IRS guidance provides little tax benefit for thefts that hit retirement funds.
By Nancy B. Nichols, CPA, Ph.D., William M. VanDenburgh, Ph.D. and Luis Betancourt, CPA, Ph.D.
Ponzi schemes continue to come to light regularly. After 2008, when Bernard Madoff’s $65 billion Ponzi scheme was exposed, the SEC made comprehensive reforms to better detect fraud within the 11,000 regulated investment advisers and 8,000 mutual funds that it oversees, according to the SEC’s description of those reforms (tinyurl.com/2fu6eog). As a result of its increased enforcement efforts, in 2009 the SEC initiated 60 enforcement actions against alleged Ponzi schemes. They included Houston financier Robert Allen Stanford’s alleged $8 billion ruse.
In each of these cases, besides their monetary losses, alleged victims face tax implications that CPAs can help untangle. This article describes tax guidance regarding the treatment of Ponzi-scheme losses from both federal and state tax perspectives. In 2009 the IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20. This guidance allowed favorable tax treatment and safe harbor elections for direct investors (see “Deducting Losses for Defrauded Investors,” The Tax Adviser, July 2009, page 442). Unfortunately, the favorable tax treatment applies only to “qualified” investors (defined below). Indirect investors that invested through IRAs and other tax deferred accounts will realize tax benefits only in certain cases, and the deduction may be deferred for years.
SEC-INVESTIGATED PONZI SCHEMES
An examination of SEC press releases between Jan. 1, 2009, and July 31, 2010, found 31 announcements of complaints filed against alleged Ponzi-scheme frauds. The size of the alleged frauds ranged from $800,000 to $8 billion. The number of investors allegedly defrauded in each scheme ranged from 12 to more than 800, with an average estimated potential loss of $867,522 per investor. Geographically, Florida and California tied for first place in the number of alleged Ponzi-scheme frauds with six each, followed by New York with five and Colorado with two. Exhibit 1 lists the 10 largest alleged Ponzi-scheme frauds between Jan. 1, 2009, and July 31, 2010, based on SEC complaints.
In reviewing the alleged frauds we found a large number that targeted retirees, including one that was brazen enough to target federal law enforcement retirees and another targeting approximately 80 retired Los Angeles Metro bus drivers. Clearly, the Madoff fraud is not the end of the Ponzi-scheme story, and retirement funds are a rich target for those perpetrating these frauds.
IRS GUIDANCE AND SAFE HARBOR ELECTION
Revenue Ruling 2009-9 addressed the amount, character and timing of investment theft losses, and Revenue Procedure 2009-20 provided a safe harbor for taxpayers reporting them. The guidance addressed the character of the loss, the appropriate year for deducting the loss and how to determine the amount of the loss.
Such losses must be “qualified losses” from “specified fraudulent arrangements,” defined as those in which a party receives cash or property from investors, reports false investment income amounts to the investors and appropriates some or all of the investors’ cash or property. Such arrangements often take the form of Ponzi schemes, the IRS stated. A qualified loss is one caused by a specified fraudulent arrangement and resulting in a federal or state criminal charge of theft (larceny, embezzlement, robbery and similar offenses) or criminal complaint making such allegations. A complaint must also allege that the perpetrator admitted the conduct, or there must have been a receiver or trustee appointed with respect to the arrangement or its assets must have been frozen.
The ruling held that when a direct investor opens an investment account, it is considered a transaction entered into for profit under IRC § 165(c)(2) and thus not subject to adjusted gross income (AGI) limits under section 165(h) applicable to personal casualty or theft losses ($100 floor and 10%-of-AGI threshold). Nor is it subject to the section 67 itemized deduction threshold of 2% of AGI or the section 68 AGI phaseout of itemized deductions. The loss is reported on Form 4684, Casualties and Thefts, Section B (“Business and Income-Producing Property”), rather than Section A (“Personal Use Property”).
Unreimbursed theft losses generally are deductible in the tax year they are discovered. If the taxpayer has a claim for reimbursement by insurance or otherwise and there is a reasonable prospect of recovery, the deduction is deferred until the year it can be determined with reasonable certainty whether a reimbursement will be received (Treas. Reg. § 1.165-8(a)(2)). However, recognizing the inherent difficulty of making such determinations in the context of Ponzi schemes, Revenue Procedure 2009-20 provided safe harbor elections for the timing and the amount of a deduction. The loss is considered discovered and deductible when charges are brought and guilt is implied. The safe harbor amount is:
(1) The “qualified investment” multiplied by
(a) 95% if the investor does not pursue any third-party recovery, or
(b) 75% if the investor intends to pursue any third-party recovery,
(2) Less any actual recovery and any potential recovery from insurance or the Securities Investor Protection Corp.
