On 3/17/09, IRS Commissioner Doug Shulman told the Senate Finance Committee:
“. . . Thousands of Taxpayers have been victimized by dozens of fraudulent investment schemes. These too-good-to-be-true investment uses have often taken the form of so-called “Ponzi schemes” (i.e., the fraud perpetrator promises investments returns, some or all of which are fictitious) . . . The Madoff scandal has affected a very large and diverse pool of Investors, some of whom are reported to have lost most of their life savings . . . To help provide clarity and to assist Taxpayers the IRS is today issuing guidance articulating the tax rules that apply and providing “safe harbor” procedures for Taxpayers who sustained losses in certain investment arrangements discovered to be criminally fraudulent.”
In response, the IRS issued Rev. Rul. 2009-9, Rev. Proc. 2009-20 which allows Investors, defrauded by “Ponzi schemes” (including Madoff’s “Ponzi scheme”) to claim an IRC §165(e) theft loss deduction (i.e., ordinary loss deductions not a capital loss deduction for their “qualified investment” (Rev. Proc. 2009-20, Sec 2.06).
(1) Rev. Rul. 2009-9
Under Rev. Rul. 2009-9 (as stated by IRS Commissioner Doug Shulman, 3/17/09 Senate Finance Committee Appearance):
1. An Investor’s theft loss from a Ponzi scheme is a theft loss, which is not a capital loss (i.e., the theft loss is not subject to the normal limits on losses from investments, which typically limit the loss deduction to $3,000 per year when it exceeds capital gains from investments).
2. “Investment” theft losses are not subject to limitations that apply to “personal” casualty and theft losses (i.e., the loss is deductible as an itemized deduction, but is not subject to the test (10%) percent of AGI reduction or the $500 reduction (2009) that applies to many casualty and theft loss deductions).
3. The theft loss is deductible in the year the fraud is discovered (2008, in the Madoff case) (except to the extent there is a claim with a reasonable prospect of recovery).
The tax year in which the Investor discovers the theft (IRC §164(e)) must be the same tax year in which an indictment or similar allegation is made at the State or Federal level against the promoter of the scheme (i.e., a conviction is not required).
Under Rev. Rul. 2009-9 (Rev. Proc. 2009-20), the amount of the theft loss is the “qualified investment” (i.e., amount of money invested that was lost), plus post-2004 “phantom net income” from the “investment” less reimbursement, or other compensation (see Rev. Rul. 2009-9, Issue #7, limitation on “phantom income post-2004”).
(2) Rev. Proc. 2009-20
The IRS “Safe Harbor” (Rev. Proc. 2009-20) provides investors with:
1. A uniform manner for determining their theft losses.
2. Alleviates Taxpayer compliance burdens.
3. Avoids evidentiary problems for fictitious income reported (i.e., a return of capital).
Under the Rev. Proc. 2009-20 “safe harbor”, Investors may claim tax deductions in the year that the theft was discovered (in the Madoff case, Tax Year 2008). If the Investor does not declare the theft loss in their original 2008 tax returns, with extensions, they may declare the loss and amend their 2008 tax returns up to 3 years after their tax returns were filed, with extensions (i.e., up to October 15, 2012).
Under the “IRS safe harbor”, the tax deductions may be claimed in an amount equal to 95% of their net loss (for Investors who do not pursue 3rd third party claims) or 75% of their net loss (for Investors who intend to pursue 3rd party claims against advisors who referred the Madoff investment).
Under Rev. Rul. 2009-9, any recovery is includible in Taxpayer’s gross income, under the tax benefit rule, to the extent the earlier deduction reduced Taxpayer’s income tax (IRC §111, Treas. Reg. Sec. 1.165-(d)(2)(iii)).
Taxpayers who invested in the Madoff scheme indirectly (e.g., through a “feeder fund”) will not directly report the tax loss. Instead the feeder fund will report the loss and the Taxpayer will report their allocable share of the loss on their individual tax return.
(3) No “Safe Harbor”
Taxpayers who do not apply the “safe harbor” treatment may deduct pre-2005 “phantom income” and amend prior years’ tax returns. (However, if there is no safe harbor election, tax returns claiming theft loss deductions from fraudulent investment arrangements are subject to examination by the IRS.)
Rev. Proc. 2009-20: “If the Taxpayer can establish the amount of net income from the investment arrangement, reported on tax returns, consistent with information received from the specified fraudulent arrangement in taxable years for which the period of limitation on filing a claim for refund under IRC §6511 has expired, the IRS will not challenge the Taxpayer’s inclusion of that amount in basis for determining the amount of any allowable theft loss, whether or not the income was genuine.”
(4) Tax-Loss Carry Forward (20 years)/Carry Back (5 years)
If the theft losses result in a 2008 net operating loss, the Taxpayer may:
1. Carry the loss forward 20 years.
2. Carry the loss back up to five tax years (and receive tax refunds). The five year loss carry-back rule requires that Taxpayer does not have more than $15M in average gross income for the 3 year period ending in which the loss occurs (IRC §172(b)(1)(H)(iv)), as amended by Section 1211 of the American Recovery and Reinvestment Act of 2009, Pub. L. No. 111-5, 123 Stat. 115 (Feb. 17, 2009).