Home >> DGM Bulletin Article: IRS Issues Ponzi Procedures
IRS Issues Ponzi Procedures
June 2009
The April 2009 CPA Client Bulletin included an article on the tax relief available to victims of investment fraud. Since that issue went to press, the IRS has issued guidance for investors who have lost money in such schemes and has provided a safe harbor for determining the amount of the investor’s loss and the year of the loss. Under this safe harbor, such investors can claim a theft loss deduction for the year in which they became aware of the fraud. They can deduct an amount based on their entire investment, including any fictitious income reported, no matter how long ago such income was reported. The following example illustrates the safe harbor announced by the IRS.
Example: Hugh Harris invested $1 million in 2001 with a spurious promoter. From 2002-2007, Hugh received $400,000 in “distributions” from this promoter, paying income tax on the reported $400,000. Hugh withdrew $100,000 of those distributions and reinvested the other $300,000. In 2009, Hugh learns that the promoter was running a Ponzi scheme and his investment is worth nothing.
Thus, Hugh’s loss is $1,300,000: his $1 million initial investment, plus $400,000 of reported income, minus $100,000 in cash withdrawn. If Hugh does not intend to pursue claims against third parties, such as a bank or another broker, his deduction might be 95% of his $1.3 million loss: $1,235,000. If Hugh does intend to pursue claims against third parties, his deduction might be 75% of his $1.3 million loss: $975,000. The IRS has announced that investors can use those 75% and 95% portions in claiming theft loss deductions resulting from fraudulent investment schemes.
Anticipating recoveries Hugh’s deduction will be reduced by an estimate of any recovery under his insurance policies and from the Securities Investor Protection Corporation (SIPC). In our example, assume that Hugh has no insurance for such a loss. However, Hugh’s securities supposedly were held at a brokerage firm that was an SIPC member. Thus, Hugh expects to receive $500,000 from the SIPC – the maximum coverage per account. Therefore, Hugh reduces his loss deduction by the expected $500,000 from the SIPC. He can claim a loss of either $735,000 ($1,235,000 minus $500,000) or $475,000 ($975,000 minus $500,000), depending on whether he intends to pursue claims against third parties. This loss will be an ordinary loss, meaning that Hugh will be able to take the deduction against his other income.
Investors who lost large sums may have losses that exceed their annual income. If so, the loss may be carried back five years, in most cases. Thus, investors can receive refunds on taxes they paid in the previous five years. If they still have losses in excess of reported income, taxpayers can carry forward those excess losses for 20 years to shelter future income from tax.
The IRS’s guidance is generally favorable to victims of investment fraud. Although the procedure for filing claims may be complicated, our office will be able to help you comply with the prescribed procedures.
