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IRS Provides Detailed Tax Guidance for Victims of Madoff-type Investment Schemes

Volume 2009 / Issue 8

March 27, 2009
Just days after Bernard Madoff's guilty plea, IRS has issued comprehensive guidance for the many investors caught in his notorious Ponzi-style fraud. Overall, the guidance takes an extremely generous, pro-taxpayer position, allowing the losses to be claimed as ordinary losses and even allowing net operating losses (NOLs) generated by Madoff-style schemes to be treated as sole proprietorship losses potentially eligible to be carried back 3, 4 or 5 years under a business tax break enacted by the American Recovery and Reinvestment Act of 2009.  
The guidance consists of: (1) a revenue ruling dealing with seven specific tax issues that victims of Madoff-type schemes may confront; and (2) a revenue procedure providing safe harbors for determining the proper time and amount of loss.
Revenue Ruling 2009-9 provides:
  •   The loss will not be subject to the $3000 annual limitation imposed on capital losses.
  •   The loss will be treated as a theft loss, but is not subject to reduction by 10% of Adjusted Gross Income.
  •   The loss is deductible in the year the fraudulent scheme is discovered by authorities.
  •   The deductible amount is the original investment, plus additional amounts invested either directly or as a result of reinvesting taxable returns; minus reimbursements,  recoveries and claims to which there is a reasonable prospect of recovery.
  •   The loss can be treated a Net Operating Loss from a “sole proprietorship” and can be carried back 3, 4 or 5 years and forward for 20 years.
Revenue Procedure 2009-20 provides a generous safe harbor for calculating the amount of the loss that will apply to most individual victims of Ponzi type schemes and in doing so relieves taxpayers that elect to take advantage of these provisions of some of the stringent documentation and substantiation requirements that are generally associated with claiming such losses. The procedure provides: 
  •     The year of loss is generally the year the legal indictment or complaint is filed. 
  •      95% of the “qualified investment” is deductible if no recovery is claimed or pursued.        
  •      75% of the loss is deductible if a recovery is being claimed or pursued.
  •       In either case the deductible loss is subject to reduction in current and future years for actual recoveries.
  •       A statement must be attached to the return setting forth general information about the fraudulent scheme and the taxpayer’s investment.
Taxpayers are thus provided with clear guidance and simplified reporting options with regard to an otherwise highly complex area of the tax law. Care should be taken in assembling and maintaining documentation in support of claimed deductions as well as in evaluating the options that are available.