Because the Ponzi scheme perpetrated by Bernard Madoff involved potentially thousands of taxpayers, the IRS has issued guidance on the tax aspects of losses from a Ponzi scheme and created a safe harbor under which investors can claim theft loss deductions.
IRC § 165(a) allows taxpayers to deduct losses sustained during the tax year and not compensated by insurance or otherwise. Under section 165(e), a theft loss is sustained in the tax year the taxpayer discovers the loss.
Because of the large number of theft loss deductions that it anticipates taxpayers will take for 2008, the IRS wants to minimize its administrative burden and the burden on investors claiming those losses. Therefore, Rev. Proc. 2009-20 provides an optional 95%/75% safe harbor under which qualified investors (as defined in the revenue procedure) may treat a loss as a theft loss deduction when certain conditions are met. The revenue procedure provides investors with a uniform manner for determining theft losses and seeks to avoid potentially difficult problems in proving how much income reported in prior years was fictitious or a return of capital.
If a qualified investor follows the procedures described in the revenue procedure, the Service will not challenge:
(1) The treatment of a qualified loss as a theft loss;
(2) The tax year in which the theft was discovered; and
(3) The amount of the deduction.
To take advantage of the safe harbor, the investor must multiply the amount of the qualified investment (as defined in the revenue procedure) by 95% for a qualified investor that does not pursue any potential third-party recovery, or by 75% for a qualified investor that is pursuing or intends to pursue any potential third-party recovery. The investor then subtracts from this product the sum of any actual recovery and any potential insurance or SIPC recovery.
If some amount of the loss is eventually recovered, the investor may have income or an additional deduction in a subsequent year, depending on the actual amount of the loss recovered.
A taxpayer that chooses not to apply the revenue procedure’s safe harbor treatment will be subject to all of the generally applicable section 165 provisions governing the deductibility of losses, such as establishing that the loss was from theft and that the theft was discovered in the year the taxpayer claims the deduction. The taxpayer must also establish the amount of the claimed loss and that no claim for reimbursement of any portion of the loss exists with respect to which there is a reasonable prospect of recovery in the tax year in which the taxpayer claims the loss.
Guidance on Ponzi Scheme Theft Loss Deductions
In Rev. Rul. 2009-9, issued simultaneously with Rev. Proc. 2009-20, the IRS answers seven questions about theft loss deductions in Ponzi schemes:
(1) Is a loss from criminal fraud or embezzlement in a transaction entered into for
profit a theft loss or a capital loss under IRC § 165? The IRS says that in the case of a Ponzi scheme in which the scheme’s promoter deprived the investors of money by criminal acts, the investors’ losses are theft losses, not capital losses.
(2) Is such a loss subject to either the section 165(h) personal loss limits or the limits on itemized deductions in sections 67 and 68? According to the IRS, theft losses are not subject to the itemized deduction limitations or to the personal loss limits of section 165(h).
(3) In what year is such a loss deductible? The Code treats a theft loss as sustained during the tax year in which the taxpayer discovers the loss (IRC § 165(e)). However, if, in the year of discovery, the taxpayer has made a claim for reimbursement and there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until the tax year in which it can be ascertained with reasonable certainty whether or not the reimbursement will be received (Treas. Reg. §§ 1.165-8(a)(2) and 1.165-1(d)). Whether a reasonable prospect of recovery exists is determined by examining all the facts and circumstances.
(4) How is the amount of such a loss determined? The amount of an investment theft loss is the basis of the property (or the amount of money) that was lost, less any reimbursement or other compensation. According to the revenue ruling, the amount of a theft loss resulting from a fraudulent investment arrangement is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims as to which there is a reasonable prospect of recovery. The amount includes “phantom” income reported by the Ponzi scheme to the investor: If an amount is reported to the investor as income in years prior to the year of discovery of the theft, and the investor includes the amount in gross income and then reinvests the amount of the arrangement, this amount increases the deductible theft loss.
(5) Can such a loss create or increase a net operating loss under section 172? Section 172(d)(4)(C) treats any deduction for casualty or theft losses allowable under section 165(c)(2) or (3) as a business deduction. Therefore, casualty or theft losses an individual sustains after Dec. 31, 2007, are considered losses from a “sole proprietorship,” and the individual may elect either a three, four or five-year net operating loss carryback for an applicable 2008 operating loss, provided the $15 million gross receipts test is satisfied. (Small businesses are allowed a longer, five-year net operating loss carryback under the American Recovery and Reinvestment Act of 2009, PL 111-5, for losses sustained in 2008 (IRC § 172(b)(1)(H)).
(6) Does such a loss qualify for the computation of tax provided by section 1341 for the restoration of an amount held under a claim of right? Section 1341 provides an alternative tax computation formula intended to mitigate against unfavorable tax consequences that may arise as a result of including an item in gross income in a tax year and taking a deduction for the item in a subsequent year when it is established that the taxpayer did not have a right to the item. However, to satisfy the claim of right requirements, the deduction must arise because the taxpayer is under an obligation to restore the income. Because a defrauded investor is not obliged to restore income, the revenue ruling states that the investor is not entitled to the tax benefits of section 1341 with regard to his or her theft loss deduction.
(7) Does such a loss qualify for the application of sections 1311–1314 to adjust tax liability in years that are otherwise barred by the section 6511 limitations period on filing a claim for refund? The mitigation provisions of sections 1311–1314 permit the IRS or a taxpayer in certain circumstances to correct an error made in a closed year by adjusting the tax liability in years that are otherwise barred by the statute of limitations. According to the IRS, a theft loss in a transaction entered into for profit does not qualify for the application of sections 1311–1314 because there is no inconsistency between the IRS’s position that a taxpayer properly included the phantom income reported by the Ponzi scheme in taxable income and the IRS’s position that the taxpayer is entitled to a theft loss deduction for the amount the taxpayer included in income due to the fraud.