008 theft loss. If the taxpayer’s gross receipts exceed $15 million, then the taxpayer may carryback the theft loss up to three years. Also, any theft loss may be carried forward up to twenty years.  
  • Neither the “claim of right” provisions of Section 1341 nor the mitigation provisions of Sections 1311 through 1314 are applicable.  
  • Theft loss is not taken into account in determining whether the transaction is a “loss transaction” for purposes of the “reportable transaction” disclosure rules of Treasury Regulations Section 1.6011-4.  

Revenue Procedure 2009-20

Revenue Procedure 2009-20 provides an optional safe harbor under which “qualified investors” may treat a loss as a theft loss deduction when certain conditions are satisfied. In general, a “qualified investor” is defined as a “United States person”: (a) that generally qualifies to deduct theft losses under Section 165 and Treasury Regulations Section 1.165-8; (b) that did not have actual knowledge of the fraudulent nature of the investment arrangement prior to it becoming known to the general public; (c) with respect to which the “specified fraudulent arrangement”3 is not a tax shelter (as defined in Section 6662(d)(2)(C)(ii)); and (d) that transferred cash or property to a specified fraudulent arrangement.4  

In general, this revenue procedure will allow Madoff victims and victims of other Ponzi arrangements to claim a theft loss deduction without having to meet certain of the normal evidentiary burdens (as described above in the discussion of Revenue Ruling 2009-9). First, in order to claim a theft loss deduction, a taxpayer must normally show that the subject loss was the result of “theft”—that is, the loss “resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent.” Instead, under the revenue procedure, a loss (referred to in the revenue procedure as a “qualified loss”) will be deemed to be the result of “theft” if the promoter was either:  

(1) charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime that, if proven, would meet the definition of “theft”; or  

(2) the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of such a crime and either (i) the complaint alleged an admission by the promoter, or the execution of an affidavit by that person admitting the crime; or (ii) a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.  

In addition, a taxpayer that wants to claim a theft loss deduction must also normally show that the loss is not covered by a claim for reimbursement or other recovery as to which the taxpayer has a “reasonable prospect of recovery.” Under the revenue procedure, a Madoff victim or victim of other Ponzi arrangements will be permitted to claim a theft loss deduction in the year that the criminal indictment, information or complaint is filed, even if the victim does, in fact, have actual or potential claims for reimbursement or recovery. Only the amount of such deduction—i.e., whether 95% or 75% of the “qualified investment” (which would include the total “fictitious income” recognized by the taxpayer in respect of the arrangement for all taxable years)—would be affected depending on the nature of such claims.5  

In order to use the safe harbor, a taxpayer must satisfy the procedural requirements set forth in Section 6 of the revenue procedure. Also, by meeting such requirements, the taxpayer would be agreeing not to (a) deduct in the discovery year any amount of the theft loss in excess of the deduction permitted; (b) file returns or amended returns to exclude or recharacterize income reported with respect to the arrangement in previous tax years; (c) apply the alternative computation in Section 1341 with respect to the theft loss deduction; and (d) apply the doctrine of equitable recoupment or the mitigation provisions in Sections 1311 through 1314.  

Finally, the revenue procedure notes that a taxpayer may choose not to use the safe harbor provision. However, and as the revenue procedure cautions, in such event: (i) the taxpayer would be subject to all of the generally applicable provisions governing the deductibility of losses under Section 165; (ii) the taxpayer would have to establish, through sufficient documentation, the amount of the loss and that no claim for reimbursement of any portion of the loss exists; (iii) if the taxpayer files or amends federal income tax returns for prior years, then the taxpayer would also need to establish that the amounts sought to be excluded were, in fact, not income that was actually or constructively received by the taxpayer; and (iv) any returns claiming theft loss deductions from fraudulent investment arrangements would be subject to examination by the IRS. The IRS did note that so long as the taxpayer can establish the amount of net income reported and included in gross income consistent with information received from the arrangement, it will not challenge the taxpayer’s inclusion of such amount in determining the allowable theft loss (even for net income for taxable years for which the statute of limitations for filing a refund claim has expired).