Awareness of Ponzi schemes and other fraudulent investment arrangements has skyrocketed following the Bernie Madoff case and other similar prosecutions. IRC section 165 allows investors to deduct losses from these schemes, but only under certain conditions. The author examines the relevant parts of the tax code, laying out the criteria for inclusion and exclusion and the safe harbor provisions of related IRS guidance.
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As the number of uncovered fraudulent investment schemes has increased, so has the need for accountants and tax preparers to be aware of the requirements and limitations of the theft loss deduction under Internal Revenue Code (IRC) section 165. This article reviews the section 165 investment theft loss requirements, taking special note of recent case law and IRS guidance. It then reviews the requirements for the safe harbor under Revenue Procedure 2009-20. It ends with a brief discussion of two other deductibility problems: a lack of basis and state income tax rules.
Fraudulent Schemes Abound
The term “Ponzi scheme” returned to common usage when Bernie Madoff’s fraudulent investment scheme was uncovered in 2008. Although the Madoff scheme was the largest in history, siphoning about $17 billion from victims, it was by no means the only recent Ponzi scheme. For example, in 2015, former New York Giant Will Allen was accused by federal regulators of running a $32 million scheme involving fraudulent loans to athletes (Rich Calder & Kevin Dugan, “Ex-N.Y. Giant Will Allen Accused of Running Ponzi Scheme,” New York Post, Apr. 7, 2015, http://nyp.st/2aJn3Oa). Just months later, Marcello Trebitsch, son-in-law to former Assembly Speaker Sheldon Silver, admitted to running a multimillion-dollar Ponzi-like scheme (Josh Saul, “Sheldon Silver’s Sonin-Law Pleads Guilty in Multimillion Dollar Ponzi Scheme,” New York Post, Jul. 13, 2015, http://nyp.st/2asa5T6). Attorney Jordan Maglich, who compiles statistics on Ponzi schemes nationwide, estimates that over 500 such schemes have been uncovered since 2008. Victims have collectively lost more than $50 billion (“A Ponzi Pandemic: 500+ Ponzi Schemes Totaling $50+ Billion in ‘Madoff Era,’” Forbes, Feb. 12, 2014, http://bit.ly/2acnO1K).
The IRC’s section 165 theft loss provision provides Ponzi victims some solace by allowing a deduction on the taxpayer’s federal income tax return for the lost investment. This deduction is also an enticement to taxpayers who do not qualify. In 2011, the Treasury Inspector General for Tax Administration issued a report entitled Many Investment Theft Loss Deductions Appear to Be Erroneous (Sept. 27, 2011, http://bit.ly/2aJp4dm) (TIGTA Report). The TIGTA Report concluded that approximately 82% of taxpayers claiming an investment theft loss deduction did so erroneously and that these unmerited deductions potentially cost the government $41 million in lost revenue. In 2010, 96% of the tax returns examined in connection with the project did not qualify for the theft loss deduction they had taken.
The IRS has since implemented Tax Preparer Projects that target tax preparers who promote investment theft loss deductions and audit the associated taxpayer clients. Under pressure from TIGTA, the IRS is likely to increase audits and investigations of those who take the theft loss deduction for investments. Accountants and tax preparers who understand the requirements and limitations of IRC section 165 can help clients avoid these audits and determine if a lost investment is deductible.
The Victim’s Solace: IRC Section 165
Normally an investment loss, for example a stock that declines in value, constitutes a capital loss, which can be deducted only to the extent that the taxpayer has capital gains. IRC section 1211 allows an additional $3,000 per year of capital loss, and losses may be carried forward indefinitely. But for Ponzi scheme victims with losses in the hundreds of thousands of dollars, it might take a very long time to fully deduct the loss under normal investment characterization.
Under IRC section 165, a loss arising from an investment theft loss is characterized as an ordinary loss rather than a capital loss. Furthermore, Treasury Regulations section 1.165-7(a)(6) specifically exempts theft loss from limitations placed on other casualty losses, allowing the taxpayer to deduct the entire loss. This deduction is “below the line,” meaning that it offsets income up to the amount of adjusted gross income (AGI) only. Any additional loss may be carried back three years and then carried forward, if necessary, for up to 20 years [IRC section 172(b)(1)(F)(ii)(I)].
