Tax News

CCH (cch.taxgroup.com) reports:

  The IRS has issued guidance addressing the tax treatment of losses criminally fraudulent investment arrangements in the form of "Ponzi" schemes. The guidance provides that investors in such schemes will be entitled to claim a theft loss under Code Sec. 165, rather than a capital loss, because the perpetrators of such fraudulent schemes actually deprive investors of money by criminal acts. The loss is deductible under Code Sec. 165(c)(2) as a loss on a transaction entered into for profit, and it is not subject to the personal loss limitations under Code Sec. 165(h), or the limits on itemized deductions under Code Secs. 67 and 68.

Rev. Rul. 2009-9

  The theft loss is deductible in the year it is discovered, provided that it is not covered by a claim for reimbursement, or other recovery as to which the investor has a reasonable prospect of recovery. To the extent that an investor's deduction is reduced by such a claim, recoveries in later tax years are not includible in the investor's income. However, if the investor recovers a greater amount in a later year, or an amount that initially was not covered by a claim to which there was a reasonable prospect of recovery, the recovery is includible in the investor's gross income in the later tax year, to the extent that the initial deduction reduced the investor's tax liability.

  The amount of the theft loss deduction includes the amount invested in the scheme, less any amounts withdrawn, reimbursements, and claims as to which there is a reasonable prospect of recovery. The deductible amount also includes any fictitious income that was reported to the investor in years prior to the discovery of the theft that was included in the investor's gross income, and reinvested in the scheme.

  To the extent an investor's theft loss deduction creates or increases a net operating loss in the year the loss is deducted, the investor may carry back up to three years and forward up to 20 years the portion of the net operating loss attributable to the theft loss. If the loss is an applicable 2008 net operating loss, an eligible small business can elect either a three-, four-, or five-year net operating loss carryback under Code Sec. 172(b)(1)(H).

  The theft loss deduction does not qualify for the alternative computation of tax under Code Sec. 1341 for the restoration of an amount held under a claim of right because the deduction does not arise from the investor's obligation to restore income. Further, the theft loss does not qualify for the application of the mitigation provisions under Code Secs. 1311 through 1314 to adjust tax liability in years that are otherwise barred by the period of limitations from filing a claim for refund under Code Sec. 6511.

  The theft loss deduction for losses on an investment in a Ponzi scheme is not taken into account in determining whether a transaction is a loss transaction for which there would be a disclosure obligation under Reg. §1.6011-4.

Rev. Proc. 2009-20

  The IRS has provided a safe harbor for taxpayers to enable them to deduct losses from fraudulent investment schemes as theft losses. The new procedure also provides guidance for taxpayers choosing not to use the safe harbor, but who plan to deduct investment fraud losses under the theft loss provisions of Code Sec. 165. The procedure applies to investment fraud losses discovered in tax years after 2007.

  Background. Since Ponzi schemes produce no real gains, when a large number of investors try to withdraw funds at the same time (e.g., when the economy takes a downturn), the Ponzi scheme falls apart because there is not enough new money being paid in by new investors to cover the withdrawals of existing investors. Taxpayers may not be aware of a fraudulent investment loss during the year in which the loss occurred, and it may be difficult for taxpayers to prove how much income reported from the fraudulent arrangement in prior years was in fact fictitious. The safe harbor is intended to help cheated investors gain some relief by providing a relatively straightforward method to calculate and deduct losses from investment fraud.

  Requirements. Taxpayers can rely on the safe harbor to deduct losses from fraudulent investment schemes as theft losses only if certain requirements and circumstances are satisfied:

  Specified fraudulent arrangement. The loss must be from a "specified fraudulent arrangement," which generally is a Ponzi scheme that takes cash or other assets from investors, purports to earn income for investors, reports fictitious income, makes any payments from funds contributed by other investors and not from bona fide earnings, and appropriates investors' cash or other assets.

  Qualified loss. The loss must be a "qualified loss" resulting from a specified fraudulent arrangement of which the "lead figure" in charge of the scheme was charged under state or federal law with committing fraud, embezzlement, or other similar crime, that, if proven, would meet the definition of theft under Code Sec. 165; or the lead figure was the subject of a state or federal criminal complaint for fraud, embezzlement, or other similar crime, and either he admitted guilt, or the assets held by the fraudulent arrangement were frozen or placed under the authority of a receiver or trustee.

  Qualified investor. The taxpayer must be a "qualified investor," in that he or she must be generally qualified to deduct theft losses under Code Sec. 165 and Reg. §1.165-8, did not have actual knowledge that the arrangement was fraudulent before it was publicly disclosed, and invested cash or other assets in the arrangement.

  Investment through intermediary. A taxpayer is not considered to be a qualified investor if he or she did not invest directly in the specified fraudulent arrangement but, instead, invested through an intermediary investment fund or advisor. Thus, investors who unknowingly invest in a Ponzi scheme, such as the Madoff investment fund, through an intermediary fund or investment advisor are not covered by the safe harbor. However, the intermediary investment fund may itself qualify to claim the loss deduction under the safe harbor.

  Amount of deduction. Up to 95% of qualified losses from a specified fraudulent arrangement, calculated through detailed definitions and formulas, may be deducted by a qualified investor as a theft loss. However, the amount of deductible losses cannot take into account any funds that were borrowed from the fraudulent arrangement or any of its principals or agents and invested in the arrangement, investment fees paid and deducted, amounts the fraudulent arrangement reported as income but that the qualified investor did not include in his gross income, funds that were not invested directly but, rather, were invested through an intermediary investment fund or advisor, any amount paid to the taxpayer for reimbursement or recovery, and other amounts paid or payable through insurance, the Securities Investor Protection Corporation (SIPC), and other similar potential claims or recovery payments.

