Deducting losses for defrauded investors.

• Author: Zimmerman, John C.

EXECUTIVE SUMMARY

* A theft toss incurred in an activity engaged in for profit is deductible as a miscellaneous itemized deduction not subject to the 2% of adjusted gross income floor. Whether or not a theft loss has occurred is determined under the law of the state where the loss occurred.

* Generally, for an investment loss to be a theft loss, the party perpetrating the fraud must have had a specific intent to defraud the victim and the victim must have purchased the investment directly from the perpetrator.

* A theft loss for which there is no prospect of recovery is deductible in the year the theft is discovered; however, if there is a reasonable prospect of recovery, the loss is not deductible until it is determined with reasonable certainty whether a reimbursement will be received.

* Losses from Ponzi schemes will generally be treated as theft losses; under Rev. Proc. 2009-20, if specific safe-harbor requirements are met, an investor with a loss from a Ponzi scheme may deduct a specified percentage of the loss as a theft loss in the year the theft is discovered.

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The financial collapse of high-profile investment institutions has generated billions of dollars of losses. A recent report notes that federal and state prosecutors "are preparing for a surge of prosecutions of financial fraud." (1) A question may arise as to whether these losses for tax purposes are to be treated as investment losses, giving rise to capital loss limitations, or theft losses, which can be deducted without any limitations under the casualty loss rules.

Sec. 1211 limits an individual to a maximum of $3,000 per year of net capital losses, while a corporation can deduct capital losses only to the extent of capital gains. Sec. 1212 allows corporations to carry back unused capital losses three years and to carry forward the losses for five years. Corporate capital losses that are unused are permanently lost. Individuals cannot carry unused capital losses back but are allowed an unlimited carryforward period. Therefore, it will usually be more beneficial to have an investment loss classified as a theft loss than a capital loss. Individuals calculate casualty losses on Form 4684, Casualties and Thefts.

Sec. 165(c) recognizes three types of casualty or theft losses:

1. Losses incurred in a trade or business;

2. Losses incurred in an activity engaged in for profit; and

3. Losses of personal use property not connected with a trade or business or an activity engaged in for profit.

   Trade or business casualty or theft losses for self-employed individuals can be deducted in computing adjusted gross income (AGI). For employees, these losses are treated as itemized deductions subject to the 2% of AGI floor imposed by Sec. 67. Losses for personal use property of individuals are itemized deductions that are reduced by 10% of the individual's AGI plus $100 ($500 beginning in 2009) for each casualty occurrence.

   The types of losses considered in this article are theft losses "incurred in an activity engaged in for profit." These investment theft losses are not subject to the 10% of AGI reduction for losses of personal use property, the 2% of AGI floor for miscellaneous itemized deductions, or the itemized deduction phaseout rules of Sec. 68. They are reported on Form 4684, Section B, and carried to line 28 of Form 1040, Schedule A, Itemized Deductions.

   Sec. 172(d)(4)(C) provides that these losses (along with losses from casualties or thefts of personal use property) can be used in the calculation of a net operating loss (NOL), which can be carried back 3 years and forward 20 years. (2) Recently enacted Sec. 172(b)(1)(H) allows an eligible small business for a tax year ending in 2008 or, if the taxpayer elects, for any tax year beginning in 2008 to elect to carry back an NOL either three, four, or five years. An eligible small business is one whose average annual gross receipts do not exceed $15 million over a three-year period.

   Rev. Rul. 2009-9 (3) allows an individual who has been the victim of a theft loss to elect to have the provisions of Sec. 172(b)(1)(H) apply, providing the gross receipts test is met. Since the mandatory carryback for a theft loss is three years, essentially this means that a taxpayer who has an NOL as the result of theft could elect to carry back the loss either four or five years. The ruling also notes that because Sec. 172(d)(4)(C) treats a casualty or theft loss as a business deduction, an individual who sustains a casualty or theft after 2007 will be treated as an eligible small business. (4) This means that the individual does not actually have to be in a trade or business to have the section apply as long as the gross receipts test is satisfied. Rev. Proc. 2009-19 explains the procedures necessary for making the election. (5)

   Sec. 165(e) provides that theft losses are deductible in the year of discovery, not in the year the theft occurs. However, as discussed below, the loss is not deductible if there is a reasonable prospect for recovery. This is an especially important provision for defrauded investors because many times the theft is not discovered until years after it has occurred. Absent this provision, many taxpayers would lose the benefit of the theft loss deduction because of the three-year statute of limitation for claiming a deduction. In the recent case of defrauded investors in Bernard Madoff's Ponzi scheme (discussed in more detail below), many of the losses discovered in 2008 could be traced back to fraud committed in the 1990s or earlier.