The “qualified investment” is defined in the revenue procedure as the initial investment made by a “qualified investor,” plus any additional investments, plus any “phantom income” (income reported for tax purposes prior to the year of discovery of the fraud), less any withdrawals. A qualified investor is a U.S. person that generally qualifies to deduct theft losses and invested directly into a fraudulent investment arrangement but lacked actual knowledge of the fraudulent nature of the arrangement before it became known to the general public. The investment arrangement must not have been a tax shelter as defined by section 6662(d)(2)(C)(ii). Unfortunately, if a taxpayer invests in a Ponzi scheme through a qualified retirement plan, these beneficial rules generally do not apply.
Example 1: Qualified investors. Wayne and Sue Nelson are a retired couple, both over age 65, with pension and investment income. They originally invested $200,000 of nonretirement account funds in a Ponzi scheme that was discovered in 2010. Over the previous four years, they reported a total of $100,000 in taxable income from the investment. The Nelsons reinvested all the earnings and meet the definition of qualified investors. They are eligible to determine their loss under the safe harbor rules. Their qualified investment amount is $300,000 ($200,000 + $100,000). Since the Nelsons are not seeking any third-party recovery, their allowed deduction equals $285,000, or 95% of the qualified investment of $300,000. Exhibit 2 includes the remainder of the Nelsons’ 2010 income and expense information.
Because the Nelsons are direct investors, they have a deductible loss of $285,000, which results in a net operating loss (NOL). Additionally, this loss deduction is not added back when determining their alternative minimum taxable income (AMTI).
NET OPERATING LOSSES
In the prior example, the Nelsons’ NOL is their loss of $234,700 before personal exemptions. Because theft losses can be carried back three years under section 172(b)(1)(F), the Nelsons can carry back the loss to 2007, 2008 and 2009 (in 2008 and 2009, Ponzi-scheme NOLs could be carried back up to five years). Any remaining NOL can be carried forward for 20 years. The Nelsons could also elect not to carry back the loss and only carry the loss forward for 20 years. Most taxpayers will decide to carry the loss back to receive a current refund of taxes paid in prior years. Also, for investors left with large NOL carryforwards, tax planning should focus on generating taxable income that can be offset by the remaining loss. For example, those age 59½ or older should consider taxable IRA withdrawals. Instead of waiting until age 70½ to start taking the minimum required distributions, taxpayers can withdraw from the IRA and pay no tax on the distribution by using the NOL carryforward. This will reduce the minimum required distribution in later years when the NOL is no longer available.
Many factors, including the age of the taxpayer, other available funds and the size of the NOL carryforward will determine whether extended family tax planning should focus on shifting income to the taxpayers with the NOL carryforward. However, if taxpayers believe that tax rates may increase in future years or that they will be in a higher tax bracket, then an election to carry forward the loss may be appropriate. A present value calculation of the two alternatives can assist the taxpayer in determining whether to forgo the carryback.
On July 29, 2009, the Treasury Department sent a letter to four members of the House of Representatives responding to their questions regarding Ponzi losses of indirect investors (IRS information letter 2009-0154). The letter addressed the tax impact of Ponzi losses on IRAs and similar tax-deferred investment vehicles. Most taxpayers who invested in a Ponzi scheme through a retirement account will receive little or no tax benefit from these losses.
The letter explains that only taxpayers with basis in their IRA or other tax-favored retirement account after the entire interest in the plan is distributed may eventually realize some tax benefit from the loss. To have basis in the account, a taxpayer must have made after-tax contributions to the account. Moreover, the loss is treated as a miscellaneous itemized deduction to the extent the taxpayer has unrecovered basis after the entire interest in the plan is distributed. As such, the deduction is limited by the 2%-of-AGI threshold and is not allowed for AMT purposes. If the loss was incurred in an IRA, the aggregate amounts in all the taxpayer’s IRAs of the same type must be distributed before the loss can be claimed. This will significantly delay the deduction for most taxpayers, drastically reducing the present value of the tax benefit.
Example 2: IRA investors. Assume the same facts as in Example 1. However, this time the investment was made through a traditional IRA where the Nelsons have $10,000 of basis in the account. Exhibit 3 shows the unfavorable tax results for the Nelsons.
Because they are indirect investors, instead of a deductible loss of $285,000, the Nelsons have a miscellaneous itemized deduction of only $8,884. Additionally, the taxes and miscellaneous itemized deductions would be added back to determine AMTI.