The two most contested requirements are that the loss be caused by criminal theft and that there be no reasonable prospect of recovery in the year of discovery.
In order to claim a theft loss deduction, the taxpayer must meet the requirements in Treasury Regulations section 1.165-8. The two most contested requirements are that the loss be caused by criminal theft and that there be no reasonable prospect of recovery in the year of discovery.
Loss caused by criminal theft.
IRC section 165 provides a deduction for theft losses, but does not define “theft.” Treasury Regulations section 1.165 8(d) adds limited guidance, stating that theft is “deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery.” Because the deductibility of theft loss rests on this definition, the courts’ determination of what is and is not theft is quite important.
In Goeller v. Comm’r [109 Fed. Cl. 534, 540–41 (2013)], the Court of Federal Claims opined at length about the definition of theft in the context of section 165. The court pointed out that even though the IRS requires the theft to be a crime under state law, no such requirement exists in the statute. Although the opinion has limited precedential value, the court’s reasoning suggests that a theft might be a deductible loss even if it is not a crime. In United States v. Elsass [769 F.3d 390, 397 (6th Cir. 2014)], a case related to Goeller, the Sixth Circuit Court of Appeals acknowledged the reasoning in Goeller, but firmly embraced the well established analysis of theft from Edwards v. Bromberg [232 F.2d 107 (1956)]. Edwards established that “theft” is a word of general and broad connotation and covers any criminal appropriation of another’s property, including theft by swindling, false pretenses, and any other form of guile. Revenue Ruling 72-112 (1972-1 C.B. 60) further explains that a taxpayer claiming a theft loss must prove that the loss resulted from a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Under this definition, a violation of a federal criminal statute would also establish a theft for purposes of section 165.
Notably, under IRC section 165, a criminal conviction, or even an indictment, is not necessary in order for the taxpayer to claim a theft loss. In Halata v. Comm’r (T.C. Memo. 2012-351, 2012), the Tax Court found it sufficient that the taxpayer’s money was appropriated unlawfully by someone, even though “the evidence does not definitively resolve the identity of the thief.” Furthermore, the Halata court noted that a “taxpayer must prove a theft occurred under state law by only a preponderance of the evidence and not beyond a reasonable doubt.” Therefore, failure to convict a perpetrator under the higher criminal standard of “beyond a reasonable doubt” does not necessarily prevent a theft loss deduction.
Specifically excluded from the definition of theft by Treasury Regulations sections 1.165-4 and 1.165-5 is the loss of value of an investment, even if the loss is due to the negligence or poor business decisions of the perpetrator. Only where the actions rise to the level of theft according to the standards of state or federal criminal law will the loss be deductible under section 165. The TIGTA Report noted that the most common basis for the improper claim of the theft loss deduction was the claim of the deduction for regular investment losses.
For example, no theft loss occurs for purposes of IRC section 165 when a taxpayer buys stock on the open market and the company subsequently is found to be running a fraudulent scheme. In Greenberger v. United States [280 F.2d 472 (1st Cir. 1960) (2015)], the taxpayers bought stock in Spongetech Delivery System, Inc., and lost over $500,000. The company went bankrupt in 2010 and its executives were convicted in 2012 of running a “pump-and-dump” scheme, where fictitious sales figures pumped the stock price up and the executives then dumped the stock at a huge profit. The IRS denied a theft loss deduction, and the court agreed, finding that because the taxpayers did not buy the stock from the perpetrators, but rather on the open market, there was no theft.
In summary, the taxpayer must show that the loss was due to criminal acts by the perpetrators of the scheme. Fraudulent statements or misrepresentations of fact by the perpetrator may be key in showing a theft of investment money has occurred. As a practical matter, the more evidence a taxpayer can gather of false or fraudulent actions or statements by perpetrators of the scheme, the easier it will be to show, by a preponderance of the evidence, that criminal activity was the cause of the investment loss. Helpful evidence includes proof of false representations by the perpetrator and fictitious documents received by the taxpayer. A taxpayer forced to go this route will benefit from a conversation with an attorney who can explain the elements of state theft crimes and suggest what evidence would be sufficient.
Year of discovery with no reasonable prospect of recovery.
