CPAs in both public practice and in business and industry must often address the tax consequences of theft losses sustained by their clients or employer. There are myriad theft losses that can be treated very differently for tax purposes. This article addresses some of the prominent tax issues associated with recent losses from Madoff-type Ponzi schemes and provides reference to recent specific guidance pertaining to those losses.
Investment guru, Warren Buffett, is well known for his pithy sayings. Perhaps none is more salient than his comment about financial chicanery during our severe financial meltdown than “when the tide goes out, we find out who’s been swimming naked.”
That comment certainly resonates with victims of financial fraud from simple theft and similar swindles to devious Ponzi Schemes such as ones orchestrated by Bernard Madoff and Allan Stanford and other lesser-known promoters of the promise of something too good to be true.
Madoff-Type Losses: Guidance from Internal Revenue Service
With respect to theft losses from Madoff-type Ponzi schemes, the Internal Revenue Service (IRS) issued Revenue Ruling 2009-9 and “safe harbor” Revenue Procedure 2009-20 on March 17, 2009, for individuals and taxable business entities.
Note that the Ruling provides the legal authority for claiming these Madoff scheme theft losses. The Procedure is limited to applying the legal authority to a narrow set of facts intended to address losses specifically sustained by Madoff victims; however, the Procedure may apply to situations analogous to Madoff, such as, losses sustained in the Allan Stanford Ponzi Scheme discovered in early 2009.
Revenue Ruling 2009-9
In summary, the Ruling and Procedure provide:
- 2008 year of discovery for Madoff scheme losses.
- Theft loss allowed in “year of discovery” of amounts for which no reasonable prospect of recovery exists (including amounts recoverable from third parties). The “Year of Discovery” is the critical factor for investors attempting to apply the Ruling (and safe harbor procedure). The facts and circumstances of the Madoff scheme were sufficient for IRS to arrive at a conclusion that in the “year of discovery,” it was also clear that a very small percentage of the monies investors believed they owned would be recovered. Investors that attempt to apply the IRS guidance to other similar situations will be required to demonstrate that they “fit” within the narrow scope of the Procedure and to estimate with some degree of certainty the limited amount of potential recovery if they rely upon the analysis set forth in the Ruling.
- Inclusion of phantom income credited but not paid as part of loss.
- Three-, four- or five-year (optional) carryback if victim meets the under $15 million gross receipts test for small business net operating losses. Also, no 10 percent of adjusted gross income (AGI) reduction for non-business theft loss (transaction considered entered into for profit under Sec. 165(c)(2), not Sec. 165(c)(3). For pass-through partnership entity investors, a question may arise concerning whether the $15 million dollar gross receipts limit applies at the entity or at the investor level. Treasury Reg. §1.702-1(c)(1) appears to provide authority to apply the test at the investor level; it generally treats as a partner’s “gross receipts,” the partner’s allocable share of the partnership’s gross receipts.
- Rejection of any theories of income removal, claim of right (under Sec. 1341 of the Internal Revenue Code) and mitigation tax treatment (under Sec. 1311).
- The Ruling contains an exception to the Reportable Transaction rules of Reg. Sec. 1.6011-4 for losses described in Sec. 165(c)(2). Therefore, taxpayers following the ruling need not file disclosure reports.
Revenue Procedure 2009-20 — the Safe Harbor
In summary, the Safe Harbor provides:
- Limited to “Qualified Investor” — but pass-through entity presumably receives the benefit by virtue of the entity electing to apply
- Ninety-five percent of investment is allowable loss if an action is not filed against third parties (e.g. lawsuits against advisers, SIPC recovery claims). Investment includes undistributed, reinvested phantom income.
- Seventy-five percent allowable if an action is filed against third parties.
- What percent when there is a “derivative” lawsuit? Sub-feeder issues and feeder elections?
- Waiver of income removal, claim of right and mitigation type claims is required. However, a “protective claims” filed by a non-qualified investor that discloses that the concept of the Ruling and Procedure are being followed, but who wants to retain the opportunity to pursue other alternative refund options in the event of denial of the primary approach, should not cause the primary approach to fail.
- If the taxpayer opts out of the Rev. Proc. safe harbor and instead pursues a refund by amending earlier returns to remove phantom income, that approach will not preclude a theft loss claim for unrecovered phantom income for years otherwise closed by the statute of limitations.
- The Procedure’s specifically heightened scrutiny reminds taxpayers that claims for theft losses are subject to examination.
Future Clawback Issues
Some investors in Madoff-type schemes may be required under law to return — for the benefit of all the investors — amounts received from the scheme’s perpetrators prior to discovery. In such cases, the investor may utilize the “claim of right” provisions of Code Sec. 1341 and receive tax relief measured by the larger of the benefit of a current year deduction for repayment or a recalculation of tax liability for the year for which the repayment is made. Performing the calculations for earlier years may be a formidable task when the benefits of the Ruling have applied.
Investors other than individuals and taxable business entities face different tax issues with regard to Madoff-type losses.
- Discovery prior to death — losses should be allowed on decedent’s final income tax return;
- Discovery during administration — the loss should be allowed either as a deduction on any Federal estate tax return or, alternatively, on the Estate’s income tax return. If reflected on the income tax return, the loss should qualify as a net operating loss; if not fully used by the Estate prior to termination, it should pass-through to the beneficiaries under Internal Revenue Code Sec. 642(h);
- Discovery after distribution of investment from estate — the loss is considered sustained by the beneficiaries.
Retirement plan assets
- Generally, no basis for claiming loss;
- If “basis” (for example non-deductible IRS contributions or Roth IRA), then the loss is deductible for basis if “all” IRA has been effectively consumed or distributed;
- Roth conversion may be reconverted until October 15, 2009 to avoid tax on amounts that included “fictitious” Madoff-type scheme amounts.
- These entities do not pay income taxes on investment income, so there is no opportunity to obtain a refund.
Financial Statement Issuers: FIN 48 Considerations
For financial statement issuers subject to FIN 48 — Accounting for Uncertain Tax Positions, theft losses (including losses from Madoff-type schemes) may present problems with respect to the “Year of Discovery” and the amount of the loss claimed.
Technically, for income tax purposes, if a theft loss has been concealed in the income statement of an earlier year still subject to examination by a tax authority, it is arguable that the concealed amount be reclassified as a recoverable asset until the year of discovery and should not reduce taxable income until the amount of loss is determinable. Consequently, an entity must evaluate the consequences of theft loss discovery for “uncertainty” under the recognition and measurement tests of FIN 48. This may require that the entity record a liability for an uncertain tax position arising for the timing and amount of the theft loss.
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Arthur J. (Kip) Dellinger, Jr., CPA, is director of Estate, Gift and Trust Services at Kallman And Co. LLP, Los Angeles. He provides services as an expert in the areas of CPA tax practice conduct and malpractice defense. He also represents clients in tax controversy matters and provides services to tax counsel in criminal and civil tax proceedings. Dellinger is current chair of the AICPA Tax Division’s Tax Practice Responsibilities Committee and is the author of the Practical Guide to Federal Tax Practice Standards (CCH, 2007). He is a speaker at the AICPA National Tax Conference being held October 26-27 in Washington, DC.