Theft Loss For “Ponzi” Schemes

The “Ponzi” scheme carried out by Bernard Madoff has had a far reaching impact and forced losses on many investors. Many of these investors wanted to claim an income tax theft loss, but it was unclear what the procedure would be for such a claim. In March 2009, the IRS responded to these concerns with Revenue Ruling 2009-9 and Revenue Procedure 2009-20 providing guidance to these investors. Under the guidance promulgated by the IRS, qualified investors may treat a loss as a theft loss deduction when certain conditions are met. This allows uniformity and ease of administration in calculating potential losses for these investors and for the IRS.

In Revenue Ruling 2009-9 the IRS held that qualified losses resulting from one of these “Ponzi” schemes would be treated as a theft loss and fully deductible under Code Section 165(c)(2), instead of being subject to the 10% limitation of Code Section 165(c)(3). Furthermore, the IRS is allowing an increase in the theft loss for income that was properly reported prior to the discovery of the “Ponzi” scheme that the investor included in gross income and reinvested. Additionally, amounts reported in years beyond the statute of limitations will be added to the total theft loss allowed to be claimed. The IRS is also allowing individuals to carry back the theft loss for 3 years and carry forward the theft loss for up to 20 years.

In Revenue Procedure 2009-20 the IRS provided an optional safe harbor for taxpayers that incurred losses in “Ponzi” schemes. This safe harbor allows up to 95% (if no third party recovery is being sought) or 75% (if third party recovery is being sought) of the theft losses to be deducted in the year that they are discovered with a future deduction of any additional losses. The benefit of this safe harbor option is that it provides a solution for taxpayers with smaller losses to end this concern and reduce future expenses associated with these losses. However, taxpayers that have incurred higher losses may choose not to opt for the safe harbor, especially those qualified investors pursuing third party recoveries that are allowed only a 75% deduction currently.

Essentially, the safe harbor allows the loss minus any actual recovery received by the taxpayer in the year of discovery. Any future recoveries would result in additional deductions or in gross income under the tax benefit rule for the taxpayer.

With Revenue Ruling 2009-9 and Revenue Procedure 2009-20, the IRS has provided a procedure for taxpayers that have suffered losses due to one of these “Ponzi” schemes to claim a theft loss in the year the loss is discovered as long as the taxpayer meticulously follows the guidance promulgated by the IRS.

(Updated December 2009)