  Statement required. To take advantage of the safe harbor, the taxpayer must complete the statement provided as "Appendix A" to Rev. Proc. 2009-20 and file it with the tax return, amended return or claim for refund. The statement requires the taxpayer to provide specified information and computations. The taxpayer must also comply with all conditions set forth in the statement and in Rev. Proc. 2009-20, including that:

  (1) The taxpayer will not deduct any amount of the theft loss in excess of the amount permitted by Rev. Proc. 2009-20.

  (2) The taxpayer will not file returns or amended returns to exclude or recharacterize income from the fraudulent arrangement for previous tax years.

  (3) The taxpayer will not later apply the alternative computation under Code Sec. 1341 regarding the theft loss deduction.

  (4) The taxpayer will not apply the doctrine of equitable recoupment or mitigation provisions to income from the fraudulent arrangement reported in prior tax years, which would otherwise be subject to the time limits for filing refund claims under Code Sec. 6511.

  Other tax treatment. Taxpayers electing not to use the safe harbor must satisfy the requirements of Code Sec. 165 in order to deduct investment fraud losses as theft losses. If the taxpayer can establish the amount of income reported and included in gross income for tax years for which the statute of limitations on refunds has expired, the IRS will not challenge the inclusion of that amount in basis for purposes of calculating the theft loss.

Shulman Comments

  "The Madoff case is tragic," IRS Commissioner Douglas Shulman told reporters in a telephone press conference. "The victims are devastated." The case also "raises a staggering array of issues for the victims," Shulman noted. "We've worked hard to provide a straightforward approach" to these issues. The new guidance "assist[s] taxpayers who are victims of losses from Ponzi-type investment schemes; the guidance is not specific to the Madoff case," he indicated. The guidance allows taxpayers to deduct the principal amount of their investment and the earnings they have reported but left in the scheme (thus addressing phantom income), Shulman explained.

  "The revenue ruling 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)," Shulman said in his testimony to Congress. "The revenue procedure simplifies compliance for taxpayers (and administration for the IRS) by providing a [uniform approach for] determining the year in which the loss is deemed to occur and a simplified means of computing the amount of the loss," Shulman testified. It also avoids difficult problems of proving how much income reported from the scheme was fictitious, and how much was real, he stated.

  Lawrence Hill, a partner with Dewey LeBoeuf in New York, told CCH that "the commissioner's guidance reduces a tremendous amount of the uncertainty and confusion surrounding the reporting of theft losses on taxpayers' 2008 returns. It will significantly reduce the cost of tax compliance for taxpayers and, in the long run, save enormous resources for the IRS."

  Hill pointed out that "Perhaps most significantly,
Rev. Rul. 2009-9 indicates, as Issue 5, that an individual is a "sole proprietorship," so that the individual, as long as he or she does not have gross revenues in 2008 of $15,000,000 or more, may elect the five-year carryback that was provided in the Stimulus Act for "small businesses", rather than only the three-year carryback that individuals would normally have. This could significantly mitigate the losses of many of the investors."

  IRS officials elaborated on the guidance in comments to reporters:

  - Investors suing Madoff are in the 95 percent category for claiming losses; investors suing third parties are in the 75 percent category.

  - Taxpayers who recognized phantom income as capital gains would still be entitled to a deduction, regardless of the manner in which the initial income was reported.

  - Taxpayers using the safe harbor in Rev. Proc. 2009-20 cannot go back to prior-year returns to remove phantom income. The entire loss must be claimed in the year of discovery.

  - If a taxpayer has filed an amended return and was to use the safe harbor, he or she must refile for the year of the loss and file Appendix A to identify the amended returns.

  - Investors that participated in a Ponzi scheme through a "feeder fund" cannot use the safe harbor directly. The fund can use the safe harbor to determine its total losses. If the fund is a partnership, it will report a share of the losses to each investor on Schedule K-1.

  - Investors who do not use the safe harbor may claim a loss under the "standard rules," applied on a case-by-case basis. These rules are less clear than the safe harbor.

  The officials would not comment when the year of discovery occurred (for claiming the loss) for Madoff investors or for any other scheme. They said it depends on the particular facts and that they had not examined these issues.

 
Rev. Rul. 71-381, 1971-2 CB 126, is obsoleted in part.

  By Brant Goldwyn, Adam Levine and Zisl Edelson, CCH News Staff

Rev. Rul. 2009-9, 2009FED ¶46,295

Rev. Proc. 2009-20, 2009FED ¶46,296

Other References:

 
Code Sec. 165

  CCH Reference - 2009FED ¶10,101.123

  CCH Reference - 2009FED ¶10,101.235

  CCH Reference - 2009FED ¶10,101.24

  CCH Reference - 2009FED ¶10,101.318

  CCH Reference - 2009FED ¶10,101.47

 
Code Sec. 172

  CCH Reference - 2009FED ¶12,014.023

  CCH Reference - 2009FED ¶12,014.4025

 
Code Sec. 1311

  CCH Reference - 2009FED ¶31,806.40

 
Code Sec. 1341

  CCH Reference - 2009FED ¶31,882.021

  CCH Reference - 2009FED ¶31,882.265

 
Code Sec. 6011

  CCH Reference - 2009FED ¶35,141.06

  CCH Reference - 2009FED ¶35,141.78

  Tax Research Consultant

  CCH Reference - TRC INDIV: 54,100

  CCH Reference - TRC INDIV: 54,106

  CCH Reference - TRC NOL: 12,103

  CCH Reference - TRC FILEBUS: 9,450

  CCH Reference - TRC ACCTNG: 27,454

  CCH Reference - TRC IRS: 30,302