What is the Tax Treatment for Ponzi / Madoff Schemes?
After being strongly urged by Congress to issue guidance to taxpayers who have been harmed by the recent rash of Ponzi schemes, including the Bernard Madoff scam for $50,000,000,000 – that is $50 billion and maybe even more, the IRS responded with guidand in March.
The IRS issued two documents, a Revenue Ruling delineating the generic facts and IRS conclusions as to how taxpayers could file returns for relief. Their conclusions modify past rulings and relax requirements that they believe are within their authority to change. It is unlikely that anyone will challenge the “safe Harbor” method, since it is an easing of many rules.
The basic standard that they proscribe is based on the concept that the Ponzi scheme is a theft. As such it is not a capital loss or a non-business bad debt. The next issue that they establish is whether, for individual taxpayers, the kind of theft it is. If your personal car is stolen that is covered as a personal loss, subject to several adjustments that reduce the amount of the deduction. The IRS has recognized that individuals who have given funds to a Ponzi theft, did so on the basis of entering into a transaction for profit, an “investment.” As such, the loss is not subject to personal loss limitations and is fully deductible, limited only to possible recoveries.
Under this method, prior year returns will stand as filed. Under no circumstances is the IRS allowing “closed” years to be opened for “correction.” Since most of the 2008 schemes were discovered before the end of the year, it is unlikely that taxpayers will receive any 1099’s for 2008 false income.
The first question is “what is the year of the loss?” Generally, theft losses are deductible in the year of discovery and once claims for recovery have been resolved or abandoned.
The amount of the loss equals the funds invested, less any funds withdrawn, plus any amounts shown as increases to the account balance as a result of income that was supposedly earned. “Earnings” might include interest, dividends and capital gains. The fact that prior year dividends and capital gains may have “benefited” from being taxed at lower rates does not change the current year theft deduction methodology.
Because there may be claims for recovery, the IRS has established parameters for making assumptions about the recovery so that the loss can be claimed on a current (2008) tax return. To deal with the possible recovery, reductions in the loss of 5% or 25%, (depending on whom the investment was made through) and a reduction for proceeds that might be paid by SIPC (Securities Investor protection Corporation) are required.
In the second ruling, a Revenue Procedure, the IRS establishes the mechanics of dealing with the tax reporting of the loss on a 2008 tax return. The previously described concepts are converted into a schedule. If taxpayers follow the recommended method, it will be considered a “safe harbor” reducing the exposure for audit that taxpayers will potentially be subjected to.
In the future, when the dust settles and all claims are finalized there will, no doubt, be differences between what is assumed to be recoverable and what is actually recovered. If the taxpayer receives “exactly” what was assumed would be paid as embodied in the above formula, no additional tax reporting is necessary. If the taxpayer receives less, then there is an additional loss that would be reported in the year of final settlement. If there is additional proceeds that effectively reduce the loss reported, then that would be reported as income in the year received.
Net operating losses arise where certain non-personal losses exceed current taxable income. In these situations the excess that is not used in the year of the loss is a net operating loss that is subject to carry over rules. The IRS, in this case determined that “the portion of an individual's net operating loss arising from casualty or theft may be carried back 3 years and forward 20 years.” In other words, a 2008 NOL can be carried back to 2005, then 2006, then 2007, with anything remaining carried forward for 20 years. Alternatively, taxpayers can forego the carry back and only carry forward the loss. But there is additional relief available.
NOL’s arising from certain casualty and theft losses, including these are treated as a business deductions for losss an individual sustains after December 31, 2007 and therefore , is considered a loss from a "sole proprietorship". “Accordingly, an individual may elect eiither a 3, 4, or 5-year net operating loss carryback for an applicable 2008 net operating loss, provided the gross receipts test provided is satisfied.” Generally, there are small business benefits that are restricted to businesses with "$5 million" or less of annual revenue. In the case of certain casualties and thefts, including these, increases to "$15 million." All individuals that meet this test are considered “sole proprietors.”
For those interested in the technical stuff, the IRS ruling sets out the following “holdings:”
(1) A loss from criminal fraud or embezzlement in a transaction entered into for profit is a theft loss, not a capital loss, under §165.
(2) A theft loss in a transaction entered into for profit is deductible under §165(c)(2), not §165(c)(3), as an itemized deduction that is not subject to the personal loss limits in §165(h), or the limits on itemized deductions in §§67 and 68.
(3) A theft loss in a transaction entered into for profit is deductible in the year the loss is discovered, provided that the loss is not covered by a claim for reimbursement or recovery with respect to which there is a reasonable prospect of recovery.
(4) The amount of a theft loss in a transaction entered into for profit is generally the amount invested in the arrangement, less amounts withdrawn, if any, reduced by reimbursements or recoveries, and reduced by claims as to which there is a reasonable prospect of recovery. Where an amount is reported to the investor as income prior to discovery of the arrangement and the investor includes that amount in gross income and reinvests this amount in the arrangement, the amount of the theft loss is increased by the purportedly reinvested amount.
(5) A theft loss in a transaction entered into for profit may create or increase a net operating loss under §172 that can be carried back up to 3 years and forward up to 20 years. An eligible small business may elect either a 3, 4, or 5-year net operating loss carryback for an applicable 2008 net operating loss.
(6) A theft loss in a transaction entered into for profit does not qualify for the computation of tax provided by §1341.
(7) A theft loss in a transaction entered into for profit does not qualify for the application of §§1311-1314 to adjust tax liability in years that are otherwise barred by the period of limitations on filing a claim for refund under §6511.