In March of 2009, the Internal Revenue Service issued Rev. Rul. 2009-9 relating to the treatment of losses resulting from Ponzi schemes (for example, the Bernard Madoff fraud case).
Under this ruling,
- Ponzi scheme losses are considered theft losses from a transaction entered into for profit. The losses are not capital losses.
- The amount of a theft loss is the amount invested in the arrangement, less amounts withdrawn, if any, reduced by reimbursements or recoveries, and reduced by claims as to which there is a reasonable prospect of recovery. Where an amount is reported to the investor as income prior to discovery of the arrangement and the investor includes that amount in gross income and reinvests this amount in the arrangement, the amount of the theft loss is increased by the reinvested amount.
- The theft loss is claimed as a miscellaneous itemized deduction on federal Schedule A.
The Internal Revenue Service also issued Rev. Proc. 2009-20. This revenue procedure provided a safe harbor deduction for losses resulting from Ponzi Schemes. This revenue procedure allowed a percentage of the theft loss to be claimed in the year of discovery as a miscellaneous itemized deduction. However, a taxpayer that chooses not to apply the safe harbor treatment to a claimed theft loss and that files or amends federal income tax returns for open years prior to discovery to exclude amounts reported as income from the investment arrangement must show that the amounts were not income that was actually or constructively received by the taxpayer. This will not prevent the taxpayer from including the reported income from closed years in the basis for determining the allowable loss.
Individual investors - Wisconsin does not allow a subtraction for itemized deductions. Instead, certain federal itemized deductions are used in the computation of the itemized deduction credit. Wisconsin law does not allow federal miscellaneous deductions for purposes of the itemized deduction credit. Individuals who invested in a Ponzi scheme may not claim a theft loss deduction or any credit for losses reported on federal Schedule A.
Refunds will be allowed on amended returns filed for years open to adjustment to exclude "phantom income" previously reported as income from the investment arrangement provided the taxpayer can show that the amounts were not income that was actually or constructively received. Taxpayers should submit copies of statements showing reinvestment of the income.
Refunds requested on an amended return for years closed to adjustment will be denied.
Pass Through Entities - A partnership or S corporation may directly incur a theft loss from a Ponzi scheme. The theft loss is treated as an ordinary loss and flows through to the partners or shareholders and remains an ordinary loss (not a capital loss). The partnership or S corporation must inform the partner or shareholder on federal Schedule K-1 whether the loss is from trade or business property or income producing property.
If the loss is from trade or business property, the individual may deduct the loss in computing federal adjusted gross income on the individual's federal income tax return (line 14 of Form 1040). This deduction is also allowed for Wisconsin income tax purposes.
If the loss is from income producing property, for federal tax purposes the individual may only deduct the loss as a miscellaneous itemized deduction on federal Schedule A. No deduction or credit is allowed for Wisconsin for the amount that is claimed as a federal miscellaneous itemized deduction.
September 14, 2009