Determining the correct year in which to take the theft loss deduction may be the most troublesome aspect of the deduction. A taxpayer with an allowable theft loss who takes the deduction in an inappropriate year can face not only the disallowance of the deduction, but also substantial penalties and interest.
IRC section 165(e) states that any loss arising from theft shall be treated as sustained in the taxable year the taxpayer discovers the loss and is thus deductible in that year. The Treasury Regulations specifically note that the loss is not deductible in the year the theft actually occurs unless that is also the year in which the loss is discovered. The troublesome caveat, however, is found in Treasury Regulations section 1.165-8(a)(2); if in the year of discovery there exists a reasonable prospect of recovery or reimbursement, that portion of the loss may not be deducted until it can be determined that recovery or reimbursement will not occur. Furthermore, if it is “unknowable” if recovery will occur, the entire deduction must be postponed until it can be determined with reasonable certainty whether such reimbursement will be received.
A reasonable prospect of recovery exists when the taxpayer has a bona fide claim for recovery or reimbursement and there is a substantial possibility that such claims will be decided in the taxpayer’s favor. The Tax Court has explained that a taxpayer does not have to be an “incorrigible optimist,” and claims for recovery whose potential for success are remote or nebulous will not cause a postponement of the deduction. Furthermore, the court does not look at facts whose existence was not reasonably foreseeable as of the end of the year in which the loss was discovered. In other words, the fact that the taxpayer subsequently succeeded in a legal action on the claim does not necessarily mean that no reasonable prospect of recovery existed in the year the deduction was taken [Ramsay Scarlett & Co. v. Comm’r, 521 F.2d 786 (4th Cir. 1974)].
This standard presents important considerations for taxpayers who are determining whether there is a reasonable prospect for recovery in a given year. If a taxpayer files suit against the perpetrator or joins in an existing suit, a prospect for recovery is usually deemed to exist. The lengthy process of lawsuits and receiverships can, however, delay the allowance of the claim. A similar delay in deductibility may occur when the taxpayer files bankruptcy claims against the perpetrator of the investment theft. In Bunch v. Comm’r (TC Memo 2014-177 2014), the Tax Court ruled that the taxpayers had a reasonable prospect of recovery at the end of the discovery year because they had filed a claim in connection with the perpetrator’s bankruptcy proceeding and it had not yet been proven that there would be no assets with which to pay the claims.
Another consideration for taxpayers is the cost of litigation. Because “reasonable prospect of recovery” is a factual determination, it is usually not resolved by a motion for summary judgment. This means that a full trial may be needed to win against an IRS action. The cost is often prohibitive for many taxpayers.
The Tax Court has explained that a taxpayer does not have to be an “incorrigible optimist,” and claims for recovery whose potential for success are remote or nebulous will not cause a postponement of the deduction.
As an example of the above, the time-line in Cramer v. United States [(885 F. Supp. 2d 859, 860 (N.D. Ohio 2012)] was as follows:
- 2004 (December): Taxpayer learned that his $70,000 investment had been in a fraudulent scheme.
- 2004 (December): State court froze the assets of the perpetrator and ordered the assets liquidated to pay investors.
- 2006: Taxpayer joined a lawsuit against a bank associated with the perpetrator.
- 2007: Taxpayer filed amended 2004 return claiming 2004 as the year of discovery.
- 2008 (March): IRS disallowed the claim, explaining that the taxpayer could not determine in 2004 what amount could be recovered.
- 2008 (September): Taxpayer amended his 2007 return and claimed the deduction because the auditing agent allegedly told him 2007 was the correct year for the deduction. The deduction created a net operating loss (NOL), which the taxpayer carried back to 2004.
- 2010: IRS disallowed the theft loss deduction for 2007 as well.
- 2011: Taxpayer received about $12,000 as a result of the lawsuit, and the receiver notified the unsecured investors that he did not expect there to be any additional repayment.
- 2012: The U.S. district court affirmed the disallowance, concluding that in 2007 there was a reasonable chance of recovery of at least some funds from either the perpetrator’s liquidated assets or the lawsuit against the bank.
This taxpayer lost, even though the IRS conceded that the taxpayer would be entitled to some amount of deduction in some subsequent year, because he did not provide evidence to show for what amount of the loss there was no reasonable prospect of recovery in 2007. He eventually recovered about 17% of his investment, but at the cost of eight years of legal fees.
