IRS Guidance Offers Crumb Of Comfort To Ponzi Scheme Victims

by Leroy Baker, Tax-News.com, New York

18 March 2009

The US Internal Revenue Service has issued two pieces of guidance to assist taxpayers who are victims of losses from Ponzi-type investment schemes, such as that perpetrated by Bernard L. Madoff.

"Beyond the toll in human suffering – as entire life savings and retirements appear to have been wiped out – the Madoff case raises numerous tax and pension implications for the victims," IRS Commissioner Doug Shulman stated in prepared testimony for delivery before a Senate Finance Committee hearing on March 17.

"To help provide clarity in this very complicated and tangled matter 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," Shulman went on to announce.

The first item of guidance is a revenue ruling that clarifies the income tax law governing the treatment of losses in such schemes. The second is a revenue procedure that provides a safe-harbor method of computing and reporting the losses.

"The revenue ruling is important because determining the amount and timing of losses from these schemes is factually difficult and dependent on the prospect of recovering the lost money (which may not become known for several years). In addition, it clarifies the reach of older guidance on these losses that is somewhat obsolete," Shulman explained.

"The revenue procedure simplifies compliance for taxpayers (and administration for the IRS) by providing a safe-harbor means of determining the year in which the loss is deemed to occur and a simplified means of computing the amount of the loss," he added.

Current rules entitle an investor to a theft loss deduction, which is not a capital loss. In other words, a theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments, which typically limit the loss deduction to USD3,000 per year when it exceeds capital gains from investments.

The revenue ruling clarifies that “investment” theft losses are not subject to limitations that are applicable to “personal” casualty and theft losses. The loss is deductible as an itemized deduction, but is not subject to the 10% of adjusted gross income reduction or the USD100 reduction that applies to many casualty and theft loss deductions.

The theft loss is deductible in the year the fraud is discovered, except to the extent there is a claim with a reasonable prospect of recovery. However, Shulman acknowledged to the panel that determining the year of discovery and applying the “reasonable prospect of recovery” test to any particular theft is "highly fact-intensive and can be the source of controversy." Therefore, the revenue procedure accompanying the revenue ruling provides a safe-harbor approach that the IRS will accept for reporting Ponzi-type theft losses.

The ruling concludes that the investor generally can claim a theft loss deduction not only for the net amount invested, but also for the so-called “fictitious income” that the promoter of the scheme credited to the investor’s account and on which the investor reported as income on his or her tax returns for years prior to discovery of the theft.

However, taxpayers will not be permitted to amend tax returns for years prior to the discovery of the theft to exclude the phantom income and receive a refund of tax in those years. "The revenue ruling does not address this argument, and the safe-harbor revenue procedure is conditioned on taxpayers not amending prior year returns," Shulman stated.

The IRS also does not intend to change loss carry back and carry forward periods for victims of investment fraud, despite current legislative attempts by two Representatives to extend loss carry back from three to up to 13 years. "A theft loss deduction that creates a net operating loss for the taxpayer can be carried back and forward according to the timeframes prescribed by law to generate a refund of taxes paid in other taxable years," Shulman stated.

The Commissioner told the panel that in the light of a number of investment scams that have emerged recently, the revenue procedure is intended to provide a uniform approach for determining the proper time and amount of the theft loss and avoid problems of proof in determining how much income reported from the scheme was fictitious. The revenue procedure provides two "simplifying assumptions" that taxpayers may use to report their losses in an attempt to alleviate compliance burdens on taxpayers and administrative burdens on the IRS that would otherwise result.

Although the law does not require a criminal conviction of the promoter to establish a theft loss, it often is difficult to determine how extensive the evidence of theft must be to justify a claimed theft loss. The revenue procedure provides that the IRS will deem the loss to be the result of theft if:

• the promoter was charged under state or federal law with the commission of fraud, embezzlement or a similar crime that would meet the definition of theft;
• or the promoter was the subject of a state or federal criminal complaint alleging the commission of such a crime, and either there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.

However, once theft is discovered, it often is difficult to establish the investor’s prospect of recovery which in turn can affect the amount of the investor’s theft loss deduction. Shulman announced that the revenue procedure generally permits taxpayers to deduct in the year of discovery 95% of their net investment less the amount of any actual recovery in the year of discovery and the amount of any recovery expected from private or other insurance, such as that provided by the Securities Investor Protection Corporation. A special rule applies to investors who are suing persons other than the promoter. These investors compute their deduction by substituting “75%” for “95%” in the formula above, Shulman explained.

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