Revenue Procedure 2009-20: Ponzi Scheme Theft Loss Deduction
Explore the optional IRS safe harbor under Rev. Proc. 2009-20, which provides a simplified framework for deducting theft losses from fraudulent investments.
Revenue Procedure 2009-20 provides an optional safe harbor for taxpayers with losses from criminally fraudulent investment arrangements, known as Ponzi schemes. The Internal Revenue Service (IRS) issued this guidance after the Bernard Madoff investment scandal to create a straightforward path for investors to claim a theft loss deduction. This procedure allows a current-year deduction without the complexities of proving the exact year the theft occurred. By using this safe harbor, investors agree to specific rules for calculating their deduction, which avoids potential disputes with the IRS over the timing or amount of the loss.
Determining Eligibility for the Safe Harbor
To use the safe harbor in Revenue Procedure 2009-20, a taxpayer’s situation must meet several conditions. Eligibility hinges on whether the loss resulted from a “specified fraudulent arrangement,” the taxpayer is a “qualified investor,” and the deduction is claimed in the “discovery year.” Failure to meet any of these conditions will prevent a taxpayer from using this simplified method.
Specified Fraudulent Arrangement
The loss must stem from a “specified fraudulent arrangement,” where a lead figure solicits funds from investors but uses money from new investors to pay returns to earlier ones. The arrangement meets the definition when the lead figure is charged under state or federal law with a crime like fraud or embezzlement. These criminal charges provide the proof required by the IRS that the investment was a criminal enterprise.
Qualified Investor
Eligibility is restricted to a “qualified investor,” a U.S. person who made a direct investment in the fraudulent scheme by giving money or property directly to the fraudulent entity. Investments made through an intermediary fund do not qualify the end investor for this safe harbor. The definition also extends to estates or trusts that inherited a direct interest from a qualified investor.
Discovery Year
The deduction must be claimed in the “discovery year,” which is the taxable year the lead figure is formally charged with a crime like theft or fraud. A taxpayer cannot choose the year to claim the deduction; it must be the year the criminal charges are filed. If an investor misses this deadline, they cannot use the safe harbor and must rely on the general rules for deducting theft losses.
Calculating the Theft Loss Deduction
Once eligibility is confirmed, the next step is to calculate the deductible theft loss. Revenue Procedure 2009-20 provides a specific formula that begins with determining the total “qualified investment,” which is the base for the calculation. A fixed percentage is then applied to this amount, depending on whether the investor is seeking recovery from third parties.
A qualified investment is determined by adding all cash or property contributed to the arrangement to any “phantom income” reported in gross income for tax years before the discovery year. This total is then reduced by any amounts the investor withdrew or received from the scheme before its discovery.
The safe harbor provides two deduction percentages based on the investor’s plans for recovering lost funds. If a qualified investor is not pursuing recovery from any third party, they can deduct 95% of their qualified investment.
If an investor is pursuing recovery from a third party, such as an auditor or financial advisor, the deductible loss is limited to 75% of the qualified investment. This lower percentage accounts for the possibility of recouping some losses from other sources. The choice between the 95% and 75% deduction must be made in the discovery year and is binding.
How to Claim the Deduction
To elect the safe harbor, a taxpayer must claim the theft loss deduction on their federal income tax return for the discovery year by completing Section C of Form 4684, “Casualties and Thefts.” Completing this form is a binding agreement with the IRS. A condition of this agreement is that the taxpayer must report any future recoveries of the lost funds as income in the year they are received.