In the early 20th century, Carlo Ponzi defrauded investors through pyramid schemes in which money solicited from new investors was not invested as promised but instead was used to pay older investors' promised returns and to meet redemption requests. Since then, such fraudulent arrangements have been called "Ponzi" schemes. Since December 2008-with the ongoing financial crisis-Ponzi schemes have been unraveling. Prominent money managers such as Bernard Madoff, R. Allen Stanford, Paul Greenwood and Arthur Nadel have been accused of (or, in Madoff's case, admitted to) orchestrating massive frauds costing investors billions of dollars.
Ponzi losses present difficult tax issues, including whether taxes paid on phantom income can ever be recovered. On March 17, 2009, the IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20 to provide guidance and relief to taxpayers. In this article, we briefly highlight things advisors should know about the general tax rules for theft losses, the conclusions of Revenue Ruling 2009-9, and the provisions of the safe harbor outlined in Revenue Procedure 2009-20.
Worthless Investments
An individual taxpayer who holds stock that becomes worthless is entitled to a capital loss deduction equal to his or her unrecovered investment in the stock (that is, the taxpayer's basis). To claim the tax deduction, the loss must be evidenced by a closed and completed transaction; fixed by identifiable events; and actually sustained in the tax year. An individual can offset capital losses against capital gains realized in the same tax year and can use any unused capital loss against up to $3,000 of ordinary income in that year. Unused capital losses can be carried forward indefinitely to offset future capital gains and up to $3,000 of ordinary income per year until fully used. Capital losses cannot be carried back by individuals to prior years.
Theft Losses
A theft loss, as opposed to a worthless investment loss, is treated as an ordinary loss that can offset both ordinary income and capital gain items. A theft loss is determined under the law of the jurisdiction where the events occurred, but generally it is any criminal appropriation of another's property by swindling, false pretenses or guile with intent to deprive.
A theft loss is deductible in the year the taxpayer discovers the theft, but the theft loss deduction is reduced by the amount of any reasonable prospect of recovery. Further, if the theft relates to property not used in a trade or business and not held for investment, the deduction is significantly limited to an amount in excess of a de minimis amount ($500 for 2009; $100 thereafter) and 10% of the taxpayer's adjusted gross income (AGI).
Revenue Ruling 2009-9
In Revenue Ruling 2009-9, which can be relied on by all taxpayers, the IRS addressed the tax treatment of Ponzi losses.
First, a Ponzi scheme victim can claim the loss as an ordinary deduction arising from a theft, not as a capital loss with respect to a worthless investment.
Second, the theft loss is treated as relating to a transaction entered into for profit, so it is neither subject to the 10% AGI limitation nor subject to other limitations on itemized deductions.
Third, a victim can deduct the theft loss in the year discovered, but the loss amount is reduced by the amount covered by a claim for reimbursement or any reasonably expected recovery. Any amount that the victim actually recovers is not includable in the victim's gross income unless the recovery exceeds the amount previously set aside to reduce the theft loss. If the recovery never happens, the victim is entitled to an additional deduction in the year it is determined that there will be no recovery.
Fourth, the theft loss deduction is equal to the amount of the victim's initial investment plus the amount of any additional investments, including reinvested "profits," minus any amounts withdrawn, minus the amounts received as reimbursements or other recoveries, minus claims as to which there is a reasonable prospect of recovery. Importantly, a victim can claim a loss on phantom profits on which the victim previously paid taxes.
Fifth, to the extent the allowable theft loss is greater than the victim's income in the year claimed, the resulting net loss can be carried back three years and-if the victim does not have enough income to absorb that loss in the carryback years-can be carried forward for 20 years. The victim can choose to forgo the carryback period. For what is referred to as an "applicable 2008 net operating loss," a victim can carry such loss back for either four or five years, in accordance with the provisions of the American Recovery and Reinvestment Act of 2009.
Sixth, the victim cannot invoke the tax rules for "claim of right" or "mitigation" as alternative remedies to recover taxes paid on phantom income.