IRS has privately ruled that a limited liability company (LLC) that filed tax returns as a partnership and conducted legitimate business activities, but which was defrauded of its property, was a “qualified investor” for purposes of claiming a theft loss deduction under IRS guidance issued to address victims of Madoff-type investment schemes. IRS further determined that, for purposes of claiming such a theft loss deduction, the discovery year was the year in which the individuals' fraudulent conduct became known to the general public.
Background. Code Sec. 165(a) allows a deduction for losses sustained during the taxable year and not compensated by insurance or otherwise. Under Code Sec. 165(e), a theft loss in a transaction entered into for profit is deductible in the year the loss is discovered, if the loss is not covered by a claim for reimbursement or recovery for which there is a reasonable prospect of recovery.
Rev Proc 2009-20, 2009-14 IRB 749, provides an optional safe harbor, applicable to losses that are discovered in a tax year beginning after Dec. 31, 2007, for “qualified investors” that experience losses in certain investment arrangements discovered to be criminally fraudulent.
Under Rev Proc 2009-20, a qualified investor is a U.S. person, as defined in Code Sec. 7701(a)(30) (which includes a domestic partnership):
... that generally qualifies to deduct theft losses under Code Sec. 165 and Reg. §1.165-8;
... that did not have actual knowledge of the fraudulent nature of the investment before it became known to the general public;
... with respect to which the specified fraudulent arrangement is not a tax shelter, as defined in Code Sec. 6662(d)(2)(C)(ii); and
... that transferred cash or property to a specified fraudulent arrangement.
A qualified investor does not include a person that invested solely in a fund or other entity (separate from the investor for federal income tax purposes) that invested in the specified fraudulent arrangement. However, the fund or entity itself may be a qualified investor within the scope of the revenue procedure.
Rev Proc 2009-20, Sec. 5.01, states that IRS won't challenge the following treatment by the qualified investor of a qualified loss:
... the loss is deducted as a theft loss;
... the taxable year in which the theft was discovered within the meaning of Code Sec. 165(e) is the “discovery year” (i.e., the tax year of the investor in which the indictment, information, or complaint is filed); and
... the amount of the deduction is 95% of the qualified investment (75% for a qualified investor that is pursuing, or intends to pursue, any potential third-party recovery), less the sum of any actual recovery and any potential insurance recovery.
Facts. LLC participated in legitimate business activities and filed as a partnership for tax purposes for each year of its existence. LLC sold its membership interests to investors and used the funds generated through the sale of membership interests to invest in loans originated by Company, the profits of which flowed through to the investors.
In Year 4, some of Company's loans began to default. The president and CEO of Company concealed this from investors and caused Company to continue to pay interest to investors regardless of whether the underlying borrowers had made loan payments. The bank account used by Company for these loans had insufficient funds to make payments to all of its investors, and Company's president and CEO began to look for sources of money to cover the shortage—for example, by not remitting principal payments to investors when borrowers paid off the loans, but instead making it appear that the borrowers had only made interest payments.
In Year 5, Company's president and CEO, who controlled LLC through several tiered entities from its formation until Date 6, caused LLC to create a fraudulent loan. The president directed a broker to form two entities to extract money from LLC via fraudulent loan transactions in order to fund the president's and CEO's private developments and other investment projects. Both entities served as conduits with no legitimate business purpose. In the end, the president and CEO defrauded LLC of its property and caused its funds to be misappropriated.
LLC continued to sell membership interests until Date 7 and allowed investors to reinvest their distributions until around Date 8. There is no indication that any of its partners, other than the entities managed by Company's president and CEO, had any knowledge of the fraudulent conduct before it became known to the general public.
On Date 6, Company and LLC filed for bankruptcy. As of the bankruptcy filing date, LLC had various legitimate note receivables from unrelated third parties. LLC emerged from bankruptcy in Year 7. Since the bankruptcy plan confirmation, LLC has been liquidating the estate, pursuing causes of action, and distributing proceeds to its investors. In Year 8, the U.S. Attorney filed a criminal information against Company's president, and he pled guilty to the undisclosed count charged.
Favorable ruling. IRS determined that LLC satisfies the requirements for a qualified investor under Rev Proc 2009-20, Sec. 4.03, for purposes of claiming the theft loss deduction. Consequently, LLC can rely on Rev Proc 2009-20’s safe harbor in claiming its theft loss deduction.
IRS based its determination on facts and representations that: (i) LLC is a U.S. person under Code Sec. 7701(a)(30) that generally qualifies to deduct theft losses under Code Sec. 165; (ii) there is no indication that the partners (other than those managed by Company's president and CEO) had any knowledge of the fraudulent conduct before it became known to the general public; (iii) the specified fraudulent arrangement was not a tax shelter under Code Sec. 6662(d)(2)(C)(ii); and (iv) Company's president and CEO caused LLC to transfer money to a specified fraudulent arrangement.
IRS further held that LLC's discovery year for purposes of Rev Proc 2009-20 is the taxable year in which the criminal information was filed by the U.S. Attorney against Company's president (i.e., Year 8).
However, IRS cautioned that it expressed no opinion as to whether the remaining requirements for claiming a theft loss under Rev Proc 2009-20 were satisfied.
References: For deductible theft losses, see FTC 2d/FIN ¶M-2100; United States Tax Reporter ¶1654.351; TaxDesk ¶367,001; TG ¶17000. For losses incurred in a transaction entered into for profit, see FTC 2d/FIN ¶M-1510; United States Tax Reporter ¶1654; TaxDesk ¶361,517; TG ¶1153.