Rev. Rul. 2009-9; Rev. Proc. 2009-20

In response to the highly-publicized Madoff scandal and other recent Ponzi schemes that have surfaced, the IRS has issued guidance on how to handle the resulting investor losses. First, Rev. Rul. 2009-9 states how these losses are treated for tax purposes. Next, Rev. Proc. 2009-20 provides a safe harbor method for claiming and computing the losses. In Rev. Rul. 2009-9, the IRS provides a fact pattern describing how a Ponzi scheme works, which includes the promoter issuing fictitious investment activity and income statements to investors and paying out purported income or principal, at least in part, from amounts invested by others into the fraudulent investment arrangement.

Tax Treatment

The following are the key points with regard to the proper tax treatment of investment losses from a Ponzi-type investment scheme:

• A loss from criminal fraud or embezzlement is a theft loss (which is not a capital loss so the $3,000 per year limit on capital losses does not apply).
• The theft loss is deductible as an itemized deduction, but is not subject to the 10 percent-of-AGI (Adjusted Gross Income) reduction that applies to many casualty and theft losses.
• The loss is deductible in the year the fraud is discovered, provided that the loss is not covered by a claim for reimbursement or there is no reasonable prospect of recovery of the loss.
• The amount of the loss is the amount invested plus income previously reported on the investor’s tax return, less amounts withdrawn and amounts recovered or with a reasonable prospect of recovery.
• A theft loss is a transaction entered into for profit so it can create or increase a net operating loss (NOL) that can be carried back or forward.

Optional safe harbors for claiming and computing losses. To help determine when, or if, a deductible theft loss has occurred and how much to claim, the IRS has provided the following safe harbor rules that taxpayers can follow if they choose.

• Deemed theft loss. A theft loss is deemed to have occurred if the lead figure/promoter was either (1) charged with commission of fraud, embezzlement or a similar crime that would meet the definition of theft; or (2) subject to a criminal complaint alleging commission of such a crime, and there was either admission of guilt or a trustee appointed to freeze the assets of the scheme.
• Year deductible. The theft loss is claimed in the year in which the indictment, information or complaint against the lead figure/promoter of the investment fraud is filed.
• Deductible amount. To account for the prospect of recovery, taxpayers may deduct 95 percent of their net investment less the amount of any actual recovery and any potential insurance proceeds, such as that provided by the Security Investor Protection Corporation (SIPC). Investors who have sued or intend to sue any third party for additional recovery use 75 percent rather than 95 percent in the computation.

Conclusion

Tax preparers with clients caught up in one of these Ponzi schemes or similar fraudulent investment schemes should consult these IRS rulings for additional details on how to determine and claim tax losses that result.

— From the Quickfinder Tax Tips Newsletter from the Tax & Accounting business of Thomson Reuters, May 2009. To subscribe to this informative monthly newsletter, visit quickfinder.thomson.com or click here. To learn more about Gear Up, visit trainingcpe.thomson.com/GearUp.