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Issue 15

IRS Provides Guidance For Investment Fraud Losses

The IRS has issued taxpayer guidance in an effort to clarify and untangle tax matters surrounding investor frauds like the Bernard Madoff scandal. Issued in March, Revenue Ruling 2009-09 clarifies the income tax law governing the treatment of losses in such investor frauds. Revenue Procedure 2009-20 provides a safe-harbor method of computing and reporting the losses.

In testimony before the Senate Finance Committee, IRS commissioner Doug Shulman, said that Rev. Ruling 2009-09 provides guidance on a number of issues relating to the tax treatment of theft loss, including:

There is no deduction limit for theft loss. A theft loss from a Ponzi-type investment scheme is not subject to the normal limits on investment losses, which typically limit the loss deduction to $3,000 per year when it exceeds capital gains from investments.

“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 percent of AGI reduction or the $100 reduction that applies to many casualty and theft loss deductions.

A 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. 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. The revenue procedure accompanying this revenue ruling provides a safe-harbor approach that the IRS will accept for reporting Ponzi-type theft losses.

The amount of the theft loss includes the investor's unrecovered investment – including income as reported in past years. 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 “phantom income” that the promoter of the scheme credited to the investor’s account, which the investor reported as income on his or her tax returns for a prior year.

Some taxpayers have argued that they should be allowed 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.

NOLs can be carried back and forward. A theft loss deduction that creates a net operating loss (NOL) for the taxpayer can be carried back and forward to generate a refund of taxes paid in other taxable years.

Shulman said that Rev. Proc. 2009-20 is intended to:

    1. Provide a uniform approach for determining the proper time and amount of a theft loss.
    2. Avoid difficult problems of proof in determining how much income reported from the scheme was fictitious, and how much was real.
    3. Alleviate compliance burdens on taxpayers and administrative burdens on the IRS that would otherwise result.

The revenue procedure provides two simplifying assumptions that taxpayers may use to report their losses:

Deemed theft loss. Although the law does not require a criminal conviction of a scheme’s 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.

Rev. Proc. 2009-20 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.

Safe harbor prospect of recovery. Once theft is discovered, it often is difficult to establish the investor’s prospect of recovery. Prospect of recovery is important because it limits the amount of the investor’s theft loss deduction. Prospect of recovery is difficult to determine, particularly where litigation against the promoter and other potentially liable third parties extends into future taxable years.

The revenue procedure generally permits taxpayers to deduct 95 percent of their net investment in the year of discovery, 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 (SIPC). A special rule applies to investors who are suing persons other than the promoter. These investors compute their deduction by substituting 75 percent of their investment.

Although Bernard Madoff pleaded guilt on March 13 to 11 counts of fraud, his case is far from over. Tax and investment experts expect the legal untangling to continue for some time. To learn more on tax issues surrounding theft losses, download Clifton Gunderson’s free whitepaper, The Bernard Madoff Affair and a recording of our webinar on the same topic.

Any tax advice included in this communication is not intended or written to be used, and it cannot be used by any taxpayer, for the purpose of avoiding penalties that may be imposed on the taxpayer.

The information contained herein is general in nature and is not intended, and should not be construed, as legal, accounting, or tax advice or opinion provided by Clifton Gunderson LLP to the reader. The reader also is cautioned that this material may not be applicable to, or suitable for, the reader’s specific circumstances or needs, and may require consideration of non-tax and other tax factors if any action is to be contemplated. The reader should contact his or her Clifton Gunderson LLP or other tax professional prior to taking any action based upon this information. Clifton Gunderson LLP assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.

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