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On March 12, 2009, Bernard L. Madoff admitted guilt to eleven counts of fraud in connection with a $50 billion Ponzi scheme. He immediately went to jail, where he will most likely spend the rest of his life. While Mr. Madoff’s victims received some comfort in knowing he will pay for his crimes, his conviction offered little hope that they would receive compensation for their losses.

In cases like this, investors have several possibilities of recovery. First, they can look to the Securities Investor Protection Corporation (SIPC). SIPC will liquidate the holdings of the defunct brokerage and distribute the proceeds to investors. Unfortunately, in the case of a Ponzi scheme, there will not be many assets left to pay victims’ claims. An investor can sue brokerages and financial planners who recommended the investments (that turned out to be fraudulent), but proving liability will be problematic at best. The only other means of asset recovery will fall to the Internal Revenue Service by means of reporting a theft loss.

The rules covering theft losses can be difficult to apply in many cases, but recent announcements by the IRS have eased the way for investors to report losses for Ponzi schemes. In Revenue Ruling 2009-9, the IRS set out the proper tax treatment of losses from such schemes. The conclusions it reaches are:

• Losses from such fraud are not capital losses,
• Although the loses are itemized deductions, they are not subject to the limits on itemized deductions, nor are they considered personal casualty losses, and
• Such losses can create a net operating loss, which can be carried back for up to five years (in certain cases) or carried forward for up to 20 years.

That losses under Ponzi schemes are not capital losses is significant because net capital losses are deductible against other income up to a limit of $3,000. While the loss can be carried forward, it would take a long time for an investor to utilize a $1 million loss carryforward at $3,000 per year. This is especially true if all your life savings perished in the scheme, making it unlikely you’ll generate gains to offset the loss carryforward.

Similarly, since the loss is not subject to limitations on itemized deductions, if an investor has significant other income, the loss won’t be reduced as a result of the floor on income of 2% of adjusted gross income. Additionally, personal casualty losses are deductible only to the extent that they offset casualty gains (plus as much of the excess of the loss over the gain as exceeds 10 percent of adjusted gross income). This revenue ruling treats losses under Ponzi schemes as if from transactions entered into for a profit, which are not subject to these limitations.

Finally, Revenue Ruling 2009-9 treats losses from Ponzi schemes as equivalent to losses from a “sole proprietorship.” This clears the way for investors to carryback their losses against all income for up to five years, thus allowing for a far greater recovery than if the loss was personal in nature.

Realizing that rules surrounding the utilization of theft losses from Ponzi schemes are “clear as mud” for most taxpayers, the IRS also issued Revenue Procedure 2009-20, which provides a ‘safe harbor’ mechanism to assist taxpayers.

In general, Revenue Procedure 2009-20 provides the following:

• The discovery year (year in which the loss is deductible) is the taxable year in which the indictment, information or complaint against the person committing the fraud is filed. In the Madoff case, that year is 2008.
• The total loss (Qualified Investment) is the sum of any cash or property invested; plus any income reported from the fraudulent scheme; less the amount the investor withdrew.
• Losses are deductible as follows
  • If an investor intends to seek recovery from a third-party, the loss is 75 percent of the Qualified Investment, less any actual recovery and any potential recovery from insurance or SIPC.
  • If an investor does not intend to pursue potential third-party recovery, the loss is 95 percent of the Qualified Investment, less any actual recovery and any potential recovery from insurance or SIPC.
• As facts change, or recoveries occur in later years, the investor may have additional deductions or be required to report additional income.

Overall, the IRS has issued guidance favorable to taxpayers in the unenviable position of losing money to Ponzi schemes. In order to take advantage of the ‘safe harbor’ method in Revenue Procedure 2009-20, there are specific requirements that must be met. If you have a loss attributable to a Ponzi scheme, give us a call and let’s see if you can recover some of your losses by virtue of a deduction.

Happy April 15!