Service Provides Some Relief for Losses from 'Ponzi' Schemes

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Copyright 2009 National Underwriters Company All Rights Reserved Tax Facts News

April 2009

GENERAL INCOME TAX; Pg. 1

736 words

Service Provides Some Relief for Losses from 'Ponzi' Schemes

Amounts included in income may increase the amount of the loss

The Internal Revenue Service (IRS) recently released a revenue ruling and revenue procedure regarding losses that taxpayers may have suffered from certain investment arrangements that later turned out to be criminally fraudulent. The most famous of these were investments that were made with Bernard Madoff 's firm, but there have also been other "Ponzi" schemes uncovered recently.

In the revenue ruling, the IRS presented a situation where an investor contributed money to an account with an investment advisor and securities broker. Over a period of years the investments earned income, which the investor included on the investor's tax returns. The investor took a single distribution from the account one year before it was discovered that the investment activity was in reality a fraudulent investment arrangement, otherwise known as a "Ponzi" scheme, where the investment activities and income are partially or completely fictitious. Payments for withdrawal requests are generally made from amounts that other investors invest in the fraudulent arrangement.

The IRS has ruled that a loss from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss that is deductible as an itemized deduction. However, this type of itemized deduction is not subject to the requirement that it exceed $500 and also the requirement that the loss exceed 10 percent of the individual's gross income. These itemized deductions are also not subject to the two percent rule that applies to most miscellaneous itemized deductions or the limitation on itemized deductions based on the individual's adjusted gross income or total itemized deductions.

The theft loss is deductible in the year the loss is discovered, provided the loss is not covered by a claim for reimbursement or where there is a reasonable prospect of recovery. The amount of the loss is the amount invested in the arrangement, less any amounts withdrawn, amounts recovered, and amounts where there is a reasonable prospect of recovery. If the investor reported income prior to the discovery of the fraud, the amounts that were included in income and reinvested in the arrangement will increase the amount of the theft loss. Also, a theft loss may lead to net operating loss (NOL) that may be carried back up to three years (for a theft loss, generally NOLs may be carried back up to two years) and forward 20 years. If the theft was discovered in 2008, the investor may be able to elect either a 3, 4, or 5 year NOL carryback.

The IRS also issued a revenue procedure which provides an optional safe harbor treatment for taxpayers who experienced losses from criminally fraudulent investment arrangements. The revenue procedure also describes how the IRS will treat a return that claims this type of loss and does not use the safe harbor treatment.

If a taxpayer follows the safe harbor procedures, the IRS will not challenge that the loss deducted was a theft loss, the year the taxpayer claims the loss, and the amount of the loss deduction calculated using the safe harbor procedure. Under the safe harbor procedure, the amount that may be deducted is the amount of the "qualified investment" multiplied by (1) 95 percent for an investor that is not seeking third-party recovery, or (2) 75 percent for an investor who is pursuing, or intends to pursue third party recovery. This amount is then reduced by any actual recovery and any insurance or SIPC recovery.

The term "qualified investment" means the excess of (1) the sum of the total amount of cash, or basis in property, invested in the arrangement, and the net income the investor included in income for all taxable years prior to the discovery of the fraud; over (2) the total amount of cash or property the investor withdrew in all years from the arrangement.

A taxpayer who chooses not to use the safe harbor treatment is subject to all the generally applicable provisions governing the deductibility of losses under Code section 165. The taxpayer claiming the theft loss deduction must establish the loss was from theft and that the theft was discovered in the year the taxpayer claims the deduction. The taxpayer must also establish, through appropriate documentation, the amount of the claimed loss and must also establish that no claim for reimbursement exists to which there is a reasonable prospect of recovery in the taxable year in which the taxpayer claims the loss. JFS