While the safe harbor provisions of Revenue Procedure 2009-20 apply only to taxpayers who invested directly with the perpetrators of the scheme, IRS information letter 2009-0154 explains that theft losses incurred by pass-through entities can be ratably deducted by the partners or other owners who are indirect investors via pass-through entities. The direct investor (partnership) may elect the safe harbor, calculate the loss amount and then allocate the loss to the partners, who may deduct their allocated portion of the loss on Schedule K-1.
STATE TAX CONSIDERATIONS
Most states with an individual income tax start with an income figure from the individual’s federal tax return, typically either federal taxable income or federal AGI. In the former, Ponzi losses will generally be reflected in the number flowing from taxpayers’ federal tax return, often resulting in a state NOL.
Eight states have adopted specific guidance regarding the tax treatment of Ponzi losses (see sidebar, “State Guidance Regarding Ponzi-Scheme Losses,” at bottom of page). Some states base taxable income on federal AGI with no allowance for itemized deductions. In these states, taxpayers may be unable to deduct a Ponzi-scheme loss. Two states (New Hampshire and Tennessee) have only an interest and dividends tax. In these two states, taxpayers should consider filing amended returns for the last three years, taking the position that the amounts reported as dividends and interest were either phantom income or a return of capital and therefore not taxable.
STATE NET OPERATING LOSSES
Many states follow the federal net operating loss carryback and carryforward periods. Section 172(b)(1)(F)(i) provides a three-year carryback for the portion of an NOL attributable to a theft loss (and section 172(b)(1)(A) provides the 20-year carryforward general rule). Taxpayers carrying back an NOL for federal tax purposes should file state amended returns where possible to carry back the loss for state purposes.
Three states—Delaware, Kansas and Idaho—limit the NOL carryback. Delaware limits it to $30,000, and Idaho to $100,000. Kansas has an unusual statute, allowing a three-year NOL carryback, but only after a 10-year loss carryforward expires. Kansas residents will need to retain copies of their state tax returns for the loss year and the carryback period until the NOL has been fully utilized.
Other states do not allow NOL carrybacks but do provide an option to carry forward the loss. These states include Arkansas, Kentucky, Maine, New Mexico, Rhode Island, South Carolina, Vermont and Wisconsin. For a list of states and a summary of their provisions with respect to itemized deductions for a theft loss in a current tax year, plus carryback and carryforward periods, click here (PDF).
State Guidance Regarding Ponzi-Scheme Losses
The following paragraphs summarize state guidance on Ponzi-scheme losses for the eight states that have issued specific guidance.
California issued guidance on theft-loss deductions in March 2009 (tinyurl.com/39yzmzc). The guidance indicated that the state will allow taxpayers to follow Revenue Ruling 2009-9 and Revenue Procedure 2009-20. However, taxpayers that adopt the safe harbor for federal purposes are not required to make the adoption for Calif. purposes. Current Calif. law did not allow NOL carrybacks for 2010 but is allowing them again beginning in 2013, when the NOL deduction may be carried back two years; it will be phased in gradually, allowing a carryback of 50% of the NOL from 2013, 75% of the NOL from 2014, and all of the NOL from 2015.
Connecticut issued guidance on reporting Ponzi-scheme losses in Announcement 2009(7) (tinyurl.com/2bgraf2). Since the state does not allow itemized deductions, the theft-loss deduction will not reduce Conn. taxable income. However, if the theft-loss deduction creates a federal NOL carryback, then the individual must file amended Conn. returns for the years to which the NOL was carried back for federal tax purposes. If a taxpayer did not elect the safe harbor provisions of Revenue Procedure 2009-20 and chose to file amended federal income tax returns to eliminate the phantom income, then the taxpayer must also file amended Conn. returns.
Hawaii issued Announcement no. 2009-31 in October 2009 (tinyurl.com/26k3tpu). Hawaii law generally conforms to federal law. Therefore, Revenue Ruling 2009-9 and Revenue Procedure 2009-20 apply.
Idaho issued guidance in December 2009 (tinyurl.com/2vng6ne). Idaho law follows the federal determination of the year of the loss and the loss amount. Federal itemized deductions (less state and local income/sales taxes) are allowed on the Idaho return, so the theft loss will reduce Idaho taxable income in the year of loss. Although Idaho law allows an NOL carryback of two years (not the three-year federal NOL carryback), the NOL must be recalculated. In determining the Idaho NOL, itemized deductions are added back, except for casualty losses allowed under federal section 165(c)(3) on property physically located in Idaho. Therefore, the theft loss must be added back when calculating the Idaho NOL (Idaho Code § 63-3021). If a taxpayer does not elect the safe harbor under Revenue Procedure 2009-20 and files amended federal returns to eliminate the phantom income, then the taxpayer should also file Idaho amended returns.
