By Geoffrey A. Weg and Thomas M. Giordano-Lascari
As a result of the Bernie Madoff “Ponzi” scandal, IRS has issued guidance regarding the tax treatment of losses suffered by taxpayers that invested with Madoff and other fraudulent investment funds. Revenue Procedure 2009-20 offers taxpayers a “safe harbor” to compute and report these losses, allowing qualifying investors to deduct the vast majority of their losses in 2008. Revenue Ruling 2009-9 provides general guidance to taxpayers regarding the tax treatment of losses suffered by investors in such fraudulent arrangements.
Revenue Procedure 2009-20
For qualifying investors, Revenue Procedure 2009-20 (the “Rev. Proc.”) safe harbor offers an attractive option. Prior to IRS guidance, Madoff investors may have been precluded from deducting any of their losses in 2008 due to a reasonable prospect of recovery (or at least an unknowable prospect of recovery) from the Securities Investor Protection Corporation (“SIPC”), any remaining Madoff assets, and potential “clawback” claims against other Madoff investors.
Under the Rev. Proc., a “qualified investor” may deduct a specified percentage of the loss of its “qualified investment” in 2008 as a theft loss. A “qualified investor” is one who did not have actual knowledge of the fraudulent nature of the investment arrangement prior to it becoming known to the general public, and who directly transferred cash or property to the fraudulent arrangement. Accordingly, taxpayers who invested indirectly with Madoff through so-called “feeder funds” are barred from the safe harbor. Feeder funds may themselves qualify for the safe harbor, which can take the loss deduction and potentially pass it through to its investors.
The amount of an investor’s “qualified investment” equals the total investment in the arrangement in all years plus the total net income the investor included in income for federal tax purposes for all taxable years prior to 2008, less amounts withdrawn from the investment. An investor’s qualified investment does not include amounts borrowed from Madoff (to the extent not repaid at the time of discovery), fees paid to Madoff, and amounts reported as taxable income that were not included in gross income by the taxpayer.
A qualified investor’s 2008 deduction equals:
• 95% of the qualified investment if the qualified investor is not pursuing any third-party recovery, less any actual recovery and any potential recovery from SIPC or other insurance claim; or
• 75% of the qualified investment if the qualified investor is pursuing any third party recovery, less any actual recovery and any potential recovery from SIPC or other insurance claim.
The qualified investor may have income or an additional deduction in future years depending on any actual recovery.
Procedurally, the qualified investor seeking safe harbor treatment must mark “Revenue Procedure 2009-20” at the top of the Form 4684, Casualties and Thefts, for their 2008 federal income tax return. The taxpayer must also enter the deductible theft loss amount from line 10 in Part II of Appendix A of this revenue procedure on line 34, section B, Part I of the Form 4684 and should not complete the remainder of section B, Part I, of the Form 4684. In addition, the qualified investor must complete and sign a statement provided in Appendix A of the revenue procedure, and attach the signed statement to its timely filed 2008 federal income tax return. By doing so, the taxpayer also agrees to: abide by the provisions of the Rev. Proc.; not file amended returns for prior periods; and waive any claims under IRC §§ 1341 and 1311-1314 with respect to the fraudulent arrangement.
Revenue Ruling 2009-09
Nature of the Loss
Revenue Ruling 2009-09 (the “Rev. Rul.”) provides that investors in a fraudulent investment arrangement, such as the one operated by Madoff, suffer a theft loss under IRC § 165, not a capital loss (capital losses are otherwise limited under IRC §§ 1211 and 1212 to $3,000 annually where the loss exceeds the taxpayer’s capital gains). The Rev. Rul. also clarifies that the loss to the investor is a theft loss stemming from a transaction for profit under IRC § 165(c)(2), and therefore is not subject to IRC § 165(h) limitations imposed on other types of casualty losses (i.e., a reduction by 10% of adjusted gross income and the $100 per occurrence floor). Further, the Rev. Rul. provides that the investor’s theft loss is an itemized deduction not subject to the limits on itemized deductions under IRC §§ 67 and 68 (2% of adjusted gross income limitation and limitation on overall itemized deductions allowed).
