Deducting Ponzi scheme losses: practical issues.

• Author: Takacs, Natalie Bell

On December 11, 2008, Bernard Madoff, former NASDAQ chairman, was arrested and charged with a securities fraud whose $50 billion of losses, if proved, would make it the biggest Ponzi scheme in history. While Madoff's system was typical of a Ponzi scheme in its structure--paying returns to investors out of the money received from subsequent investors rather than from profit--his strategy was unique. Instead of offering suspiciously high returns to a group of investors with whom he had personal relationships, Madoff offered steady returns to a wider clientele, extending his reach through an international network of hedge funds that funneled their clients' money into his scheme.

In March 2009, the IRS issued Rev. Rul. 2009-9 and Rev. Proc. 2009-20, which provided guidance on the tax treatment of theft losses from Ponzi-type schemes. Although it is evident from the provisions of Rev. Proc. 2009-20 that it was intended to offer a 2008 theft loss deduction to victims of the Madoff scheme, its provisions apply to victims of all Ponzi-type thefts.

The content of Rev. Rul. 2009-9 and Rev. Proc. 2009-20 was covered in the May 2009 issue of The Tax Adviser ("IRS Issues Guidance on Losses from Ponzi Schemes," p. 334). This item will address some practical issues that practitioners may encounter in preparing returns for taxpayers who have been victims of the Madoff Ponzi scheme.

Determining Whether a Loss Is a Theft Loss

Regs. Sec. 1.165-8(d) states that theft is "deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery." Rev. Rul. 72-112 expands on this definition by defining "theft" as a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Various IRS pronouncements and court cases have distinguished between theft losses and other types of losses (e.g., worthless securities, bad debt, gifts, etc.). These pronouncements and cases are the topic of other articles and thus will not be discussed in this item; however, it is important to note that the Madoff Ponzi scheme's unique nature may raise issues that have not been previously addressed. For example, certain funds used swap transactions to leverage their investments into the Madoff strategy. In addition to multiplying the amount of the fund's losses, the use of such Madoff derivatives presents some complex and ambiguous tax issues that remain unanswered, including whether the affected investors in the swap transactions will be eligible for an ordinary loss. To the extent that the losses from the swap transaction are considered ordinary under other Code provisions, taxpayers may concede that such losses are not theft losses; however, to the extent that the losses from the swap transaction are considered capital losses, taxpayers can be expected to advance arguments that such losses are theft losses.

Safe-Harbor Election

In Rev. Proc. 2009-20, the Service and Treasury acknowledge that whether and when investors meet the requirements for claiming a theft loss for an investment in a Ponzi scheme are highly factual determinations that taxpayers often cannot make with certainty in the year the loss is discovered. The revenue procedure goes on to indicate that the safe harbor's purpose is to provide a uniform manner for taxpayers to determine their theft losses, and it explicitly states that use of the safe harbor is optional (i.e., use of the safe harbor requires an election).

The revenue procedure permits taxpayers who choose to use the safe harbor to deduct either 75% or 95% of the loss in the discovery year. Section 4.04 of Rev. Proc. 2009-20 defines the discovery year as the year in which the indictment, information, or complaint establishing the qualified loss is filed. For the Madoff Ponzi scheme's victims, the discovery year is 2008.

The use of the safe harbor is limited to "qualified investors" as defined in Rev. Proc. 2009-20, [section]4.03. This section effectively precludes persons that had actual knowledge of the investment arrangement's fraudulent nature prior to its becoming known to the general public from using the safe harbor. It also limits the use of the safe harbor to investors that transferred cash or other property to the fraudulent arrangement, thus ruling out investors who invested in the fraudulent arrangement through a fund or other entity. Presumably, however, such indirect investors may claim a safe-harbor deduction if the fund or other entity makes the safe-harbor election.

Section 8.01 of Rev. Proc. 2009-20 explicitly states that taxpayers who do not use the safe harbor to claim a theft loss must establish that the loss was from theft, that the theft was discovered in the year the taxpayer claims the deduction, and that no claim for reimbursement of any portion of the loss exists for which there is a reasonable prospect of recovery in the year in which the taxpayer claims the loss.

Despite Rev. Proc. 2009-20's stipulation of 2008 as the year in which a taxpayer can deduct Madoff theft losses under the safe harbor, it is not certain that a taxpayer who does not use the safe harbor could claim a Madoff theft loss deduction in 2008. It is possible that the Service could make an argument that the taxpayer must defer...