IRS issues guidance on losses from Ponzi schemes.

• Author: Beavers, James

[ILLUSTRATION OMITTED]

The IRS has released guidance on how investors who have fraud losses from a Ponzi scheme should treat their losses for tax purposes and has provided a safe harbor for taxpayers to use in determining the amount and the timing of their losses from a Ponzi scheme.

Background

Thousands of taxpayers have suffered losses from their investments in the Ponzi schemes of New York financier Bernard Madoff and Texas financier Robert Stanford. While Ponzi schemes are not new, the number of investors in these two schemes and the amount of money involved in them has brought the treatment of fraud losses from Ponzi schemes into the public eye and highlighted the lack of clear guidance on their treatment. Seeking to rectify the situation, the IRS has issued guidance on the proper treatment of these losses in question and answer format in Rev. Rul. 2009-9. In addition, in order to simplify a taxpayer's determination of the amount of losses from a Ponzi scheme and the year in which they should be deducted, the IRS has provided a safe-harbor method for making these determinations in Rev. Proc. 2009-20.

Specified Fraudulent Arrangements

While the IRS is clearly reacting to the Madoff and Stanford schemes, the new guidance has general application to what the IRS calls specified fraudulent arrangements. The IRS defines a specified fraudulent arrangement in Rev. Proc. 2009-20 as an arrangement

in which a party (the lead figure) receives cash or property from investors; purports to earn income for the investors; reports income amounts to the investors that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investors' cash or property. This definition would apply to most typical Ponzi schemes, including the Madoff and Stanford schemes. The revenue procedure also specifically states that the scenario presented in Rev. Rul. 2009-9 is an example of a specified fraudulent arrangement.

Rev. Rul. 2009-9

In Rev. Rul. 2009-9, the IRS presents a Ponzi scheme scenario that qualifies as a specified fraudulent arrangement under Rev. Proc. 2009-20 and then lists seven questions and answers about the proper federal tax treatment of fraud losses from such a scenario.

1. Is a loss from criminal fraud or embezzlement in a transaction entered into for profit a theft loss or a capital loss under...