If you did not know what a Ponzi scheme was prior to last year, you probably know by now thanks to Bernie Madoff. While Ponzi and Ponzi-like schemes have been going on for years, last year's economic downturn has brought the losses suffered by investors into focus.
There is no question that innocent investors have lost money in these schemes. For tax purposes though, it is sometimes unclear how and when to deduct these losses. Fortunately, in March 2009, the IRS issued Revenue Ruling 2009-9 which attempts to guide individual taxpayer victims of fraudulent investment schemes.
This ruling addressed a situation where the investor/taxpayer invested money with an investment advisor who perpetrated a criminal Ponzi scheme fraud on the investor. When the fraud was discovered, there was no money left in the fictitious account.
The first question that needed to be answered is whether the loss is capital in nature or a theft deduction. Taxpayers generally do not want capital loss treatment because such losses are limited to capital gains plus $3,000. IRS answered that if the loss resulted from illegal activity, then it is not a capital but a theft loss.
The next question is whether the theft loss was the result of a transaction entered into for profit. If not, the loss is deductible only to the extent it exceeds 10% of Adjusted Gross Income. Fortunately, the IRS decided that such fraudulent investment losses are the result of transactions entered into for profit and thus not so limited.
In this Revenue Ruling, the IRS concluded that the theft loss deduction for fraudulent investment schemes is a miscellaneous itemized deduction not limited by the 2% of Adjusted Gross Income or any other rule, therefore reported in full without limitation.
The IRS also addressed the timing of the theft loss. This is an issue because the loss was incurred in part in years that were closed by the Statue of Limitations. The IRS concluded that since a theft loss is deductible in full in the year the theft is discovered, losses incurred in previous years are not closed by the Statute of Limitations.
The amount of a deductible loss is the taxpayer's basis (contributions plus income reported as taxable less distributions). The deductible loss should be reduced by any amount for which in the year of discovery there is a reasonable prospect for recovery. Finally the IRS concluded that such a theft loss can create a net operating loss which can be carried back 3 years and carried forward 15 years.
This Revenue Ruling assumed certain important facts which helped the IRS reach its favorable opinion. It assumed the taxpayer's loss was from a theft discovered in the year a deduction was claimed. The amount was easy to determine because it was assumed that there was no reasonable prospect for recovery. These clear cut facts are not always the case, so the IRS went one step further and provided a safe harbor for taxpayers. If the provisions of Revenue Procedure 2009-20 are followed the IRS will not contest the taxpayer's treatment as a theft loss.
For this Revenue Procedure to apply, the loss must be connected with the commission of a crime which the investor had no knowledge of until it became public. If so, in the year in which the criminal indictment or complaint is filed the investor can deduct 95% of the loss if he or she does not pursue any avenue of recovery or 75% if the investor intends to pursue potential third party recovery. Please consult this Revenue Procedure (Rev. Proc. 2009-20, 2009-14 I.R.B. 749) for further details.
There is no question that innocent investors have lost money in these schemes. For tax purposes though, it is sometimes unclear how and when to deduct these losses. Fortunately, in March 2009, the IRS issued Revenue Ruling 2009-9 which attempts to guide individual taxpayer victims of fraudulent investment schemes.
This ruling addressed a situation where the investor/taxpayer invested money with an investment advisor who perpetrated a criminal Ponzi scheme fraud on the investor. When the fraud was discovered, there was no money left in the fictitious account.
The first question that needed to be answered is whether the loss is capital in nature or a theft deduction. Taxpayers generally do not want capital loss treatment because such losses are limited to capital gains plus $3,000. IRS answered that if the loss resulted from illegal activity, then it is not a capital but a theft loss.
The next question is whether the theft loss was the result of a transaction entered into for profit. If not, the loss is deductible only to the extent it exceeds 10% of Adjusted Gross Income. Fortunately, the IRS decided that such fraudulent investment losses are the result of transactions entered into for profit and thus not so limited.
In this Revenue Ruling, the IRS concluded that the theft loss deduction for fraudulent investment schemes is a miscellaneous itemized deduction not limited by the 2% of Adjusted Gross Income or any other rule, therefore reported in full without limitation.
The IRS also addressed the timing of the theft loss. This is an issue because the loss was incurred in part in years that were closed by the Statue of Limitations. The IRS concluded that since a theft loss is deductible in full in the year the theft is discovered, losses incurred in previous years are not closed by the Statute of Limitations.
The amount of a deductible loss is the taxpayer's basis (contributions plus income reported as taxable less distributions). The deductible loss should be reduced by any amount for which in the year of discovery there is a reasonable prospect for recovery. Finally the IRS concluded that such a theft loss can create a net operating loss which can be carried back 3 years and carried forward 15 years.
This Revenue Ruling assumed certain important facts which helped the IRS reach its favorable opinion. It assumed the taxpayer's loss was from a theft discovered in the year a deduction was claimed. The amount was easy to determine because it was assumed that there was no reasonable prospect for recovery. These clear cut facts are not always the case, so the IRS went one step further and provided a safe harbor for taxpayers. If the provisions of Revenue Procedure 2009-20 are followed the IRS will not contest the taxpayer's treatment as a theft loss.
For this Revenue Procedure to apply, the loss must be connected with the commission of a crime which the investor had no knowledge of until it became public. If so, in the year in which the criminal indictment or complaint is filed the investor can deduct 95% of the loss if he or she does not pursue any avenue of recovery or 75% if the investor intends to pursue potential third party recovery. Please consult this Revenue Procedure (Rev. Proc. 2009-20, 2009-14 I.R.B. 749) for further details.
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