Ponzi-scheme investors receive some good news from the IRS
In recognition of the magnitude of the fraud perpetrated by Bernard Madoff, the IRS has issued much-anticipated, and welcomed, guidance to help victims of Ponzi-type investment schemes. The guidance provides favorable tax treatment to victims of the Bernard Madoff scandal, although making no reference to his $50 billion Ponzi-scheme, as well as similarly-situated investors. The IRS Commissioner has stated that there are “dozens” of such schemes that have surfaced during the current economic turmoil.
Theft loss treatment
The IRS’s guidance details the tax treatment of fraudulent investment arrangements under which income amounts that are wholly or partially fictitious have been reported as income by investors.
The guidance provides the following clarification:
- The investor is allowed to take an ordinary theft loss rather than just a capital loss;
- The investment theft loss deduction will not be subject to the $100 per event (for pre-2009 years) or the ten percent adjusted gross income (AGI) personal casualty loss floors;
- The investment theft loss deduction is available only to taxpayers that itemize;
- The investment theft loss deduction is deductible in the year that the fraud is discovered, subject to reduction for amounts for which a reasonable prospect of recovery remains; and
- The investment theft loss forms part of the taxpayer’s net operating loss (NOL) that may be carried back or forward under normal NOL rules.
Amended returns
Instead of taking a loss deduction, taxpayers can still file an amended return for those open tax years in which tax was paid on phantom income, gains and dividends. But the IRS will not reopen closed tax years to make such adjustments.
Safe harbors
To save time and expense both for the taxpayer and the IRS, the agency has streamlined determining the right to favorable tax treatment. It has done so by providing safe-harbor treatment using two assumptions:
- The loss will be deemed to have resulted from theft if (a) the promoter was charged under federal or state law with the commission of fraud, embezzlement, or a similar theft-type crime, or was subject to a criminal compliant alleging the commission of such a crime, and (b) there is some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.
- The IRS will deem the amount of an investor’s prospect of recovery to equal five percent of his or her net investment, plus any actual recovery in the year of discovery and the amount of any recovery expected from private or other insurance (including Securities Investor Protection Corporation (SIPC) insurance).
The five-percent amount will apply to investors who are suing the scheme’s creator. For investors suing other persons outside the promoter class, the five percent amount is raised to 225 percent.