Relief for Madoff Investors

by Steven M. Appel

The IRS has issued guidance in the form of a Revenue Ruling and a Revenue Procedure for investors who were victims of Madoff-type investment schemes. The relevant portions of the text are copied below. The guidance allows losses to be claimed as ordinary losses and even allows NOLs generated by the schemes to be treated as sole proprietorship losses potentially eligible to be carried back 3, 4, or 5 years under a business tax break enacted by the American Recovery and Reinvestment Act of 2009 (the "2009 Act"). Below is a summary of the Revenue Ruling and the Revenue Procedure.

The IRS concluded in Revenue Ruling 2009-9 that:

1. The investor's loss is a theft loss, which is an ordinary loss, not a capital loss.
2. The theft loss is an itemized deduction that is not subject to the limits on itemized deductions.
3. The victim may deduct the theft loss in the year the theft loss is discovered, provided that the loss is not covered by a claim for reimbursement or other recovery as to which the victim has a reasonable prospect of recovery. To the extent that the victim's deduction is reduced by such a claim, recoveries on the claim in a later taxable year are not includible in the victim's gross income. If the victim recovers a greater amount in a later year, or an amount that initially was not covered by a claim as to which there was a reasonable prospect of recovery, the recovery is includible in the victim's gross income in the later year under the tax benefit rule, to the extent the earlier deduction reduced A's income tax. Finally, if the victim recovers less than the amount that was covered by a claim as to which there was a reasonable prospect of recovery that reduced the deduction for theft in the year the loss was discovered, an additional deduction is allowed in the year the amount of recovery is ascertained with reasonable certainty.
4. The amount of the victim's theft loss includes the amounts invested and the amounts that the victim reported as gross income on income tax returns, and would be reduced by the amount of any money that had been distributed to the victim. If the victim has a claim for reimbursement with respect to which there is a reasonable prospect of recovery, he may not deduct the portion of the loss that is covered by the claim.
5. 5. To the extent the victim's theft loss deduction creates or increases a net operating loss in the year the loss is deducted, the victim may carry back the portion of the net operating loss attributable to the theft loss up to 3 years and forward up to 20 years. If the victim's loss is an applicable 2008 net operating loss the loss may qualify for a special election under the 2009 Act under which the victims may elect either a 3, 4, or 5-year net operating loss carryback for the applicable 2008 net operating loss.

Under Revenue Procedure 2009-20, the IRS provides an optional safe harbor treatment for taxpayers that experienced losses in certain investment arrangements discovered to be criminally fraudulent. The revenue procedure also describes how the Internal Revenue Service will treat a return that claims a deduction for such a loss and does not use the safe harbor treatment described in this revenue procedure.

Under Revenue Procedure 2009-20, the IRS provides safe harbor treatment under which it will not challenge the following treatment by a qualified investor of a qualified loss if certain procedures are followed:

1. The loss is deducted as a theft loss;
2. The taxable year in which the theft was discovered is the discovery year; and
3. The amount of the deduction is calculated as follows:
   1. Multiply the amount of the qualified investment by -
      1. 95 percent, for a qualified investor that does not pursue any potential third-party recovery; or
      2. 75 percent, for a qualified investor that is pursuing or intends to pursue any potential third-party recovery; and
   2. Subtract from this product the sum of any actual recovery and any potential insurance/SIPC recovery.

The amount of the deduction calculated above is not further reduced by potential direct recovery or potential third-party recovery.

The qualified investor may have income or an additional deduction in a year subsequent to the discovery year depending on the actual amount of the loss that is eventually recovered.

A qualified investor that uses the safe harbor treatment described above must-

1. Mark "Revenue Procedure 2009-20" at the top of the Form 4684, Casualties and Thefts, for the federal income tax return for the discovery year. The taxpayer must enter the "deductible theft loss" amount from line 10 in Part II of Appendix A of this revenue procedure on line 34, section B, Part I, of the Form 4684 and should not complete the remainder of section B, Part I, of the Form 4684;
2. Complete and sign a statement (provided in the revenue procedure); and
3. Attach the executed statement to the qualified investor's timely filed (including extensions) federal income tax return for the discovery year. If a taxpayer has filed a return before April 17, 2009 for the discovery year or an amended return for a prior year that is inconsistent with the safe harbor treatment provided by the revenue procedure, the taxpayer must indicate this fact on the executed statement and must attach the statement to the return (or amended return) for the discovery year that is consistent with the safe harbor treatment provided by this revenue procedure and that is filed on or before May 15, 2009.

By signing the statement provided in the revenue procedure, the taxpayer agrees-

1. Not to deduct in the discovery year any amount of the theft loss in excess of the deduction permitted by the revenue procedure; and
2. Not to file returns or amended returns to exclude or recharacterize income reported with respect to the investment arrangement in taxable years preceding the discovery year;

Revenue Procedure 2009-20 applies to losses for which the discovery year is a taxable year beginning after December 31, 2007.

A taxpayer that chooses not to apply the safe harbor treatment provided by this revenue procedure to a claimed theft loss is subject to all of the generally applicable provisions governing the deductibility of such loss. For example, a taxpayer seeking a theft loss deduction must establish that the loss was from theft and that the theft was discovered in the year the taxpayer claims the deduction. The taxpayer must also establish, through sufficient documentation, the amount of the claimed loss and must establish that no claim for reimbursement of any portion of the loss exists with respect to which there is a reasonable prospect of recovery in the taxable year in which the taxpayer claims the loss.

A taxpayer that chooses not to apply the safe harbor treatment of this revenue procedure to a claimed theft loss and that files or amends federal income tax returns for years prior to the discovery year to exclude amounts reported as income to the taxpayer from the investment arrangement must establish that the amounts sought to be excluded in fact were not income that was actually or constructively received by the taxpayer (or accrued by the taxpayer, in the case of a taxpayer using an accrual method of accounting). However, provided a taxpayer can establish the amount of net income from the investment arrangement that was reported and included in the taxpayer's gross income consistent with information received from the specified fraudulent arrangement in taxable years for which the statute of limitation on filing a claim for refund has expired, the Service will not challenge the taxpayer's inclusion of that amount in basis for determining the amount of any allowable theft loss, whether or not the income was genuine.

Returns claiming theft loss deductions from fraudulent investment arrangements are subject to examination by the Service.

Careful planning is required in determining an investment scheme victim's course of action in preparing income tax returns to recover tax benefits associated with the losses. Please note that the summary provided above is a general summary, and the Revenue Ruling and Revenue Procedure should be read to determine whether the benefits would be available to a particular investor.