Massachusetts did not adopt the provisions of Revenue Ruling 2009-9 and Revenue Procedure 2009-20 because the state’s personal income tax statute does not allow the federal deduction for theft loss under IRC § 165 (tinyurl.com/dmzgzv). In addition, Massachusetts does not allow an NOL deduction. However, an individual investor in Massachusetts may receive a benefit from the loss in two ways: First, a taxpayer may file an application for abatement for open years to exclude phantom income previously taxed. Second, based on the definitions in Revenue Procedure 2009-20, a taxpayer with a “qualified loss” from a “specified fraudulent arrangement” may recognize a capital loss deduction when the loss is ultimately sustained. The capital loss may be claimed in the year the asset becomes worthless. A Ponzi-scheme investment is considered worthless when there is no reasonable prospect of any recovery (or further recovery) and when the investment has no current liquidating or potential value.
New Jersey issued updated guidance on Ponzi schemes in April 2010 (tinyurl.com/2u3gq5y). Under N.J. law, taxpayers claim losses under their federal accounting method including basis rules. Since N.J. does not allow itemized deductions, it does not have a theft-loss provision. However, investment losses may be claimed under NJSA 54A:5-1.c, “Net gains or income from disposition of property.” N.J. taxpayers should claim the investment loss in the same year they claim the theft loss for federal tax purposes. The investment loss can only offset net income in the same category, so the benefit of the loss is limited to the net gain or income from the disposition of property. New Jersey does not allow carrybacks or carryforwards of losses and prohibits amended returns to eliminate undistributed or phantom income.
New York issued guidance (TSB-M-09(7)I) in May 2009 (tinyurl.com/2g7sbkv) indicating that it would recognize the safe harbor under Revenue Procedure 2009-20. Taxpayers using the safe harbor provisions to calculate their federal theft-loss deduction are allowed to use the same amount in computing their N.Y. itemized deduction. The theft-loss deduction would still be subject to the state’s itemized deduction reduction. Itemized deductions are reduced by up to (a) 25% for single taxpayers with N.Y. AGI in excess of $100,000, married taxpayers filing jointly with N.Y. AGI in excess of $200,000, and heads of household with N.Y. AGI in excess of $150,000; and (b) an additional 25% for taxpayers with N.Y. AGI in excess of $475,000.
Wisconsin issued guidance for taxpayers in September 2009 (tinyurl.com/375fjr7). Wisconsin does not allow a subtraction for itemized deductions. However, certain itemized deductions are used to compute an itemized deduction credit. Casualty and theft losses are not allowed in the computation of the Wisconsin credit; therefore, no benefit will be realized on the Wisconsin state return in the year of loss. Taxpayers may amend their open returns to exclude phantom income previously reported.
More than two years after the revelation of Bernard Madoff’s massive fraud, Ponzi schemes continue to come to light. Some have targeted investors of modest means, including workers’ retirement accounts.
The IRS has provided guidance and a safe harbor election that may prove beneficial for victims of Ponzi losses. An investment account is considered a transaction entered into for profit and therefore subject to deduction without regard to the $100 floor and threshold of 10% of adjusted gross income (AGI) applicable to losses of personal-use property. Nor is it subject to the 2%-of-AGI threshold for miscellaneous itemized deductions.
The guidance also provided relief for the timing and amount of loss recognition with respect to when the Ponzi loss was discovered and to reasonable certainty as to whether any reimbursement will be received by the taxpayer.
However, these beneficial provisions apply only to taxpayers that invested directly in the fraudulent scheme, which may put such relief beyond the reach of many retirement fund investors.
Tax planning for qualifying investors will include managing carrybacks and carryforwards of excess deductions from a Ponzi loss, relative to income and other deductions in past and future tax years.
Planning must also take into account states’ treatment of Ponzi losses for personal income taxes, which may differ from federal treatment in both current-year deduction of itemized expenses and length and conditions of carryover periods.
Nancy B. Nichols (email@example.com) is a professor of accounting, William M. VanDenburgh (firstname.lastname@example.org) is an assistant professor of accounting, and Luis Betancourt (email@example.com) is an assistant professor of accounting, all at James Madison University in Harrisonburg, Va.