IRS provides detailed tax guidance for victims

of Madoff-type investment schemes

Rev Rul 2009-9, 2009-14 IRB, Rev Proc 1009-20, 2009-14 IRB

Just days after Bernard Madoff's guilty plea, IRS has issued comprehensive guidance for the many investors caught in his notorious Ponzi-style fraud. Overall, the guidance takes an extremely generous, pro-taxpayer position, allowing the losses to be claimed as ordinary losses and even allowing NOLs generated by Madoff-style schemes to be treated as sole proprietorship losses potentially eligible to be carried back 3, 4, or 5 years under a business tax break enacted by the American Recovery and Reinvestment Act of 2009 (see yesterday's Newsstand e-mail for article "Detailed guidance clarifies the new longer NOL carryback for eligible small businesses").

The guidance consists of:

(1) a revenue ruling dealing with seven specific tax issues that victims of Madoff-type schemes may confront; and

(2) a revenue procedure providing safe harbors for determining the proper time and amount of loss.

RIA observation: In prepared testimony before the Senate Finance Committee on tax issues relating to Ponzi schemes (as well as offshore tax evasion), IRS Commissioner Doug Shulman stressed that the new guidance was not specific to the Madoff scandal. Thus, the guidance also could apply to investors caught up in other frauds that have been unearthed by the stock market's decline, if they qualify for relief under the revenue ruling and revenue procedure.

RIA observation: IRS's guidance doesn't address the fallout to Madoff investors such as pension plans and charitable foundations.

Rev Rul 2009-9 Prescribes Generous Tax Treatment for Madoff's Victims

Rev Rul 2009-9, illustrates and explains its holdings by way of an example dealing with Investor, a cash-method, calendar-year victim of a Ponzi scheme, and Baker, its perpetrator.

In Year 1, Investor, in a transaction entered into for profit, opened an investment account with Baker, who held himself out to the public as an investment advisor and securities broker. Investor contributed $100,000 to the account, and gave Baker power of attorney to use the money to buy and sell securities on Investor's behalf. Investor's income and gains were to be reinvested. In Year 3, Investor contributed an additional $20,000 to the account. Baker periodically issued account statements to Investor that reported the securities purchases and sales that Baker purportedly made in his investment account and the balance of the account. Baker also issued tax reporting statements to Investor and to IRS that reflected purported gains and losses on his investment account. Baker also reported to Investor that no income was earned in Year 1 and that for each of the Years 2 through 7 the investments earned $10,000 of income (interest, dividends, and capital gains), which Investor included in gross income on his federal income tax returns. Investor took a single distribution of $30,000 from the account in Year 7.

Before and part way through Year 8, Baker was able to make distributions to investors who requested them. In Year 8, it was discovered that Baker's purported investment advisory and brokerage activity was in fact a fraudulent Ponzi scheme, and that his reported investment activities and resulting income amounts for his investors were partially or wholly fictitious. In some cases, in response to withdrawal requests, Baker paid purported income or principal to investors, but these payments were made, at least in part, from amounts that other investors had invested in the scheme. When Baker's fraud was discovered in Year 8, Baker had only a small fraction of the funds that he reported on his investors' account statements. Investor did not receive any reimbursement or other recovery for the loss in Year 8. Baker's actions constituted criminal fraud or embezzlement under the law of the jurisdiction in which the transactions occurred. At no time before the discovery did Investor know that Baker's activities were a fraudulent scheme (which was not a tax shelter as defined in Code Sec. 6662(d)(2)(C)(ii) with respect to Investor). Years 1-4 are closed for Investor, but years 5-7 are not.

Tax consequences to investors in Ponzi schemes. Following are the holdings in Rev Rul 2009-9 and what they mean to Investor (and other similarly situated taxpayers taken in by Ponzi schemes):

(1) Nature of loss. A loss, such as Investor's, from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss, not a capital loss, under Code Sec. 165.

RIA observation: Were it a capital loss it would be limited to $3,000 annually when the loss exceeds capital gains from other sources.

(2) Theft loss not subject to reductions. A theft loss in a transaction entered into for profit is deductible under Code Sec. 165(c)(2) , not Code Sec. 165(c)(3) . Investor's loss thus is an itemized deduction that is not subject to reduction by 10% of adjusted gross income (AGI), and the $100 per occurrence floor (for 2008; $500 for 2009 only, returning to $100 after 2009) applicable to personal losses in Code Sec. 165(h) . It also is not subject to the Code Sec. 67 2%-of-AGI limit on itemized deductions, or the Code Sec. 68 overall limit on most itemized deductions.

