Can an investment become a theft for tax purposes?

• Author: Coleman, Jeffrey P.
• Position: Tax Law

The classic Ponzi scheme may soon be renamed the "Madoff scheme," simply by virtue of the massive amount of money invested with Madoff. It is now known that Madoff, like his famous predecessor, Charles Ponzi, used monies given to him by new investors to pay prior investors promised returns on their earlier investments. Madoff, like Ponzi--and also allegedly like Arthur Nadel and others--robbed Peter to pay Paul. Their massive scams wrongfully deprived thousands of investors of billions of dollars.

This column addresses the characterization of an investment loss as a "theft" for federal income tax purposes under existing case law and under Revenue Procedure 2009-20, issued March 17, 2009, creating a "safe harbor" for treatment of certain losses from Ponzi schemes as theft losses for federal income tax purposes. Additional issues that are beyond the scope of this article include (but are not limited to) the privity requirement, the effect of an open-market transaction, and the timing of the deduction. In addition, determinations outside of the "safe harbor" are highly dependent upon the facts and circumstances and are subject to challenge by the Internal Revenue Service (IRS). Thus, if proceeding outside of the "safe harbor," consideration should be given to the advisability of disclosure of the theft loss under [section][section] 6662 and 6664 of Internal Revenue Code of 1986, as amended (I.R.C.), for the purpose of minimizing exposure to certain tax penalties in the event the position does not survive a challenge by the IRS.

The Federal Income Tax Problem

For individual investors, the I.R.C. generally treats investment losses as capital losses, deductible only to the extent of $3,000 in excess of the capital gain experienced by the taxpayer for the year in question. (1) Even though the excess capital loss may be carried forward to later tax years, the deductibility of these losses is still subject to the same limitations. (2) In addition, because a capital gain is only experienced upon the sale or exchange of property, (3) capital gains are less likely to be recurring income. Thus, there is the potential that these losses may never be utilized in the investor's lifetime.

Theft losses, on the other hand, are not limited in the same manner that capital losses are limited. More importantly, a theft loss can be used by individuals as a deduction against ordinary income to the extent that the theft loss is not covered by insurance or otherwise. (4) Ordinary income, of course, is more likely to be recurring, substantial, and taxed at higher marginal rates. Thus, a theft loss deduction can give the victim of a fraudulent investment scheme greater, more immediate relief than can a capital loss deduction. But, is it proper under federal income tax law to treat an investment loss as a theft loss? The answer for victims of Ponzi schemes is often "yes." For victims of other kinds of investment loss caused by securities fraud or other wrongdoing, "theft loss" treatment, though possible, is more difficult.

Establishing a Theft under Federal Income Tax Laws

The Definition of "Theft"--The court in Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), provided what is the most often-cited definition of "theft" for purposes of I.R.C. [section] 165, as follows:

[The word "theft" is not ... a technical word of art with a narrowly defined meaning but is ... a word of general and broad connotation, intended to cover ... any criminal appropriation of another's property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile.... [T]he exact nature of the crime ... is of little importance so long as it amounts to theft. (5)

The broad approach of the Bromberg court to the definition of "theft" is reflected in the Treasury Regulations promulgated under I.R.C. [section] 165, deeming "theft" to include, but "not be limited to, larceny, embezzlement, and robbery." (6)

Whether a "theft" has occurred depends upon the law of the jurisdiction in which the loss was sustained. (7) Either state or federal law can provide the requisite basis for establishing a theft loss to the extent applicable to the conduct at issue in the jurisdiction where the theft occurred.

And the record before us establishes that Livingstone's fraud in obtaining money from petitioners brings this case within the applicable Florida criminal statute in respect of obtaining money by "false representations or pretense," Fla. Stat., sec. 811.021(s), as well as within the provisions of the United States Code which makes it a crime to use the mails to defraud, 18 U.S.C., sec. 1341. The crime under either Florida or federal law was a "theft" within section 165 of the Internal Revenue Code. (8)

Furthermore, it is unnecessary that the perpetrator of the "theft" be convicted or charged with theft. (9)

Examples of Conduct Giving Rise to "Theft" for Purposes of LR.C. [section] 165--The Bromberg court's inclusion of "any other form of guile" within the ambit of "theft" for purposes of [section] 165 is certainly broad enough to include the Ponzis, the Madoffs, and, allegedly, the Nadels. The court's emphasis, in particular, on "swindling, false pretenses, and any other form of guile" potentially includes securities fraud within its scope. The IRS acknowledged this possibility in Chief Counsel Advice (CCA) 200811016. (10)

In CCA 200811016, the investors invested in Company X, a mortgage lending company. Company X was later acquired by Company Y, but Company X remained in existence and continued soliciting funds from investors. After some time, Company Y was staying afloat only through loans from Company X, and Company X was solvent only by treating its loans to Company Y as assets on its financial statements. Company X's officers and directors misrepresented the financial condition of Company X in its financial statements and prospectuses, and the officers and directors were later criminally charged with securities fraud. In addition, at least one Company X officer was indicted for obtaining property...