The burden is on the taxpayer to show that no reasonable prospect of recovery existed in the year the deduction was taken. For example, in Vincentini v. Comm’r (T.C. Memo. 2008-271, 2008), the taxpayer claimed that he had tried unsuccessfully to recover his money from the perpetrators of the scheme. Although the perpetrators were convicted in the tax year in which the deduction was claimed, the Tax Court found a reasonable chance of recovery existed because the criminal court could (and ultimately did) order restitution. Moreover, the taxpayer failed to provide the court with any documents or witnesses related to recovery attempts. Not only was the deduction disallowed, but the Tax Court affirmed an additional 20% accuracy-related penalty under IRC section 6662.
As a practical matter, taxpayers can take proactive steps to support their argument that no reasonable prospect of recovery existed in a particular year. Taxpayers should copy and keep news articles or other information related to the fraudulent scheme and the recovery of assets. Even unofficial information can show that a reasonable person would have considered recovery unlikely.
Theft Loss Safe Harbor
In response to the large number of victims created by Bernie Madoff’s Ponzi scheme, the IRS issued Revenue Ruling 2009-9, which explained the deduction procedure for investment theft losses, and Revenue Procedure 2009-20, which created an optional safe harbor for “qualified investors” that experience losses in “certain investment arrangements” discovered to be criminally fraudulent. If a taxpayer follows the proper procedures, the IRS will not challenge—
- that the loss is a theft,
- that the correct discovery year was used, or
- that the amount claimed was correct.
Thus, many of the uncertainties of the theft loss deduction are avoided. In return, the taxpayer waives some rights. She may not amend prior tax returns that included fictitious income. She may deduct only 75% of her losses if she is seeking recovery of her investment, or 95% of her losses if she agrees not to seek recovery. She must specifically follow the procedures outlined in the safe harbor, which include attaching a signed Appendix A and making a notation on Form 4684.
The TIGTA Report found that 5% of the returns sampled, claiming an aggregate of $10.6 million in investment losses, failed to include Appendix A as required by the safe harbor instructions. The report also observed, “Safe harbor treatment on these claims should not have been allowed until the taxpayers provided the required information.” In the face of criticism from TIGTA, the IRS will likely increase compliance actions in this area.
Qualified investors under the safe harbor include only investors who transferred cash or property to the perpetrators of the scheme. The transfer may be through a third person acting in the role of agent. For example, in Halata the Tax Court held that the taxpayer was entitled to a theft loss deduction for the funds she had given to her live-in paramour to invest in a scheme that turned out to be fraudulent. Likewise, a 2014 Chief Counsel Advisory indicated that a taxpayer who invested in a fund that then invested in a fraudulent scheme was entitled to the deduction because a deduction allowed to the fund would never flow back to the taxpayer who actually sustained the loss [IRS CCA 201445009 (June 06, 2014)].
Specifically excluded from “qualified investors” are arrangements where the taxpayer invests indirectly through ownership in another entity. The fund or entity itself, however, may be a qualified investor within the scope of the revenue procedure. For example, investors who contribute to a limited liability company or limited partnership that then invests in a fraudulent scheme are not entitled to use the safe harbor provision. The pass-through entity, however, is allowed to claim the safe harbor deduction at the partnership level and then pass the deduction proportionately to its owners.
The other safe harbor requirement concerns “specified fraudulent arrangements.” Determination of a specified fraudulent arrangement has three prongs. First, the lead figure must receive “cash or property from investors; purports to earn income from investors; reports income amounts to the investors that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investor’s cash or property” (Revenue Procedure 2009-20 section 4.01). Although the term “Ponzi scheme” is not used, the definition is clearly aimed at the typical Ponzi scheme, where the perpetrator uses the funds of later investors to pay fictitious interest on the investments of earlier investors. Embezzlements may also qualify, because once the embezzled funds have been taken, they are no longer earning a return, and the perpetrator must shuffle newly invested money to the earlier investors in an effort to hide the theft.
A theft loss sustained in a traditional IRA, which consists of pretax contributions, is not deductible, because the pretax contributions were already deducted from gross income when they were made.