(3) Year loss is deductible. A theft loss in a transaction entered into for profit is deductible in the year the loss is discovered, if the loss is not covered by a claim for reimbursement or recovery with respect to which there is a reasonable prospect of recovery.

IRS concludes that Investor may deduct the theft loss in Year 8, when the theft loss is discovered, if the loss is not covered by a claim for reimbursement or other recovery as to which he has a reasonable prospect of recovery. To the extent that Investor's deduction is reduced by such a claim, recoveries on the claim in a later tax year are not includible in Investor's gross income. If he recovers a greater amount in a later year, or an amount that initially was not covered by a claim as to which there was a reasonable prospect of recovery, the recovery is includible in his gross income in the later year under the tax benefit rule, to the extent the earlier deduction reduced Investor's income tax.

If Investor recovers less than the amount that was covered by a claim as to which there was a reasonable prospect of recovery that reduced the deduction for theft in Year 8, he may claim an additional deduction in the year the amount of recovery is ascertained with reasonable certainty.

RIA observation: Rev Proc 2009-20, covered below, carries a safe harbor for determining the loss year in a Ponzi-type scheme.

(4) Amount deductible as theft loss. The amount of a theft loss in a transaction entered into for profit is generally: (a) the amount invested in the arrangement, less any amounts withdrawn; minus (b) reimbursements or recoveries, and claims as to which there is a reasonable prospect of recovery. Where an amount is reported to the investor as income prior to the scheme's discovery and the investor includes that amount in gross income and reinvests this amount in the scheme, the amount of the theft loss is increased by the purportedly reinvested amount.

In Investor's case, his theft loss under Code Sec. 165 is $150,000:

$100,000 original Year 1 investment plus $20,000 additional Year 3 investment; plus

$60,000 Investor reported as gross income on his federal income tax returns for Years 2 through 7; minus

$30,000, the amount distributed to Investor in Year 7.

If Investor has a claim for reimbursement with respect to which there is a reasonable prospect of recovery, he can't deduct in Year 8 the portion of the loss that is covered by the claim.

RIA observation: Rev Proc 2009-20 , covered below, carries a safe harbor for determining the amount of loss in a Ponzi-type scheme.

(5) Net operating loss (NOL) carryback. Because Code Sec. 172(d)(4)(C) treats any deduction for casualty or theft losses allowable under Code Sec. 165(c)(2) or Code Sec. 165(c)(3) as a business deduction, IRS says a casualty or theft loss an individual sustains after Dec. 31, 2007, is considered a loss from a “sole proprietorship” within the meaning of Code Sec. 172(b)(1)(F)(iii). Accordingly, an individual may elect either a 3, 4, or 5-year net operating loss (NOL) carryback for an applicable 2008 net operating loss, provided the gross receipts test in Code Sec. 172(b)(1)(H)(iv) is met. (For details on the longer NOL carryback election, see article in yesterday's Newsstand e-mail.)

As applied to Investor's situation, to the extent his theft loss deduction creates or increases an NOL in the year the loss is deducted, he may carry back up to 3 years and forward up to 20 years the portion of the NOL attributable to the theft loss. If his loss is an applicable 2008 net operating loss and the gross receipts test in Code Sec. 172(b)(1)(H)(iv) is met, Investor may elect either a 3, 4, or 5-year net operating loss carryback for the applicable 2008 net operating loss.

(6) No claim of right benefits. IRS says a theft loss in a transaction entered into for profit does not qualify for the claim of right computation of tax provided by Code Sec. 1341 , because under Code Sec. 1341(a)(2) , a deduction must arise because the taxpayer is under an obligation to restore the income. IRS concludes that when Investor incurs a loss from criminal fraud or embezzlement by Baker in a transaction entered into for profit, any theft loss deduction to which Investor may be entitled does not arise from an obligation on Investor's part to restore income. Therefore, Investor is not entitled to the tax benefits of Code Sec. 1341 with regard to his theft loss deduction.

(7) Mitigation provisions don't apply. In general, the mitigation provisions of Code Sec. 1311 through Code Sec. 1314 permit IRS or a taxpayer in certain circumstances to correct an error made in a closed year by adjusting the tax liability in years that are otherwise barred by the statute of limitations. Under Code Sec. 1311(b)(1) , an adjustment may be made under the mitigation provisions only if, in cases when the amount of the adjustment would be credited or refunded under Code Sec. 1314 , the determination adopts a position maintained by IRS that is inconsistent with the erroneous prior tax treatment referred to in Code Sec. 1312 . IRS says that Investor cannot use the mitigation provisions to adjust tax liability in close Years 2 through 4 because there is no inconsistency in IRS's position with respect to his prior inclusion of income in those years.

