Ponzi-Scheme Losses: Indirect Investor and State Tax Issues

IRS guidance provides little tax benefit for thefts that hit retirement funds.

February 2011
by Nancy Nichols, et al./Journal of Accountancy

Ponzi schemes continue to come to light regularly. After 2008, when Bernard Madoff’s $65 billion Ponzi scheme was exposed, the U.S. Securities and Exchange Commission (SEC) made comprehensive reforms to better detect fraud within the 11,000 regulated investment advisers and 8,000 mutual funds that it oversees, according to the SEC’s description of those reforms. As a result of its increased enforcement efforts, in 2009 the SEC initiated 60 enforcement actions against alleged Ponzi schemes. They included Houston financier Robert Allen Stanford’s alleged $8 billion ruse.

In each of these cases, besides their monetary losses, alleged victims face tax implications that CPAs can help untangle. This article describes tax guidance regarding the treatment of Ponzi-scheme losses from both federal and state tax perspectives. In 2009, the Internal Revenue Service (IRS) issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20. This guidance allowed favorable tax treatment and safe harbor elections for direct investors (see “Deducting Losses for Defrauded Investors,” The Tax Adviser, July 2009, page 442). Unfortunately, the favorable tax treatment applies only to “qualified” investors (defined below). Indirect investors that invested through IRAs and other tax deferred accounts will realize tax benefits only in certain cases and the deduction may be deferred for years.

SEC-Investigated Ponzi Schemes

An examination of SEC press releases between Jan. 1, 2009 and July 31, 2010, found 31 announcements of complaints filed against alleged Ponzi-scheme frauds. The size of the alleged frauds ranged from $800,000 to $8 billion. The number of investors allegedly defrauded in each scheme ranged from 12 to more than 800, with an average estimated potential loss of $867,522 per investor. Geographically, Florida and California tied for first place in the number of alleged Ponzi-scheme frauds with six each, followed by New York with five and Colorado with two. Exhibit 1 lists the 10 largest alleged Ponzi-scheme frauds between Jan. 1, 2009 and July 31, 2010, based on SEC complaints.

In reviewing the alleged frauds we found a large number that targeted retirees, including one that was brazen enough to target federal law enforcement retirees and another targeting approximately 80 retired Los Angeles Metro bus drivers. Clearly, the Madoff fraud is not the end of the Ponzi-scheme story and retirement funds are a rich target for those perpetrating these frauds.

IRS Guidance and Safe Harbor Election

Revenue Ruling 2009-9 addressed the amount, character and timing of investment theft losses and Revenue Procedure 2009-20 provided a safe harbor for taxpayers reporting them. The guidance addressed the character of the loss, the appropriate year for deducting the loss and how to determine the amount of the loss.

Such losses must be “qualified losses” from “specified fraudulent arrangements,” defined as those in which a party receives cash or property from investors, reports false investment income amounts to the investors and appropriates some or all of the investors’ cash or property. Such arrangements often take the form of Ponzi schemes, the IRS stated. A qualified loss is one caused by a specified fraudulent arrangement and resulting in a federal or state criminal charge of theft (larceny, embezzlement, robbery and similar offenses) or criminal complaint making such allegations. A complaint must also allege that the perpetrator admitted the conduct or there must have been a receiver or trustee appointed with respect to the arrangement or its assets must have been frozen.

The ruling held that when a direct investor opens an investment account, it is considered a transaction entered into for profit under IRC § 165(c)(2) and thus not subject to adjusted gross income (AGI) limits under section 165(h) applicable to personal casualty or theft losses ($100 floor and 10%-of-AGI threshold). Nor is it subject to the section 67 itemized deduction threshold of two percent of AGI or the section 68 AGI phase-out of itemized deductions. The loss is reported on Form 4684, Casualties and Thefts, Section B (“Business and Income-Producing Property”), rather than Section A (“Personal Use Property”).

Unreimbursed theft losses generally are deductible in the tax year they are discovered. If the taxpayer has a claim for reimbursement by insurance or otherwise and there is a reasonable prospect of recovery, the deduction is deferred until the year it can be determined with reasonable certainty whether a reimbursement will be received (Treas. Reg. § 1.165-8(a)(2)). However, recognizing the inherent difficulty of making such determinations in the context of Ponzi schemes, Revenue Procedure 2009-20 provided safe harbor elections for the timing and the amount of a deduction. The loss is considered discovered and deductible when charges are brought and guilt is implied.

This article has been excerpted from the Journal of Accountancy. View the full article here.