The IRS issued two guidance items to assist taxpayers victimized by losses in Ponzi investment schemes. While the guidance will cover investors in the Bernard Madoff investment firm, the IRS guidance is not specific to the Madoff fraud. The first item is a revenue ruling clarifying federal tax law governing the treatment of losses in such schemes. The second is a revenue procedure providing a safe harbor method for computing and reporting the losses.
According to IRS Commissioner Douglas Shulman, the Revenue Ruling 2009-9 is important because determining the amount and timing of losses from these schemes is factually difficult and dependent on the prospect of recovering the lost money, which may not become known for several years. In addition, it clarifies the reach of older guidance on these losses that is somewhat obsolete. The revenue procedure simplifies compliance for taxpayers by providing a safe harbor means of determining the year in which the loss is deemed to occur and a simplified means of computing the amount of the loss.
The revenue ruling states that investors are entitled to a theft loss, which is not a capital loss. In other words, a theft loss from a Ponzi scheme is not
subject to the normal limits on losses from investments, which typically are limited to $3,000 per year when it exceeds capital gains from investments.
The revenue ruling clarifies that investment theft losses are not subject to limitations applicable to personal casualty and theft losses. The loss is deductible as an itemized deduction, but is not subject to the 10 percent of AGI reduction or the $100 reduction that applies to many casualty and theft loss deductions.
In addition, the theft loss is deductible in the year the fraud is discovered,
except to the extent there is a claim with a reasonable prospect of recovery. Determining the year of discovery and applying the reasonable prospect of recovery test to any particular theft is highly fact-intensive and can be the source of controversy. The revenue procedure accompanying the ruling provides a safe-harbor approach that the IRS will accept for reporting Ponzi scheme theft losses.
The ruling also provides that the amount of the theft loss includes the investor's unrecovered investment, including income as reported in past years. The ruling
concludes that the investor generally can claim a theft loss deduction not only for the net amount invested, but also for the so-called fictitious income that the promoter of the scheme credited to the investor’s account and on which the investors reported as income on their tax returns for years prior to discovery of the theft.
Some taxpayers argued that they should be permitted to amend tax returns for years prior to the discovery of the theft to exclude the phantom income and receive a refund of tax in those years. The revenue ruling does not address this argument, and the safe harbor procedure is conditioned on taxpayers not amending prior year returns.
Finally, the ruling provides that a theft loss deduction creating a net operating loss for the taxpayer can be carried back and forward according to the time frames prescribed by law to generate a refund of taxes paid in other taxable years.
Revenue Procedure 2009-20
In light of the number of investment arrangements recently discovered to be
fraudulent and the number of taxpayers affected, the revenue procedure is
intended to: (1) provide a uniform approach for determining the proper time
and amount of the theft loss; (2) avoid difficult problems of proof in determining
how much income reported from the scheme was fictitious, and how much
was real; and (3) alleviate compliance burdens on taxpayers and administrative burdens on the IRS.
To do this, the revenue procedure provides two simplifying assumptions of theft loss and prospect of recovery that taxpayers may use to report their losses. First, although the law does not require a criminal conviction of the promoter to establish a theft loss, it often is difficult to determine how extensive the evidence of theft must be to justify a claimed theft loss. The revenue procedure provides that the IRS will deem the loss to be the result of theft if: (1) the promoter was charged with fraud or embezzlement and there is some evidence of an admission of guilt by the promoter or a trustee has been appointed to freeze the assets of the scheme.
Once theft is discovered, it is difficult to establish the investor’s prospect of recovery. Prospect of recovery is important because it limits the amount of the investor’s theft loss deduction. Prospect of recovery particularly difficult to determine where litigation against the promoter extends into future taxable years.
The revenue procedure permits taxpayers to deduct in the year of discovery 95 percent of their net investment less the amount of any actual recovery in the year of discovery and the amount of any recovery expected from private or other insurance, such as that provided by the Securities Investor Protection Corporation. A special rule applies to investors who are suing persons other than the promoter. These investors compute their deduction by substituting in the formula 75 percent for 95 percent.