Second, the perpetrator must be criminally charged. While taxpayers may take the theft loss deduction under IRC section 165 by showing only that a criminal theft has occurred, the safe harbor requires that the lead figure be charged with a crime and either that the perpetrator admits committing the crime or that the court freezes the assets of the arrangement or appoints a receiver/trustee.
Finally, the loss must be deducted only in the year in which the criminal complaint is filed against the lead figure. As a result, the safe harbor is usually not available where no charges are filed or where the perpetrator is unknown. Furthermore, the taxpayer must wait until state or federal prosecutors have sufficient evidence to charge a lead figure, and the criminal complaint must contain the elements of a “specified fraudulent arrangement” as described above.
A problem arises if the perpetrator dies before charges are brought. The IRS responded with Revenue Procedure 2011-58, which modified the safe harbor’s definitions of qualified loss and discovery year when the lead figure dies before being charged.
Safe Harbor Obstacles
Lack of basis.
Taxpayers often invest through their Individual Retirement Accounts (IRA), but when the investment turns out to be fraudulent, deducting the loss can be problematic. First, the safe harbor procedure is not available for IRA investments because the investment is indirect, that is, by the IRA and not by the individual. Furthermore, the deduction is limited to the basis of the lost funds. The basis for an IRA usually equals the amount of after-tax contributions.
For example, a theft loss sustained in a traditional IRA, which consists of pretax contributions, is not deductible, because the pretax contributions were already deducted from gross income when they were made. Deducting the same funds as a theft loss would represent a double deduction [IRS INFO 2009-0154 (June 18, 2009)].
If the taxpayer has a basis in the IRA, however (e.g., through after-tax contributions to a Roth IRA), a theft loss may be deducted to the extent of the unrecovered tax basis. The unrecovered tax basis cannot be calculated until all the IRA funds are distributed; at that point, a miscellaneous deduction is allowed for the unrecovered basis, subject to the 2% floor.
IRAs are not the only arrangement where the lack of tax basis may prevent a theft-loss deduction. For example, where embezzlement by way of fictitious expenses decreases the taxpayer’s gross income in the prior year, the taxpayer is not entitled to a deduction in the year of discovery unless the taxpayer amends the prior returns to reflect the embezzled income.
State income tax returns.
Although a theft loss deduction may be permitted on a taxpayer’s federal return, it does not necessarily follow that the deduction will also apply to the state income tax return. For example, in Sturrus v. Department of Treasury [809 N.W.2d 208 (2011)], the taxpayer received over $4 million in fictitious interest payments over four years, on which he paid both federal and state income tax. The investment was then discovered to be a Ponzi scheme in which the taxpayer had over $5 million in investment theft loss. He took a below-the-line IRC section 165 deduction for the theft loss on his federal income tax return. Michigan, however, taxes its citizens on AGI without below-the-line adjustments. Therefore, he was not able to deduct the theft loss on his Michigan state return. To make matters worse, a subsequent theft-loss recovery was included in gross income “above the line” on the federal return and thereby included in his Michigan taxable income.
Although New York recognizes the safe harbor deduction, it is subject to the same limits as other itemized deductions. Taxpayers with high New York AGI may therefore find that the loss is not fully deductible. New York allows to residents the same net operating loss (NOL) carry-back and carry-forward as allowed on the federal return. Nonresidents, however, may have restrictions on the treatment of the NOL (N.Y. State Department of Taxation and Finance, Pub. 145, Sec. IV, “Losses from Ponzi-type Fraudulent Investment Arrangements,” November 2013).
State tax law varies widely and changes constantly, and this article cannot provide an in-depth review of state treatment of theft loss deductions. Tax preparers should look carefully for an applicable state statute or specific guidance on the deduction of fraudulent investment losses. As fraudulent schemes affect more taxpayers, state guidance should become more robust.
Helping Fraud Victims
Armed with an understanding of the theft loss deduction, accountants and tax preparers can help taxpayers who have suffered from fraudulent investments take the best advantage of the deductions available. As the number of uncovered fraudulent schemes rises, so does the need for CPAs who understand the requirements and limitations of IRC section 165, the safe harbor under Revenue Procedure 2009-20, the special problems with no-basis arrangements, and the deductibility of theft losses on state income tax returns.