You missed the warning signs and got suckered into a Ponzi scheme. Can the IRS help by giving you some tax relief? This is a critical issue for long-term Ponzi scheme investors (like some of the Madoff victims) who have paid taxes on gains from the investment. After all, they have been paying real taxes on fictional gains.
The IRS has stepped up with guidance on what to do. They clarified the federal tax law governing the treatment of losses in Ponzi schemes. They also set out a safe harbor method for computing and reporting the losses.
The revenue ruling (2009-9) addresses the difficulty in determining the amount and timing of losses from Ponzi schemes and the prospect of recovering the lost money. Some of the older guidance from the IRS on these losses is somewhat obsolete.
The revenue procedure (2009-20) simplifies compliance for taxpayers by providing a safe-harbor for determining the year in which the loss is deemed to occur and a simplified means of calculating the amount of the loss.
The first question is whether a loss from a Ponzi scheme is a “theft loss” or a “capital loss” under IRC §165? With the criminal intent of a Ponzi scheme, it is a theft loss. That also results in it being an itemized deduction that is not subject to the deduction limits in IRC §67 or IRC §68. You can read further in Revenue Ruling 2009-9 for more information.
Even with the clarification in the revenue ruling there many factual issues that have to be addressed to properly take the deduction. Given the ongoing investigations, it is hard to know the facts. So the safe-harbor in the revenue procedure draws some bright lines around what you need to take the deduction.
The first thing you need to determine is whether the Ponzi scheme was a theft. 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.
That seems to work very nicely with the facts for the Madoff scheme.
Now that you can claim the theft loss, you need to calculate the amount of the loss. It may take years to find any assets and distribute them to the victims. Therefore, you have a problem figuring out the actual amount of the loss and the prospect of recovery. The revenue procedure generally permits taxpayers to take a deduction in the tax year they discover the loss and to deduct 95% of their net investment (less the amount of any actual recovery in the year of discovery and the amount of any recovery expected). If you are an investor suing persons other than the promoter (like the Madoff feeder funds), then your deduction is reduced by substituting “75%” for “95%”.
This new guidance seems to address the phantom income concerns, but are predicated on the victims not filing amended returns for prior tax years. Are there other concerns that the IRS did not address?