IRS Regulations for Investors Who Are Defraudedby
Fortunately for those who fall prey to Ponzi schemes and the like, the IRS does allow for the losses to be deducted from annual tax returns. Of course, investors must follow certain regulations, and not everyone will be permitted to take the deduction. Tax guru Julian Block discusses IRS regulations on capital gains and losses and more.
Just joining us? Go back to part one for a summary of how the notorious Bernard Madoff orchestrated a Ponzi scheme that stole more than $50 billion from investors. Madoff’s clients were a who’s who of financial outfits, well-endowed philanthropies and ultra-wealthy persons including A-listers and boldface names.
Part one also touched on some highlights of the IRS guidelines that authorize unprecedented tax relief for victims of Madoff-type schemes and other too-good-to-be-true investment ruses. It also discussed safe harbor provisions that ensure favorable treatment for investors. Part two will focus on other aspects of these guidelines, including safe harbors and restrictions on special relief eligibility.
Internal Revenue Code Section 1211. As noted in part one, the IRS guidelines treat losses from Ponzi and other schemes as theft losses deductible in accordance with Section 165. They are not treated as investor losses deductible in accordance with Section 1211, which imposes severe limitations on capital losses.
Section 1211 allows investors to offset all of their capital losses and capital gains from sales or redemptions of stocks, bonds, mutual funds or ETFs. However, that relief is of little to no help for most investors when profits are scarce, as they were when Madoff’s scheme was revealed in 2008.
What if there aren’t any gains or losses that exceed gains? This is where Section 1211 comes in, since it authorizes limited relief. Investors are able to use as much as $3,000 (dropping to $1,500 per person for married couples filing separate returns) of their net losses as deductions against ordinary income. This wide-ranging category includes salaries and other forms of compensation, pensions, interest and “dividends” (considered interest) paid on savings accounts, certificates of deposit or similar savings vehicles.
Some fine print. Investors can’t offset any losses against ordinary income from Roth conversions (money moved out of traditional IRAs and into Roth accounts) or distributions from traditional IRAs and other tax-deferred plans. It’s neither here nor there that the accounts grew only because the securities they held appreciated. The law allows investors to push the rest of their losses forward and use them in future years to soak up any future gains and reduce ordinary income.
Suppose the IRS had been less forthcoming and promulgated guidelines that mandated use of the rules for capital losses. In that case, victims whose losses were followed by five or more zeros would have to outlive Methuselah to use all those losses. This assumes no future gains and no increase in the cap of $3,000. This amount hasn’t been revised since it took effect in 1978, during Jimmy Carter’s presidency.
There’s something else that’s a plus. The guidelines make clear that “Investment” theft losses aren’t subject to the $100 reduction or the 10 percent of adjusted gross income reduction that apply to many “personal” casualty and theft losses.
Moreover, in contrast to capital losses, theft losses can offset all kinds of income. Net operating losses created by theft loss deductions are subject to the same rules as those for businesses.
Finally, the year of deduction of the theft loss is the year the fraud is discovered, except to the extent there’s a claim with a reasonable prospect of recovery. This holds true even if the theft took place earlier.
Now, let's move on to Revenue Procedure 2009-20, which defines a Ponzi scheme as involving a “lead figure” (or figures) who receives cash or property from investors, purports to earn income for them, reports income that is partly or totally fictitious, makes payments from amounts invested by other investors and appropriates some or all of the amounts invested.
More on safe harbors. The IRS guidelines make it possible for investors to avoid having to prove how much income reported in prior years was a return of capital or fictitious.
Under the guidelines, the amount of theft loss includes the investor’s unrecovered investment––including income as reported in past years. The investor generally can claim a deduction not only for the net amount invested, but also for the so-called “fictitious income” that was credited to the investor’s account and reported as income on his or her tax returns before the discovery of the theft. Previously, the IRS read the law as allowing investors to deduct only their original principal, meaning there was no deduction for phantom income.
Restrictions on who’s eligible for special relief. The safe harbors don’t authorize tax deductions for investments made through IRAs or other tax-deferred accounts; they authorize write-offs only for investments in taxable accounts.
Another stipulation is that the IRS will consider the loss to be the equivalent of theft, provided any of the following requirements is met:
The promoter of the scheme, such as Madoff, was charged under federal or state law with the commission of fraud, embezzlement or a similar crime that would meet the definition of theft.
The promoter was the subject of a federal or state complaint alleging the commission of such a crime.
There was some evidence of an admission of guilt by the promoter, or a trustee was appointed to freeze the assets of the scheme
The IRS subsequently clarified the requirement that the promoter of the scheme must be charged with a crime. Revenue Procedure 2011-58 specifies that investors will be able to deduct their losses even if the lead figure has died.
Victims must establish that they invested solely with promoters and not indirectly through so-called feeder funds, partnerships or other entities. It does not make any difference that indirect investors tend to have a lower net worth than victims who invest directly.
The bottom line is that the safe harbors cap the amount deductible for qualifying losses. The cap depends on whether investors are pursuing any third-party recoveries from persons other than the promoter of the scheme or are pursuing or intend to pursue such recoveries.
The ceilings are percentages of investors’ net investments, generally 95 percent for investors who don’t pursue any potential third-party recovery and 75 percent for investors who are pursuing such a recovery. Net investments are reduced by the amount of any actual recovery in the year the loss was discovered.
They’re also reduced by any recovery expected from private or other insurance, such as that provided by the Securities Investor Protection Corporation, an organization created by Congress in 1970. It’s an industry-financed outfit set up to pay investors as much as $500,000 (a pittance for the ultra wealthy) for theft or proven unauthorized trading in brokerage accounts when a brokerage firm fails.