The Ponzi loss safe harbor recently set forth in Revenue Procedure 2009-20 and Revenue Ruling 2009-9 brought welcome clarity to permissible treatment of such losses as well as the possibility of expedited theft loss deductions, practitioners said.
“It’s about as taxpayer-friendly as one could have hoped for,” said Rick Klahsen, managing director of the National Tax Department at RSM McGladrey.
The revenue procedure allows qualified investors to elect to take a deduction in the tax year of discovery of a qualified theft loss of 75% of the amount of loss if the investor is pursuing a third-party recovery, or 95% of the amount if the investor is not. Such third parties include the Securities Investment Protection Corp., which can pay claims of up to $500,000 per investor in a failed brokerage firm. In either case, the allowed deduction is minus any actual recovery received. Future recoveries will result in additional deductions or in gross income under the tax benefit rule.
Without the safe harbor, taxpayers generally must show they have no remaining claim for reimbursement on any portion of a loss for which they have any reasonable prospect of recovery before they may deduct it as a theft loss.
“Allowing things to go through the legal process until you have that reasonableness of determining how much you’re going to be able to recover can take years,” Klahsen said. “And to try and figure out when you have enough of a sense of what the recovery might or might not be to make that claim—obviously it doesn’t help investors in a lot of circumstances.”
Qualified investors are those whose loss otherwise qualifies for the theft loss deduction under section 165 and related regulations. These include that the loss must meet the definition of theft or fraud under the law of the jurisdiction in which it occurred. Beyond that, the “lead figure” in a “specified fraudulent arrangement” (Ponzi scheme) must have been charged with the theft or fraud under state or federal law in an indictment or information.
Alternatively, a qualified loss is one in which either (a) the lead figure has admitted the fraud, as alleged or attested by affidavit in a state or federal criminal complaint, or (b) a receiver or trustee has been appointed with respect to the scheme, or its assets have been frozen. Qualified investors also must not have had actual knowledge of the fraudulent nature of the scheme before it became known to the public. Furthermore, the scheme must not have involved a tax shelter under section 6662(d). Only primary investors in the Ponzi scheme, including funds or similar vehicles, may take advantage of the safe harbor.
The revenue ruling laid to rest some theories of tax treatment of Ponzi losses but approved others that had been suggested by practitioners after Bernard Madoff’s arrest and admission that his once celebrated investment firm was in reality a $50 billion Ponzi scheme. For instance, the ruling said a deduction under section 1341 for restoration of an amount held under a claim of right would not apply to a theft loss because the theft does not give rise to an obligation by a bilked investor to restore previously reported taxable income to another party.
On the other hand, even an individual taxpayer’s 2008 theft loss can be eligible for the five-year carryback provision for 2008 for operating losses of small businesses (defined as having up to $15 million in gross annual receipts) under the American Recovery and Reinvestment Act of 2009 rather than the usual three years under section 172(b)(1)(F). The reason is that section 172(d)(4)(C) treats a deduction for casualty or theft losses allowable under section 165(c)(2) or (3) as a business deduction, including for a noncorporate taxpayer. Thus an individual taxpayer who meets the gross receipts test for an applicable 2008 net operating loss that is also a theft loss from a specified fraudulent arrangement may carry the loss back up to five years. See Issue 5 of Revenue Procedure 2009-20.
The guidance came five days after Madoff’s guilty plea in the U.S. District Court for the Southern District of New York in Manhattan and after months of requests to the Service on behalf of his victims for such relief, although the guidance did not refer to Madoff specifically.
Revenue Procedure 2009-20, Revenue Ruling 2009-9
By Tax Matters Editor Paul Bonner.