MEMORANDUM

RE: THE IRS & MADOFF INVESTORS: “THEFT LOSSES”

(PONZI SCHEMES)

On 3/17/09, IRS Commissioner Doug Shulman told the

Senate Finance Committee:
“. . . Thousands of Taxpayers have been victimized by
dozens of fraudulent investment schemes. These too-good-to-
be-true investment uses have often taken the form of so-called
“Ponzi schemes” (i.e., the fraud perpetrator promises
investments returns, some or all of which are fictitious) . . . The
Madoff scandal has affected a very large and diverse pool of
Investors, some of whom are reported to have lost most of their
life savings . . . To help provide clarity and to assist Taxpayers
the IRS is today issuing guidance articulating the tax rules that
apply and providing “safe harbor” procedures for Taxpayers
who sustained losses in certain investment arrangements
discovered to be criminally fraudulent.”
In response, the IRS issued Rev. Rul. 2009-9, Rev. Proc. 2009-
20 which allows Investors, defrauded by “Ponzi schemes” (including
Madoff’s “Ponzi scheme”) to claim an IRC §165(e) theft loss
deduction (i.e., ordinary loss deductions not a capital loss deduction
for their “qualified investment” (Rev. Proc. 2009-20, Sec 2.06).

(1) Rev. Rul. 2009-9

Under Rev. Rul. 2009-9 (as stated by IRS Commissioner Doug

Shulman, 3/17/09 Senate Finance Committee Appearance):
1. An Investor’s theft loss from a Ponzi scheme is a theft
loss, which is not a capital loss (i.e., the theft loss is not
subject to the normal limits on losses from investments,
which typically limit the loss deduction to $3,000 per year
when it exceeds capital gains from investments).

1
 2. “Investment” theft losses are not subject to limitations that
apply to “personal” casualty and theft losses (i.e., the loss
is deductible as an itemized deduction, but is not subject
to the test (10%) percent of AGI reduction or the $500
reduction (2009) that applies to many casualty and theft
loss deductions).
3. The theft loss is deductible in the year the fraud is
discovered (2008, in the Madoff case) (except to the
extent there is a claim with a reasonable prospect of
recovery).
The tax year in which the Investor discovers the theft (IRC
§164(e)) must be the same tax year in which an
indictment or similar allegation is made at the State or
Federal level against the promoter of the scheme (i.e., a
conviction is not required).
Under Rev. Rul. 2009-9 (Rev. Proc. 2009-20), the amount of the
theft loss is the “qualified investment” (i.e., amount of money invested
that was lost), plus post-2004 “phantom net income” from the
“investment” less reimbursement, or other compensation (see Rev.
Rul. 2009-9, Issue #7, limitation on “phantom income post-2004”).

(2) Rev. Proc. 2009-20

The IRS “Safe Harbor” (Rev. Proc. 2009-20) provides investors

with:
1. A uniform manner for determining their theft losses.
2. Alleviates Taxpayer compliance burdens.
3. Avoids evidentiary problems for fictitious income reported
(i.e., a return of capital).
Under the Rev. Proc. 2009-20 “safe harbor”, Investors may
claim tax deductions in the year that the theft was discovered (in the
Madoff case, Tax Year 2008). If the Investor does not declare the
theft loss in their original 2008 tax returns, with extensions, they may
declare the loss and amend their 2008 tax returns up to 3 years after
their tax returns were filed, with extensions (i.e., up to October 15,
2012).

2
 Under the “IRS safe harbor”, the tax deductions may be
claimed in an amount equal to 95% of their net loss (for
Investors who do not pursue 3rd third party claims) or 75% of
their net loss (for Investors who intend to pursue 3rd party claims
against advisors who referred the Madoff investment).
Under Rev. Rul. 2009-9, any recovery is includible in Taxpayer’s
gross income, under the tax benefit rule, to the extent the earlier
deduction reduced Taxpayer’s income tax (IRC §111, Treas. Reg.
Sec. 1.165-(d)(2)(iii)).
Taxpayers who invested in the Madoff scheme indirectly (e.g.,
through a “feeder fund”) will not directly report the tax loss. Instead
the feeder fund will report the loss and the Taxpayer will report their
allocable share of the loss on their individual tax return.

(3) No “Safe Harbor”

Taxpayers who do not apply the “safe harbor” treatment may

deduct pre-2005 “phantom income” and amend prior years’ tax
returns. (However, if there is no safe harbor election, tax returns
claiming theft loss deductions from fraudulent investment
arrangements are subject to examination by the IRS.)
Rev. Proc. 2009-20: “If the Taxpayer can establish the amount
of net income from the investment arrangement, reported on tax
returns, consistent with information received from the specified
fraudulent arrangement in taxable years for which the period of
limitation on filing a claim for refund under IRC §6511 has expired,
the IRS 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.”

(4) Tax-Loss Carry Forward (20 years)/Carry Back (5 years)

If the theft losses result in a 2008 net operating loss, the

Taxpayer may:
1. Carry the loss forward 20 years.
2. Carry the loss back up to five tax years (and receive tax
refunds). The five year loss carry-back rule requires that
Taxpayer does not have more than $15M in average
gross income for the 3 year period ending in which the

3
 loss occurs (IRC §172(b)(1)(H)(iv)), as amended by
Section 1211 of the American Recovery and
Reinvestment Act of 2009, Pub. L. No. 111-5, 123 Stat.
115 (Feb. 17, 2009).

Gary S. Wolfe
A PROFESSIONAL LAW CORPORATION
9100 Wilshire Blvd., Suite 530 East
Beverly Hills, CA, 90212
Tel: 310-274-8847 Fax: 310-274-3118
http://www.gswlaw.com
email: gsw@gswlaw.com