The IRS recently issued two rulings about the tax treatment of victims of Ponzi schemes and similar financial frauds. Rev. Rul. 2009-9 addresses the standard tax treatment for losses from fraud or embezzlement. Rev. Proc. 2009-20 provides a safe-harbor treatment that allows deductions in the year of discovery where the amount of potential recovery is uncertain.
Rev. Rul. 2009-9
Rev. Rul. 2009-9 explains that a theft loss is allowed for a transaction in the year of discovery as long as it is not compensated by insurance or otherwise. If the taxpayer sustains the loss in a transaction entered into for profit, the loss is deductible under Sec. 165(e). Other theft losses are deductible as capital losses under Secs. 1211 and 1212.
Because the taxpayer sustains the loss in a transaction entered into for profit, it is not subject to the limitations of personal losses under Sec. 165(h). The loss is reported as an itemized deduction not subject to the 2% adjusted gross income floor under Sec. 165(c)(2). If there is a claim for reimbursement where there is a reasonable prospect of recovery, the taxpayer cannot claim the loss until there is reasonable certainty of the reimbursement amount to be received.
The loss amount is generally the initial amount invested plus any other investments less withdrawals. In addition, the revenue ruling states that the loss also includes amounts reported as gross income on the taxpayer’s federal income tax return and reinvested. Note that this is contrary to Kaplan, No. 8:05-cv-1236-T-24 EAJ (M.D. Fla. 2007), where it was ruled that the reported income was not includible in the theft loss.
Specifically, the Kaplan case held that the phantom income reported as a result of the Ponzi scheme on earlier tax returns now closed by statute could not be claimed as a theft loss deduction because there was no evidence that the income ever existed, so the plaintiffs could not show that such income was unlawfully taken. The IRS Office of Chief Counsel had issued a memorandum at the time of that Ponzi scheme’s discovery, concluding that investors who reported and paid taxes on phantom income could claim a theft loss deduction for the phantom income. The court reasoned that there was no evidence that the memorandum’s conclusion was actually implemented by the IRS, and it denied the deduction. The court also denied the deduction for the taxes paid on the phantom income because that money was not unlawfully taken and therefore there was no theft.
Rev. Rul. 2009-9 goes on to explain the proper treatment of an NOL carryback for these losses. It also explains that a taxpayer may not use the mitigating provisions under Sec. 1341 or Secs. 1311–1314 to adjust tax liabilities.
Rev. Proc. 2009-20
Rev. Proc. 2009-20 provides a safeharbor treatment for victims of such frauds, which simplifies the determination of the loss. It applies to Ponzi-type fraud schemes where the lead figure is indicted under state or federal law.
The safe harbor provides that an investor may take a loss in the year of discovery in the amount of:
- 95% of the investment if the investor does not intend to pursue potential third-party recovery; or
- 75% if the investor is pursuing or intends to pursue potential third-party recovery less any amounts received or potential insurance/SIPC recovery.
If the investor subsequently has a recovery, he or she may have income. The revenue procedure instructs the taxpayer to mark “Revenue Procedure 2009-20” at the top of Form 4684, Casualties and Thefts, in the discovery year.
The IRS provides a statement in the appendix of Rev. Proc. 2009-20 to calculate the deductible theft loss. The taxpayer must sign the statement and attach it to a timely filed return. By executing the statement, the taxpayer agrees not to deduct any theft loss in excess of the permitted deduction or to file or amend returns to exclude or recharacterize income reported on the form. The taxpayer also may not apply the alternative computation under Sec. 1341 or the mitigation provisions in Secs. 1311–1314.
Any individual not using the safe-harbor provisions of Rev. Proc. 2009-20 must report the loss in accordance with Rev. Rul. 2009-9. The revenue procedure concludes by stating that “returns claiming theft losses from fraudulent investment arrangements are subject to examination by the Service.” (For more on the tax treatment of defrauded investors, see Zimmerman, “Deducting Losses for Defrauded Investors,” on p. 442.)
John Miller is a faculty instructor at Metropolitan Community College in Omaha, NE. Wendy Kravit is a sole proprietor in Annapolis, MD. Mr. Miller and Ms. Kravit are members of the AICPA Tax Division’s IRS Practice and Procedures Committee. For further information about this column, contact Mr. Miller at firstname.lastname@example.org.