Tax planning and compliance for investors
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By Kaye A. Thomas
Posted March 17, 2009
Clearing up some thorny tax issues.
Losing money in a Ponzi scheme is bad enough. Having problems claiming the loss on your tax return would make it even worse. Some of the tax issues are thorny. What kind of loss can you claim? When? How much? The IRS has issued guidance that will make it easier for taxpayers to resolve these issues and claim the loss. The guidance comes in the form of a Revenue Ruling that clarifies how the tax law applies to these losses, and a Revenue Procedure providing a "safe harbor" under which the loss can be claimed even though some of the facts remain unclear. Although the guidance was prompted by the Madoff situation and other well publicized recent events, it applies generally to any taxpayer whose circumstances are as described in the guidance.
Revenue Ruling 2009-9 provides answers to many of the questions concerning interpretation of the tax law as it applies to these losses. It begins by describing a factual situation that might be typical of a Ponzi scheme, where a promoter fraudulently claimed to be undertaking investment activity on behalf of an investor when in fact some or all of the investment activities were fictitious.
Issue 1: Theft loss. The ruling distinguishes a Ponzi scheme from other forms of wrongdoing. For example, many investors had losses due to accounting fraud at WorldCom several years ago. While the losses occurred because of wrongdoing, the fraud did not involve theft (in the view of the IRS) because there was no specific intent on the part of the corporate officers to deprive the investor of money or property by a criminal act. As a result, people who lost money on their WorldCom investments had to claim a capital loss, not a theft loss, so their loss was subject to the $3,000 capital loss limitation. This ruling says a Ponzi scheme is different because it involves the kind of specific intent required to be considered theft as that word is used in the tax law. Therefore, participants in a Ponzi scheme can claim a theft loss rather than a capital loss, and the loss will not be subject to the capital loss limitation.
Issue 2: Deduction limitations. Although a theft loss is not subject to the capital loss limitation, there are other limitations that potentially may apply. One is the floor amount for casualty and theft losses: generally you can't deduct the first $100 of such a loss ($500 for year 2009). Another limitation says that after taking into account the floor just described, casualty and theft losses are allowed only to the extent they exceed 10% of adjusted gross income. The ruling says these limitations do not apply to a theft loss occurring in a Ponzi scheme, because those limitations do not apply to losses that are connected with a transaction entered into for profit, and the opening of the investment account with the Ponzi scheme operator was a transaction entered into for profit.
The ruling provides further details concerning the nature of the deduction. It says the deduction is an itemized deduction, and that means the deduction will not reduce the taxpayer's adjusted gross income. However, this deduction is not subject to the 2% floor that applies to miscellaneous itemized deductions, nor is it subject to the phase-out rule that applies based on adjusted gross income or total itemized deductions.
Issue 3: Year of deduction. A theft loss is allowed in the year of discovery, but subject to reduction for any part of the loss as to which there is a reasonable prospect of recovery. The amount of the reduction has to be determined under the facts and circumstances (but see later discussion of the safe harbor provided in the Revenue Procedure). If the taxpayer later recovers a greater amount, this added amount is reported as income in the year recovered. If the taxpayer later recovers a lesser amount, the difference is reported as an additional deduction in the year the amount of the recovery can be "ascertained with reasonable certainty."
Issue 4: Amount of deduction. There has been some debate over the proper determination of the amount lost in a situation where the promoter of the Ponzi scheme reported fictitious investment earnings to the investor, who left the earnings to be reinvested in the scheme. The investor never actually had this money, but it seems reasonable to allow a loss for this amount because the investor reported the fictitious earnings as taxable income. The IRS agreed with this idea, so the ruling says the amount of the theft loss is generally the initial amount invested, plus any additional investments, increased by any earnings reported as income in years prior to discovery of the theft, and reduced by any amount withdrawn and by reimbursements or other recoveries as well as claims as to which there is a reasonable prospect of recovery.
Issue 5: Net operating loss. For purposes of the net operating loss rules, this loss is treated as a business deduction (even though, as discussed earlier, it is considered an itemized deduction). An NOL attributable to casualty or theft can generally be carried back three years and forward twenty. However, a special provision in the stimulus law enacted a few weeks ago allows certain small businesses to choose a 3, 4, or 5-year carryback for 2008 losses. Solely for purposes of applying this rule, an individual who lost money in a Ponzi scheme may be treated as if the loss occurred in a sole proprietorship, and may avail himself of the more generous carryback, subject to a gross receipts test.
Issue 6: Claim of right. The ruling says the "claim of right doctrine" does not apply to the loss deduction. If you don't know what this is, you don't need to know, because it doesn't apply.
Issue 7: Mitigation provisions. Some tax experts have suggested that investors in Ponzi schemes should be able to amend tax returns to eliminate the fraudulent income they unknowingly reported, even in years that are closed under the statute of limitations. The IRS ruled that these "mitigation" rules don't apply in this situation, so amendments to returns for closed years will not be allowed.
The IRS recognizes that taxpayers face difficult factual determinations in the year a Ponzi scheme is discovered. Revenue Procedure 2009-20 provides an optional safe harbor for claiming a theft loss from a Ponzi scheme if certain conditions are met. To make use of the safe harbor, the taxpayer has to meet a number of conditions. For example, the taxpayer must not have had actual knowledge of the fraudulent nature of the arrangement prior to it becoming known to the general public. Also, the arrangement must not be a tax shelter (within a particular definition) with respect to the taxpayer. Furthermore, the taxpayer must have transferred cash or property to the fraudulent arrangement. An indirect investor cannot use this procedure (for example, someone who invested in a hedge fund that invested in the arrangement).
A taxpayer meeting these requirements (and others set forth in the Revenue Procedure) can file a return in which he elects to use a safe harbor. In this case, the IRS will allow the following treatment:
Taxpayers are not required to use this procedure, but for those who qualify these rules may make it much easier to determine an amount that can be claimed as a theft loss without fear of having the IRS challenge the deduction.
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