And seventh, the amount of theft loss is not taken into account in determining whether the victim has engaged in a "reportable loss" transaction of the type that must be disclosed to the IRS.
Revenue Ruling 2009-9 is generally favorable to taxpayers, but it provides limited relief to those victims with insufficient income for the year of the theft and the past three years (or up to five years if the victim is eligible for a 2008 net operating losses). Furthermore, the ruling precludes the use of claim of right and mitigation as possible avenues to seek a refund of taxes overpaid in prior years, with interest.
Revenue Procedure 2009-20
Acknowledging that the determination of whether-and when-a victim qualifies for a theft loss is highly factual and uncertain, the IRS issued Revenue Procedure 2009-20 to set out a safe harbor. Under the procedure, the IRS will not challenge a Ponzi scheme loss by a "qualified investor" who elects the safe harbor. Under the safe harbor:
The loss is deductible as a theft loss.
The theft loss is deductible in the year in which the indictment, information or complaint against the promoter of the fraudulent scheme is filed.
The amount of the claimed theft loss is initially determined in accordance with Revenue Ruling 2009-9. Next, the amount of the loss is multiplied by 95% if the victim is not seeking recovery from third parties, or by 75% if the victim is seeking third-party recovery. The amount of the deduction is reduced by the amount of any actual recovery by insurance or other recoveries available to the victim.
Advisors considering the safe harbor must weigh the size of the theft loss "haircut" (5% or 25%) against the certainty of obtaining the deduction in the correct tax year. A victim who claims a theft loss outside of the safe harbor is obviously open to IRS audit and should carefully evaluate all disclosure obligations.
Summary
While both Revenue Ruling 2009-9 and the safe harbor provide helpful guidance and relief to taxpayers, important unanswered questions must still be considered. For example, is relief available to victims who indirectly invested in fraudulent Ponzi schemes through intermediate or "feeder" funds in lieu of a direct investment in the promoter entity? The safe harbor says it is not available to these investors because they are not in direct privity with the investor promoter.
However, lawsuits have been filed against these feeder funds and their managers over their role in investing monies with Ponzi scheme promoters. To the extent the actions of those managers would constitute theft under the applicable jurisdiction for tax purposes, investors in feeder funds should be able to rely on Revenue Ruling 2009-9 or the safe harbor.
Further, under Revenue Ruling 2009-9, the Madoff scheme presents a fairly straightforward fact pattern because the theft and amount of the loss was readily identifiable. Other Ponzi scheme investments present difficult tax issues, such as whether there were both legitimate and fraudulent schemes being undertaken and whether the investor can distinguish between legitimate and fraudulent schemes.
Special considerations must be addressed for tax-exempt retirement plans, charities, private foundations and investors that are required to return (or "claw back") any proceeds received from the fraudulent investment.
The bottom line is that advisors should tread carefully if considering stepping outside of the guidance provided by Revenue Rule 2009-9 and the safe harbor.
Andrea S. Kramer ([email protected]) and Thomas P. Ward ([email protected]) are partners in the international law firm of McDermott Will & Emery LLP, resident in its Chicago office.