The IRS has released guidance on how investors who have fraud losses from a Ponzi scheme should treat their losses for tax purposes and has provided a safe harbor for taxpayers to use in determining the amount and the timing of their losses from a Ponzi scheme.
Background
Thousands of taxpayers have suffered losses from their investments in the Ponzi schemes of New York financier Bernard Madoff and Texas financier Robert Stanford. While Ponzi schemes are not new, the number of investors in these two schemes and the amount of money involved in them has brought the treatment of fraud losses from Ponzi schemes into the public eye and highlighted the lack of clear guidance on their treatment. Seeking to rectify the situation, the IRS has issued guidance on the proper treatment of these losses in question and answer format in Rev. Rul. 2009-9. In addition, in order to simplify a taxpayer’s determination of the amount of losses from a Ponzi scheme and the year in which they should be deducted, the IRS has provided a safe-harbor method for making these determinations in Rev. Proc. 2009-20.
Specified Fraudulent Arrangements
While the IRS is clearly reacting to the Madoff and Stanford schemes, the new guidance has general application to what the IRS calls specified fraudulent arrangements. The IRS defines a specified fraudulent arrangement in Rev. Proc. 2009-20 as an arrangement
in which a party (the 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.
This definition would apply to most typical Ponzi schemes, including the Madoff and Stanford schemes. The revenue procedure also specifically states that the scenario presented in Rev. Rul. 2009-9 is an example of a specified fraudulent arrangement.
Rev. Rul. 2009-9
In Rev. Rul. 2009-9, the IRS presents a Ponzi scheme scenario that qualifies as a specified fraudulent arrangement under Rev. Proc. 2009-20 and then lists seven questions and answers about the proper federal tax treatment of fraud losses from such a scenario.
- Is a loss from criminal fraud or embezzlement in a transaction entered into for profit a theft loss or a capital loss under Sec. 165? The IRS states that in the case of a Ponzi scheme in which the scheme’s promoter deprived the investors of money by criminal acts, the investors’ losses are theft losses under Sec. 165(a), not capital losses.
- Is such a loss subject to either the Sec. 165(h) personal loss limits or the limits on itemized deductions in Secs. 67 and 68? According to the IRS, theft losses are not subject to the personal loss limits of Sec. 165(h) or to the itemized deduction limitations.
- In what year is such a loss deductible? Under Sec. 165(e), a theft loss is treated as sustained during the tax year in which the taxpayer discovers the loss. However, if, in the year of discovery, the taxpayer has made a claim for reimbursement and there is a reasonable prospect of recovery, no portion of the loss for which the taxpayer may receive reimbursement is sustained until the tax year in which it can be ascertained with reasonable certainty whether or not the reimbursement will be received (Regs. Secs. 1.165-8(a)(2) and 1.165-1(d)). Whether a reasonable prospect of recovery exists is determined by examining all the facts and circumstances.
- How is the amount of such a loss determined? The amount of an investment theft loss is the basis of the property (or the amount of money) that was lost, less any reimbursement or other compensation. According to the revenue ruling, the amount of a theft loss resulting from a fraudulent investment arrangement is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims for which there is a reasonable prospect of recovery. If an amount is reported to the investor as income in years prior to the year of discovery of the theft, and the investor includes the amount in gross income and then reinvests the amount in the arrangement (so-called phantom income), this amount increases the deductible theft loss.
- Can such a loss create or increase a net operating loss under Sec. 172? Sec. 172(d)(4)(C) treats any deduction for casualty or theft losses allowable under Sec. 165(c)(2) or (3) as a business deduction that may create or increase a net operating loss. Therefore, casualty or theft losses that an individual sustains after December 31, 2007, are considered losses from a “sole proprietorship,” and the individual may elect either a three-, four-, or five-year net operating loss carryback for a loss that is an applicable 2008 operating loss, provided the $15 million gross receipts test is satisfied. (Small businesses are allowed a longer, five-year net operating loss carryback under the American Recovery and Reinvestment Act of 2009, P.L. 111-5, for losses sustained in 2008 (Sec. 172(b)(1)(H)).