   This article will examine:

   * The criteria for establishing when an investment loss has resulted from fraud;

   * When the fraud loss can actually be deducted on the tax return; and

   * Special tax issues that can arise as a result of Ponzi schemes, with special attention focused on the Madoff fraud, Rev. Rul. 2009-9, and Rev. Proc. 2009-20.

   Capital Loss vs. Theft Loss

   The principal issue that arises in investor cases involving theft is whether the loss occurred as the result of theft or was due simply to a bad investment. Invariably, the Service will argue that the taxpayer made a bad investment and is therefore subject to the capital loss limitations or that the fraud committed against the taxpayer does not constitute theft under the applicable state law. A decrease in the stock's value as a result of the theft is sufficient to deduct a loss. However, the amount of the loss cannot exceed the taxpayer's adjusted basis in the investment. (6)

   Regs. Sec. 1.165-8(d) states that "the term 'theft' shall be deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery." In Rev. Rul. 72-112, the IRS stated that "to qualify as a 'theft' loss ... the taxpayer needs only to prove that his loss resulted from a taking of property that is illegal under the law of the state where it occurred and that the taking was done with criminal intent." (7) However, it is not necessary that an actual conviction for theft be obtained against the perpetrator for the victim to take the deduction if the facts and circumstances indicate that theft occurred under state law. (8)

   State Law Controls

   In Rev. Rul. 77-17, (9) the Service denied a theft loss deduction to a taxpayer who purchased publicly traded corporate stock from a stockbroker. Trading of the stock was subsequently suspended due to irregular activities that constituted security fraud. The taxpayers were supposed to receive stock in a new corporation under a reorganization in bankruptcy. The ruling emphasized that the definition of fraud in the state where the fraud occurs is to be followed for tax purposes. In this jurisdiction, four elements were required to show fraud:

1. The perpetrator of the crime must have the specific intent to fraudulently deprive an owner of his or her property (in this case cash);

2. The perpetrator must obtain possession of and title to the victim's property;

3. The property must be obtained by means of false pretenses; and

4. The property owner must have relied upon the fraudulent representations in parting with his or her property.

   In the taxpayer's case, the stock's loss in value did not come within the definition of theft for federal income tax purposes because the fraud's perpetrators did not (1) have the specific intent to defraud the taxpayer and (2) obtain possession and title to the taxpayer's property. The taxpayer had purchased his stock from a broker, not from the perpetrator of the fraud.

   Intent to Defraud

   In Paine, (10) the Tax Court considered whether there was a specific intent to defraud the taxpayer of his property. The taxpayer purchased shares of stock in a corporation through a public stock exchange. Paine alleged that he was induced to do so by fraudulent financial statements issued by corporate officials. The officials issued those fraudulent statements to artificially inflate the stock's market price. The court denied a theft loss deduction because there was no evidence that the false representations to Paine were made with the specific intent of criminally obtaining his property or destroying his right to enjoyment, as required under Texas law. Significantly, the court noted that Paine had not purchased the stock from the persons who made the misrepresentations, but on the open market. There was no evidence that the prior owners of the stock were involved in deceiving Paine. Instead they had engaged in a standard market transaction involving the sale and purchase of stock. Paine also failed to show that he relied on the misrepresentations to make the purchase.

   The Paine court made the point that fraud could occur at the level of the corporate officers who were responsible for issuing false financial statements but that this would not necessarily constitute theft at the level of the investor who relied on the false financial statements to purchase the stock. For theft to occur at the investor level under the Texas law at...