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Deduction for losses in Ponzi schemes

IRS announced special relief for victims of Bernard Madoff's Ponzi scheme (and for investors in other similar fraudulent schemes). Because Madoff's scheme continued for years, many investors are faced not only with the loss of their original investments, but also with having paid taxes on "phantom income," based on fraudulent statements sent by Madoff's firm to investors over a number of years.

The first question IRS answers—generally positively for investors—is exactly how the loss from the investment will be treated for tax purposes. If the loss was considered a capital loss, which is often the case when a taxpayer loses money on an investment in stocks or securities, individual taxpayers would be limited to offsetting the loss against their capital gains, plus an additional $3,000 allowed as a deduction against ordinary income. Although the excess loss can be carried forward indefinitely, it would do little for losses of the magnitude incurred by the typical Madoff investor. So it was good news for investors when IRS announced that investors can take an ordinary loss deduction and the deduction isn't subject to the 2% of adjusted gross income (AGI) limit on miscellaneous itemized deductions, the income-based limitation on itemized deductions, or the 10% of AGI limitation on the deduction for casualty losses.

When the deduction is taken.

Taxpayers can deduct the loss in the year the theft was discovered, which was 2008 for Madoff investors. This deduction can be taken if the loss isn't covered by a claim for reimbursement or other recovery that has a reasonable chance of occurring. If there is a reasonable chance of recovery, the taxpayer must either reduce the deduction by that amount or, alternatively, make a special election under a 2009 revenue procedure, which is discussed farther below. If, after reducing the deduction, the taxpayer actually recovers less than the reduction in a later year, he or she can take an additional deduction in the year the recovery amount is ascertained. And a taxpayer is required to include in income any amount recovered greater than the amount anticipated at the time of taking the deduction.

The amount of the deduction.

According to IRS, the amount of the theft loss is determined by adding to the amount of the initial investment any additional investments and any amounts the taxpayer reported as income and reinvested, minus any amounts withdrawn over the years and any reimbursements or likely recovery.

Here's an example. Assume A invested $500,000 with Madoff's scheme in 2002, reported $40,000 of income on the investment each year in 2003, 2004, 2005, 2006, and 2007, all of which ($200,000) he reinvested. A made no withdrawals over the years, and has filed a claim for reimbursement with the Securities Investor Protection Corporation (SIPC). A is likely to recover $500,000, which is the most any investor can recover from SIPC (subject to a $100,000 cash maximum). His ordinary loss deduction for 2008 is $200,000.

There is an alternative way to calculate the loss under an elective provision, which is described below.

Net operating losses.

Taxpayers with losses from Madoff's fraud may have loss deductions in excess of their income for 2008. Under the general rules for net operating losses (NOLs), the losses can be carried back two years and forward 20 years. For casualty or theft losses, the carryback is increased to three years. For 2008 and 2009 NOLs, most taxpayers could elect a three-, four- or five-year carryback period (instead of two years). In addition, a special increased carryback period election was available for small businesses, but only for 2008 NOLs. The interaction of the NOL rules with the rules for other deductions and credits is complex; if you had a potential NOL, you needed tax advice before choosing a carryback period.

Safe-harbor relief.

Some investors will qualify for elective relief under Rev Proc 2009-20, 2009-14 IRB 735. The amount of the investment that qualifies for relief under the revenue procedure is the same as it is under the rules described above. But the amount to be deducted is 95% of the qualified investment if the investor doesn't pursue any potential third party recovery or 75% of the qualified investment if the investor is pursuing or intends to pursue a third party recovery. These amounts must be reduced by any actual recovery or potential SIPC recovery. The biggest advantage of this method is that the deduction isn't further reduced by a potential direct or third party recovery (although further deductions or income from losses or recoveries occurring in later years are covered by the rules above). The safe harbor can be elected only by investors who invested directly with Madoff (or in a similar fraudulent scheme).

To qualify for relief under Rev Proc 2009-20, investors must file Form 4684, Casualties and Thefts, marked "Revenue Procedure 2009-20," with the tax return for the year in which the theft was discovered. Appendix A of Rev Proc 2009-20 contains a worksheet for calculating the amount of the theft loss and a statement that must be signed by the investor and submitted with Form 4684. We expect that this can be done on extension.

Posted: August 2012

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