- Does such a loss qualify for the computation of tax provided by Sec. 1341 for the restoration of an amount held under a claim of right? Sec. 1341 allows a taxpayer to use an alternative tax computation formula intended to provide relief from the unfavorable tax consequences that may arise as a result of including an item in gross income in a tax year and taking a deduction for the item in a subsequent year when it is established that the taxpayer did not have a right to the item. However, to satisfy the claim of right requirements, the deduction must arise because the taxpayer is under an obligation to restore the income. Because a defrauded investor is not obliged to restore income, the revenue ruling states that the investor is not entitled to the tax benefits of Sec. 1341 for his or her theft loss deduction.
- Does such a loss qualify for the application of Secs. 1311–1314 to adjust tax liability in years that are otherwise barred by the Sec. 6511 limitation period on filing a claim for refund? The mitigation provisions of Secs. 1311–1314 permit the IRS or a taxpayer in certain circumstances to correct an error made in a closed year by adjusting the tax liability in years that are otherwise barred by the statute of limitation. However, a taxpayer can use the provisions only where the erroneous tax treatment in the closed year is inconsistent with the treatment required by the IRS’s determination in the current year. According to the IRS, a theft loss in a transaction entered into for profit does not qualify for the application of Secs. 1311–1314 because there is no inconsistency between the IRS’s position that a taxpayer properly included the phantom income reported by the Ponzi scheme in taxable income and its position that the taxpayer is entitled to a theft loss deduction for the amount the taxpayer included in income due to the fraud.
Rev. Proc. 2009-20
The IRS recognizes that the amount of fraud losses from Ponzi schemes and the year in which they occur are highly factual determinations that are difficult to make in the year of the discovery of the losses. Therefore, the IRS has provided a safe harbor that gives taxpayers a uniform method for making these determinations for fraud losses from specified fraudulent arrangements (see the definition above). These arrangements include typical Ponzi schemes like the Madoff and Stanford schemes. Rev. Proc. 2009-20 contains an optional 95%/75% safe harbor under which qualified investors (as defined in the revenue procedure) may treat a loss as a theft loss deduction if the conditions of the safe harbor are met.
If a qualified investor with a qualified loss follows the procedures described in the revenue procedure, the Service will not challenge:
- The treatment of a qualified loss as a theft loss;
- The tax year in which the theft was discovered; and
- The amount of the deduction.
Under the safe-harbor method, to determine his or her deductible loss, the investor must multiply the amount of the qualified investment (as defined in the revenue procedure) by 95% for a qualified investor that does not pursue any potential third-party recovery or by 75% for a qualified investor that is pursuing or intends to pursue any potential third-party recovery. The investor then subtracts from this product the sum of any actual recovery and any potential insurance or Securities Investor Protection Corporation recovery. If the investor eventually recovers some amount of the loss, the investor may have income or an additional deduction in a subsequent year, depending on the actual amount of the loss recovered.
In addition to calculating the amount of the theft loss as described above, the safeharbor rules require the taxpayer to follow specific instructions for filling out Form 4684, Casualties and Thefts. The taxpayer must also execute the statement provided in Appendix A of the revenue procedure and attach the statement to his or her return for the year he or she discovers the loss.
A taxpayer that chooses not to apply the Rev. Proc. 2009-20 safe-harbor treatment will be subject to all the generally applicable Sec. 165 provisions governing the deductibility of losses, such as establishing that the loss was from theft and that the theft was discovered in the year in which the taxpayer claims the deduction. The taxpayer must also establish the amount of the claimed loss and confirm that no claim for reimbursement of any portion of the loss exists for which there is a reasonable prospect of recovery in the tax year in which the taxpayer claims the loss.
Reflections
The IRS does not comment in Rev. Rul. 2009-9 on whether Sec. 1314 applies where a taxpayer is required to repay distributions that he or she received from a Ponzi scheme before it collapsed (clawback payments). Some practitioners have argued that taxpayers making clawback payments meet the restoration of income requirement of Sec. 1314 and should be allowed a deduction under that section.
Rev. Rul. 2009-9, 2009-14 I.R.B. 735; Rev. Proc. 2009-20, 2009-14 I.R.B. 749
