Everyone wants their money to work for them and to invest it in a way that prepares them for retirement, but fear of Ponzi-like schemes is leading money away from private equity (PE) investments into more mainstream securities.
However, PE investors can gain some comfort from the clarity that the IRS has provided for claiming tax losses resulting from Ponzi-type schemes. Thanks to recent IRS-issued guidance — Revenue Ruling 2009-09 and Revenue Procedure 2009-20 — investors have been provided a safe-harbor method (an IRS approved method) of computing and reporting losses.
“These pronouncements are very taxpayer-friendly,” says Walter M. McGrail, JD, CPA, a senior manager at Cendrowski Selecky PC. “The IRS wanted to clarify its position for claiming losses on Ponzi-like schemes and white-collar crimes while alleviating some of the pain of those victimized by these acts.”
Smart Business spoke with McGrail about what the new IRS pronouncements mean for investors and how to use the rules to your advantage if you become a victim of fraud.
How can investors protect themselves from becoming a victim of these schemes in the first place?
Look at whether there is transparency with the investment. It’s cliché, but if it sounds too good to be true, it probably is.
But, if you are a victim and you want to be safe when claiming deductions, follow procedures, fill out the proper forms and make sure you comply with all safe harbor laws. Being prepared and knowledgeable before, during and after you make an investment is your best protection.
If an investor does fall victim to an investment scheme, how can Revenue Ruling 2009-09 help?
The IRS concluded that investment theft losses are not subject to the limitations otherwise applicable to personal, casualty and theft losses; that such loss is deductible in the year of discovery; and that the loss includes unrecovered investments and income reported in prior tax years.
Also, theft losses that result in net operating losses can be carried back two years and forward 20 years.
How can Revenue Procedure 2009-20 assist victims of fraud?
Revenue Procedure 2009-20 states that the IRS will deem the loss to be the result of theft if the promoter was charged with fraud or embezzlement.
There must also be some evidence of an admission of guilt, or a trustee who has been appointed to freeze the assets of the scheme. In the past, the determination of whether a deductible loss had occurred as the result of a criminal act involved a subjective determination of whether the person perpetrating the fraud had criminal intent. That is no longer a requirement.
There is now a safe harbor that permits taxpayers to deduct these losses based on the filing of criminal charges against the perpetrator.
How do you determine the value of the loss?
You get to take a loss for all amounts you invested, minus the amount of any actual recovery through the year of discovery. If you invested $100 and got $30 in distributions, you have a $70 loss that you can get back.
Also, any income from the investment that was included on previous years’ tax returns will increase the amount of your loss. Take that same $70 in the previous example and say you picked up $10 worth of income over the years. Then, $80 would be the amount of your loss. The loss is also adjusted by 5 to 25 percent to the extent of any recovery expected from insurance and from lawsuits against the parties involved.
In addition, the new pronouncements have clarified that taxpayers can deduct the losses in the year of discovery, in the year that the perpetrator is accused. Even if you made investments 10 or 15 years ago, you can deduct the loss in the year the fraud was alleged. So, if [Bernie] Madoff burned you, you could deduct the losses in 2008.
How does a taxpayer classify losses for tax purposes?
Capital losses — which can only be deducted against capital gains — are subject to more stringent limitations, and they can’t be carried back. Revenue Procedure 2009-20 made it clear that these types of losses are ordinary losses; they are deductible as itemized deductions and without regard to any limitations.
The IRS even went one step further by stating that these losses are not subject to the limitations of itemized deductions.
Typically, an itemized deduction is subject to a limitation of 2 to 3 percent of gross income. These safe-harbor-determined losses are deductible in full.
The character of the losses is also important because if the loss incurred is large enough to either put an investor into a net operating loss position or, when coupled with other losses, gives the person a deduction greater than overall income, such loss is classified as a business loss, which avoids complications and limitations in claiming refunds for operating losses.
WALTER M. McGRAIL, JD, CPA, is a senior manager at Cendrowski Selecky PC. Reach him at (248) 540-5760 or firstname.lastname@example.org.