Timing of the Deduction
Generally, under IRC § 165(e), a taxpayer is allowed to deduct a theft loss in the year in which the taxpayer discovered the loss. However, if in the year the loss was discovered there exists a claim for reimbursement with a reasonable prospect of recovery, no portion of the theft loss may be taken until it can be ascertained with reasonable certainty whether or not the reimbursement will be received. IRS may argue that the SIPC, any remaining Madoff assets, and potential “clawback” claims against other Madoff investors create a reasonable prospect of recovery (or at least an unknowable prospect of recovery), forcing taxpayers to wait until there is substantial certainty that no recovery is possible from such sources.
Amount of the Deduction
The Rev. Rul. provides, in relevant part, that the amount of a theft loss resulting from a fraudulent investment arrangement is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims as to which there is a reasonable prospect of recovery. Moreover, if an investor reported phantom income as gross income in years prior and the investor purportedly reinvests this amount in the scheme, this amount increases the theft loss.
Net Operating Losses
In the event the investor’s theft loss creates or increases a net operating loss (“NOL”), the Rev. Rul. clarifies that since a theft loss is treated as a business deduction under IRC § 172(d)(4)(C), the theft loss is considered a loss from a “sole” proprietorship within the meaning of IRC § 172(b)(1)(F)(iii) if sustained after December 31, 2007. This allows an investor to elect a 3, 4, or 5-year NOL carryback for an applicable 2008 NOL if the gross receipts test in § 172(b)(1)(H)(iv) is met (rather than just the general 3-year carryback allowed for most NOL’s). Accordingly, if an investor’s theft loss deduction creates or increases an NOL in the year the loss is deducted, the investor may carry back up to 3 years and forward up to 20 years the portion of the NOL attributable to the theft loss. If the investor’s loss is an applicable 2008 NOL and the gross receipts test in § 172(b)(1)(H)(iv) is met, the investor may elect a 3, 4, or 5-year NOL carryback for the applicable 2008 NOL.
Miscellaneous
Finally, the Rev. Rul. address two minor issues: (1) does the theft loss qualify for the computation of tax provided by IRC § 1341 for the restoration of an amount held under a claim of right; and (2) does the theft loss qualify for the application of IRC §§ 1311-1314 to adjust tax liability in years that are otherwise barred by the period of limitations on filing a claim for refund under IRC § 6511. The Rev. Rul. answers both questions in the negative. The theft loss does not qualify for the computation of tax provided by IRC § 1341 because the theft loss occurred in a transaction entered into for profit and thus does not arise from an obligation by the taxpayer to restore income. Moreover, the theft loss does not qualify for the mitigation provisions provided in IRC §§ 1311-1314 to adjust tax years otherwise closed by the statute of limitations because those provisions only apply if, in cases when the amount of the adjustment would be credited or refunded under IRC § 1314, the determination adopts a position maintained by IRS that is inconsistent with erroneous prior tax treatment referred to in IRC § 1312. Such is not the case with respect to previously reported positions of investor’s in fraudulent “Ponzi” schemes.
Geoffrey A. Weg and Thomas M. Giordano-Lascari are attorneys with the law firm of Valensi Rose, PLC in Century City, California where they both specialize in tax and wealth planning and tax controversy matters. Each attorney has earned a Master of Laws Degree (LL.M.) in taxation law from Loyola Law School ‘s Graduate Tax Program.
About Valensi Rose, PLC:
Established in 1952, Valensi Rose, PLC is a full-service business law firm providing its clients with the broad range of legal services needed in a complex business environment. The firm is AV® rated by Martindale Hubbell (its highest rating). The firm’s practice areas include: federal, state and international tax planning and litigation; estate planning and probate; civil litigation, family law, real estate; business and corporate law; non-profit law; labor and employment law; and music, entertainment and intellectual property law. For more information please visit www.vrmlaw.com.
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