IRS Rules On Ponzi Loss Tax Treatment

You’ve been Ponzied. Now what? Taxpayers received good news from the IRS last week in the form of formal guidance on how to treat losses sustained from fraudulent investment schemes.

Fake Investments Qualify as Theft

The biggest change coming from the IRS is the idea that theft in the form of bogus investment schemes really is theft, and not regular capital losses.

In prepared testimony before the Senate Finance Committee on Tax Issues Related to Ponzi Schemes, IRS Commissioner Doug Shulman detailed the tax relief provisions for taxpayers who sustained losses in certain investment arrangements discovered to be criminally fraudulent.

The IRS issued two guidance items to assist taxpayers who are victims of losses from Ponzi-type investment schemes. The first item is a revenue ruling that clarifies the the treatment of losses. The second is a revenue procedure that provides a safe-harbor method of computing and reporting the losses.

*Note: A ruling is a firm definition or interpretation of the tax code. A procedure is how you apply that to your particular situation.

Revenue Ruling on Income Tax Losses Resulting From a Ponzi Scheme

The problem in determining losses related to the amount and timing of the losses because the facts are not always known for several years. In addition, there is little information about the prospect of recovering the lost money.

The formal legal position of the IRS and Treasury Department is:

• The investor is entitled to a theft loss
• This is not a capital loss. 
• Therefore, a theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments (typically $3,000 per year in excess of capital gains).
• These “investment” theft losses are not subject to limitations that are applicable to “personal” casualty and theft losses. 
• Therefore, they are deductible as an itemized deduction, but is not subject to the 10 % of AGI reduction or the $100 reduction that applies to many casualty and theft loss deductions.
• The 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. 
• The amount of the theft loss includes the investor’s un-recovered investment.
• The amount also includes the “fictitious income” that the promoter of the scheme credited to the investor’s account and on which the investor reported as income on his or her tax returns for years prior to discovery of the theft.
• A theft loss deduction that creates a net operating loss for the taxpayer can be carried back and forward according to the timeframes prescribed by law to generate a refund of taxes paid in other taxable years.

As for the argument that taxpayers be allowed to amend tax returns for years prior to the discovery of the theft to exclude the ficticious income and therefore receive a refund of tax in those years, the safe-harbor revenue procedure (see below) is only available on the condition that taxpayers not amend prior year returns.

Revenue Procedure on Deterimining Timing and Amount of Loss From Ponzi Scheme

The revenue procedure simplifies compliance for taxpayers by providing a safe-harbor (or estimated) means for determining the year in which the loss occured and a simplified method of computing the amount of the loss.  In an effort to provide a uniform approach for determining timing and amount of losses and avoid the problems of prooving the fraud as well as the admininstrative burden, this revenue procedure provides two simplifying assumptions that taxpayers may use to report their losses:

Deemed Theft Loss
The revenue procedure 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
Prospect of recovery limits the amount of the investor’s theft loss deduction. However, it is difficult to determine, particularly where litigation against the promoter and other potentially liable third parties extends into future taxable years.This revenue procedure generally permits taxpayers to deduct in the year of discovery:

• 95% of their net investment 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 % for 95%  in the formula above.   

If you have any questions about how the new ruling or procedure will affect your taxes, call the IRS or seek help from a qualified tax professional.

Image Credit: saturnism, Flickr