Rev Rul 2009-9, also declares that a theft loss in a transaction entered into for profit that is deductible under Code Sec. 165(c)(2) is not taken into account in determining whether a transaction is a loss transaction under Reg. § 1.6011-4(b)(5) (in general this reg requires disclosure of certain transactions resulting in large losses).

RIA observation: The fact pattern in Rev Rul 2009-9 involves a taxpayer that invested directly with a Madoff-type perpetrator. What's unclear is the extent of the application of the ruling to investors that invested indirectly with Madoff, for example, those who invested with “feeder funds” that in turn invested with Madoff.

Rev Proc 2009-20 Allows Madoff Victims to Use Safe Harbors for Measuring Loss and Determining Year of Loss

IRS has provided several generous safe harbors for victims of Ponzi schemes (aka “specified fraudulent arrangements” as defined in Rev Proc 2009-20, Sec. 4.01). To qualify for the safe harbors, an investor must be a qualified investor. This is a U.S. person, as defined in Code Sec. 7701(a)(30):

that generally qualifies to deduct theft losses under Code Sec. 165 and Reg. § 1.165-8;

that did not have actual knowledge of the fraudulent nature of the Ponzi scheme before it became known to the general public;

with respect to which the Ponzi scheme is not a tax shelter, as defined in Code Sec. 6662(d)(2)(C)(ii); and

that transferred cash or property to a Ponzi scheme.

A qualified investor does not include a person that invested solely in a fund or other entity (separate from the investor for federal income tax purposes) that invested in the specified fraudulent arrangement. However, the fund or entity itself may be a qualified investor within the scope of the revenue procedure.

RIA observation: Thus, investors who put their money into a fund that in turn put the money into a Ponzi arrangement, such as the one run by Bernard Madoff, don't qualify for the safe harbors in Rev Proc 2009-20, Sec. 4.01.

Additionally, the safe harbors apply only to qualified losses, namely those resulting from a Ponzi scheme in which (a) the lead figure (or one of them, if more than one) was charged by indictment or information (not withdrawn or dismissed) with the commission of fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for Internal Revenue Code loss purposes, under the law of the jurisdiction in which the theft occurred; or (b) the lead figure was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a crime described in Rev Proc 2009-20, Sec. 4.02(1) , and either (1) the complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or (2) a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

Loss year safe harbor. Investors in a Ponzi type arrangement may treat the tax year in which the theft was discovered, within the meaning of Code Sec. 165(e) , as the discovery year. This is the tax year of the investor in which the indictment, information, or complaint (described above) is filed.

Safe harbor loss amount. The amount that may be deducted by a qualified investor is 95% of the qualified investment (75% for a qualified investor that is pursuing, or intends to pursue, any potential third-party recovery), less the sum of any actual recovery and any potential insurance/SIPC (Securities Investor Protection Corporation) recovery. The qualified investor may have an additional deduction (or income) in a subsequent year, depending on the actual amount of the loss recovered.

The qualified investment generally is defined the same way as for purposes of the amount deductible as a theft loss under Rev Rul 2009-9, discussed above. However, Rev Proc 2009-20, Sec. 4.06, says that the term qualified investment for purposes of the safe harbor does not include: (a) amounts borrowed from the responsible group (which includes the fraud perpetrators, the investment vehicle of the fraud or any of its personnel, and a liquidation, receivership, bankruptcy or similar estate established to recover assets for investors or creditors); (b) amounts such as fees that were paid to the responsible group and deducted for federal income tax purposes; (c) amounts reported to the qualified investor as taxable income that he did not include in gross income on his federal income tax returns; or (d) cash or property that the qualified investor invested in a fund or other entity (separate from the qualified investor for federal income tax purposes) that invested in a specified fraudulent arrangement.

Rev Proc 2009-20, Sec. 4.06, which applies to losses for which the discovery year is a tax year beginning after Dec. 31, 2007, carries detailed procedures at Rev Proc 2009-20, Sec. 6, for investors to follow (and in an Appendix, a statement to file) in order to use the safe harbors, and outlines at Rev Proc 2009-20, Sec. 8 , the consequences to taxpayers that don't use the safe harbors.

Source: Federal Tax Updates on Checkpoint Newsstand tab 3/18/09 Thomson Reuters

For Further Information, contact David Marks at 206-382-2430.