Expenses & Deductions
Whether investment losses from fraud should be treated as capital losses or theft losses when the stock is purchased through a stockbroker is currently undecided for tax purposes. Many recent court decisions have denied such theft losses citing, in part, a need for direct privity between the victim (taxpayer) and perpetrator of the fraud when a stockbroker is used. However, both Rev. Rul. 2009-9 and Rev. Proc. 2009-20 describe the IRS’s position on theft losses from fraud; and that position may be softening.
Depending on the circumstances, losses on investments due to fraud may be treated as a casualty loss, as a capital loss, or as a return of capital. Normally, worthlessness of investments or the loss on their disposal would be a capital loss. Taxpayers would generally not favor having phantom income from a Ponzi scheme classified as a return of capital because the statute of limitation on refunds may have expired for the early years of the scheme and because the courts are divided on this issue. Where a fraud exists, however, the loss may qualify for theft-loss treatment.
To deduct a theft loss, the taxpayer must have something that can actually be taken (like money) rather than the mere (and perhaps false) promise that an asset exists. A reduction in the resale value of property and other indirect effects of thefts would not normally produce a deductible casualty loss. The taxpayer must reduce the amount of a theft loss that the taxpayer actually deducts on the tax return by insurance and other expected reimbursements, if any. Net theft losses are estimated and reconciled to subsequent recoveries. If the taxpayer overestimated expected reimbursements in figuring the casualty loss, the resultant casualty loss understatement should be included as a loss with other losses in the year when the taxpayer can reasonably expect no further reimbursement.
Where a (subsequent) recovery was underestimated, the taxpayer includes the excess recovery over the original estimate in income in the year of recovery to the extent that the original casualty loss deduction reduced the taxpayer’s tax in the earlier year. Theft losses on securities are not subject to the $100 floor and 10% of adjusted gross income limitations in Sec. 165(h) because the taxpayer enters into the investment for a profit.
For individuals, capital losses are offset against capital gains in the year a security is sold or becomes totally worthless (Sec. 165(g)). If a net capital loss results, up to $3,000 of net capital losses can offset ordinary income (Sec. 1211), and the rest are carried forward to future years. Large capital losses can take several years to recoup, but theft losses are deductible immediately, perhaps creating a net operating loss.
In some cases, a loss is split between capital and theft loss, as was the situation in Chief Counsel Advice 200811016. There, a company began operating legitimately but later engaged in fraud. Taxpayers who invested before the fraud occured received capital loss treatment, whereas those investing afterward had a theft loss. Those investing over both periods allocated losses across both categories.
Ponzi-scheme victims, however, have additional tools: They can avail themselves of Rev. Rul. 2009-9 and Rev. Proc. 2009-20. In Rev. Rul. 2009-9 the IRS ruled that taxpayer-investors that are victims of fraud or embezzlement schemes may take a theft loss. Rev. Proc. 2009-20 outlines safe-harbor rules for qualified investors with (specifically) Ponzi-scheme losses beginning for tax year 2008.
Under the safe harbor, a taxpayer who transferred cash or property to a “lead figure” who promoted a “specified fraudulent arrangement” may use special rules to deduct the losses in the year the fraud is discovered without waiting for recovery. A specified fraudulent arrangement is one in which a lead figure receives cash or property from investors; purports to earn income for the investors; reports income amounts to the investors that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investors’ cash or property. Conviction is unnecessary, if the lead figure is indicted for fraud or other theft, if the lead figure is the subject of an ongoing state or federal criminal complaint alleging an admission by the lead figure, or if the assets of the arrangement have been frozen or a receiver/trustee was appointed to manage the assets of the fraudulent arrangement.
If the lead figure’s death precludes the use of the safe harbor (because a charge by indictment, information, or criminal complaint can no longer be brought against the lead figure), the taxpayer may still have a deductible loss (Rev. Proc. 2011-58). In this situation, if a civil complaint or similar document alleges the presence of substantially all of the elements of a specified fraudulent arrangement and a receiver or trustee has been appointed with respect to the arrangement, or its assets have been frozen, then the loss may still qualify under the safe harbor.
