In March of 2009, the IRS issued Rev. Rul. 2009-9 & Rev. Proc. 2009-20 to offer guidance to taxpayers who were defrauded in Ponzi schemes such as the Bernard Madoff scam. In this revenue ruling, the IRS clarified many of the complex issues involved in deducting the losses incurred in the Ponzi-type schemes, and established a taxpayer favorable safe harbor method of claiming the loss deductions. Even though we are several years past Madoff’s Ponzi, this guidance still applies to taxpayers who may have been a victim of similar fraud.
Generally, theft losses are deductible only if they exceed the AGI limits placed on them, but under Rev. Proc. 2009-20 taxpayers have two options for deducting losses from fraudulent investment schemes:
- 95% deduction for an investor that does not pursue any potential third party recovery; or
- 75% deduction for an investor that is pursuing or intends to pursue any potential third party recovery.
Theft losses related to Ponzi-type schemes
As part of the Revenue Ruling and Revenue Procedure the IRS answered six main questions about theft losses related to Ponzi-type schemes:
1. Is a loss from a criminal fraud a theft loss or a capital loss?
The IRS determined that in the case of a Ponzi scheme, in which the lead figure deprived investors of money by criminal acts, the investors’ losses are theft losses, not capital losses. Originally the IRS required the lead figure to be charged by indictment or that the lead figure be subject of a state or federal criminal complaint alleging the commission of a crime, which may be hard to get if the lead figure died prior to charges being filed.
The IRS later added Rev. Proc 2011-58 that if the death of the lead figure precludes a charge by indictment or criminal complaint, then as long as there have been civil complaints, information, or other documents that allege the facts of fraudulent activity that has been conducted by the lead figure the loss would still qualify for the favorable treatment.
2. Is such loss subject to personal loss limits or limits on itemized deductions?
The IRS concluded that a theft loss in a transaction entered into for profit is deductible as an ordinary loss and not subject to the personal loss limits, or the limits on itemized deductions.
3. In what year is the loss deductible?
The loss is deductible in the tax year which the investor discovers the loss or criminal act.
4. How is the amount of the loss determined?
The amount of the loss to be deducted is the amount of money that was lost, less any reimbursements or other compensation recovered. If there was any fraudulent income reported in previous tax years, amounts withdrawn, or additional contributions made to the scheme those amounts would be adjustments to the overall loss deduction. The result of this calculation is multiplied by either 95% or 75%, depending on taxpayers’ intentions of pursuing recovery.
5. What happens if I have future recoveries?
If in subsequent tax years, the investor recovers amounts previously written off, the investor may have additional income to report in the year of receipt. For example, if the investor chooses to write off 95% of their qualified investment and in subsequent tax years recovers amounts that were previously written off, the investor will need to take into income the recovery that was previously written off in the year it was recovered.
6. What is considered pursuing potential third-party recovery?
Potential third-party recovery means the amount of actual or potential claims for recovery of an investment as of the last day of the discovery year that are not direct recoveries from lead figure or recoveries from insurance. Although some investors may seek third party recovery and take a 75% deduction, we do not believe it would preclude them from taking an additional loss up to the 95% loss in the future. We would just caution those who do take the 95% and still pursue and do recover assets in future periods. The IRS may come back and restate the original loss deduction and charge penalties for understatement of taxes.
Claiming the loss
It appears that the IRS still has left the door open for investors to eventually claim an additional deduction to claim 100% of their loss; it just cannot be taken in the discovery year. The tax year when the investor believes that there is no opportunity for any additional recovery would be the appropriate time to claim the additional deduction.
For more information on how an investor can claim the loss under the safe harbor treatment outlined in Rev. Proc 2009-20, contact the Howard team today.