The investor must have been both previously unaware of the fraud and allowed a theft loss under Sec. 165 or Regs. Sec. 1.165-8; and the fraudulent arrangement must not be a tax shelter. The safe-harbor rules do not apply to investment “income” not declared on the taxpayer’s tax return, fees paid on the accounts and deducted on the taxpayer’s tax return, amounts the investors borrowed from the alleged fraudsters, or investments in a fund or entity that in turn invested in the arrangement.
To calculate the amount of the theft loss, previous dividend and capital gain income declared and reinvested (rather than received by the taxpayer) increases the amount of the basis and therefore the amount of the theft loss in the current year, rather than requiring a reversal of phantom, unreceived income on previous years’ tax returns. This approach is favorable to the taxpayer because, if the period of the fraud is lengthy, fraud may have occurred in years where the statute of limitation bars recovery of the taxes on the phantom income.
The loss should be shown net of any expected recovery from insurance companies or the Securities Investor Protection Corporation, as reconciled in future tax years under the tax benefit rule. Section 5.02(1) of Rev. Proc. 2009-20 provides for a two-pronged safe-harbor deduction: (1) 95% of the net loss may be deducted, where the qualified investor does not pursue any potential third-party recovery; or (2) 75% of the net loss may be deducted, where a qualified investor is pursuing or intends to pursue any potential third-party recovery. The issue is unclear, but this revenue procedure seems to indicate that a taxpayer who invested using a broker (where the taxpayer may have a cause of recovery against the broker) may still deduct the theft loss.
However, according to most court cases, the element of intent to deceive a fraud victim has traditionally required direct privity between the victim and the perpetrator of the fraud itself. Using a broker, as most taxpayers do, breaks the chain of direct privity and may result in disallowance of a theft-loss deduction (but create a less favorable capital loss deduction, even though the broker’s role may be perfunctory and somewhere between 60% and 80% of publicly traded securities are currently held by intermediaries participating in the Depository Trust Company). (See, e.g., Paine, 63 T.C. 736 (1975), and Rev. Rul. 77-17.) The exception to this rule would be where the intermediary, knowingly or not, works as a conduit to the fraudster. (See Jensen, T.C. Memo 1993-393, aff’d, 72 F.3d 135 (9th Cir. 1995) (theft loss allowed where the intermediary was a conduit).) Notice 2004-27 confirms that use of a broker may cause the IRS to disallow a fraud loss:
In cases involving stock purchased on the open market, the courts have consistently disallowed theft loss deductions relating to a decline in the value of the stock that was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations. . . . Accordingly, the Service will disallow a deduction for theft loss . . . relating to a decline in the value of stock that was acquired on the open market for investment. If the stock is sold or exchanged or becomes wholly worthless, any resulting loss is a capital loss.
IRS Information Letter 2009-0154 clarifies the position:
Qualified investors under [Rev. Proc. 2009-20] include only investors that transferred cash or property to the perpetrators of the fraudulent scheme. These direct investors include individuals, partnerships, limited liability corporations, and other “persons” as defined in section 7701(a)(30) of the Internal Revenue Code. . . . The primary reason for the restriction to direct investors in Rev. Proc. 2009-20 is because they are the party from which the perpetrator of the fraudulent arrangement stole money or property, and thus the proper party to compute and claim a theft loss deduction under section 165 of the Code. . . . However, this restriction does not prevent indirect investors from benefitting from the safe harbor treatment or from deducting their share of a theft loss sustained by a passthrough entity.
By taking the position that privity is required between the fund and the fraudster, the IRS essentially is allowing the safe harbor and theft loss to indirect investors only when there is no broker in the transaction. If an individual were to invest in a Ponzi scheme through a stockbroker or other intermediary and not be in privity with the perpetrator of the scheme, that individual would not get the same protection as other victims of the same scheme, even though he or she would be just as much a victim. For an in-depth discussion of the historical case law on this topic, please see Elzweig and Chambers, “Securities Fraud and the Tax Loss Deduction: The Rise and (Perhaps) Fall of the Stockbroker Exclusion,” 16 Journal of Legal Studies in Business 20 (2010).
Valrie Chambers is a professor of accounting and Brian Elzweig is an assistant professor of business law at Texas A&M University–Corpus Christi in Corpus Christi, TX. Prof. Chambers is a member of the AICPA Tax Division’s IRS Practice and Procedures Committee. For more information about this column, contact Prof. Chambers at firstname.lastname@example.org.