Can an Investment Become a Theft for Tax Purposes?
The classic Ponzi scheme may soon be renamed the “Madoff scheme,” simply by virtue of the massive amount of money invested with Madoff. It is now known that Madoff, like his famous predecessor, Charles Ponzi, used monies given to him by new investors to pay prior investors promised returns on their earlier investments. Madoff, like Ponzi — and also allegedly like Arthur Nadel and others — robbed Peter to pay Paul. Their massive scams wrongfully deprived thousands of investors of billions of dollars.
This column addresses the characterization of an investment loss as a “theft” for federal income tax purposes under existing case law and under Revenue Procedure 2009-20, issued March 17, 2009, creating a “safe harbor” for treatment of certain losses from Ponzi schemes as theft losses for federal income tax purposes. Additional issues that are beyond the scope of this article include (but are not limited to) the privity requirement, the effect of an open-market transaction, and the timing of the deduction. In addition, determinations outside of the “safe harbor” are highly dependent upon the facts and circumstances and are subject to challenge by the Internal Revenue Service (IRS). Thus, if proceeding outside of the “safe harbor,” consideration should be given to the advisability of disclosure of the theft loss under §§6662 and 6664 of Internal Revenue Code of 1986, as amended (I.R.C.), for the purpose of minimizing exposure to certain tax penalties in the event the position does not survive a challenge by the IRS.
The Federal Income Tax Problem
For individual investors, the I.R.C. generally treats investment losses as capital losses, deductible only to the extent of $3,000 in excess of the capital gain experienced by the taxpayer for the year in question.1 Even though the excess capital loss may be carried forward to later tax years, the deductibility of these losses is still subject to the same limitations.2 In addition, because a capital gain is only experienced upon the sale or exchange of property,3 capital gains are less likely to be recurring income. Thus, there is the potential that these losses may never be utilized in the investor’s lifetime.
Theft losses, on the other hand, are not limited in the same manner that capital losses are limited. More importantly, a theft loss can be used by individuals as a deduction against ordinary income to the extent that the theft loss is not covered by insurance or otherwise.4 Ordinary income, of course, is more likely to be recurring, substantial, and taxed at higher marginal rates. Thus, a theft loss deduction can give the victim of a fraudulent investment scheme greater, more immediate relief than can a capital loss deduction. But, is it proper under federal income tax law to treat an investment loss as a theft loss? The answer for victims of Ponzi schemes is often “yes.” For victims of other kinds of investment loss caused by securities fraud or other wrongdoing, “theft loss” treatment, though possible, is more difficult.
Establishing a Theft under Federal Income Tax Laws
The Definition of “Theft” — The court in Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), provided what is the most often-cited definition of “theft” for purposes of I.R.C. §165, as follows:
[T]he word “theft” is not…a technical word of art with a narrowly defined meaning but is…a word of general and broad connotation, intended to cover. . . any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile…. [T]he exact nature of the crime…is of little importance so long as it amounts to theft.5
The broad approach of the Bromberg court to the definition of “theft” is reflected in the Treasury Regulations promulgated under I.R.C. §165, deeming “theft” to include, but “not be limited to, larceny, embezzlement, and robbery.”6
Whether a “theft” has occurred depends upon the law of the jurisdiction in which the loss was sustained.7 Either state or federal law can provide the requisite basis for establishing a theft loss to the extent applicable to the conduct at issue in the jurisdiction where the theft occurred.
And the record before us establishes that Livingstone’s fraud in obtaining money from petitioners brings this case within the applicable Florida criminal statute in respect of obtaining money by “false representations or pretense,” Fla. Stat., sec. 811.021(s), as well as within the provisions of the United States Code which makes it a crime to use the mails to defraud, 18 U.S.C., sec. 1341. The crime under either Florida or federal law was a “theft” within section 165 of the Internal Revenue Code.8
Furthermore, it is unnecessary that the perpetrator of the “theft” be convicted or charged with theft.9
Examples of Conduct Giving Rise to “Theft” for Purposes of I.R.C. §165 — The Bromberg court’s inclusion of “any other form of guile” within the ambit of “theft” for purposes of §165 is certainly broad enough to include the Ponzis, the Madoffs, and, allegedly, the Nadels. The court’s emphasis, in particular, on “swindling, false pretenses, and any other form of guile” potentially includes securities fraud within its scope. The IRS acknowledged this possibility in Chief Counsel Advice (CCA) 200811016.10
In CCA 200811016, the investors invested in Company X, a mortgage lending company. Company X was later acquired by Company Y, but Company X remained in existence and continued soliciting funds from investors. After some time, Company Y was staying afloat only through loans from Company X, and Company X was solvent only by treating its loans to Company Y as assets on its financial statements. Company X’s officers and directors misrepresented the financial condition of Company X in its financial statements and prospectuses, and the officers and directors were later criminally charged with securities fraud. In addition, at least one Company X officer was indicted for obtaining property by false pretenses under the applicable state law.
Chief counsel’s office opined that “these facts establish that a theft occurred,” notwithstanding the structure of the transactions. “[A] loss that is the direct result of fraud or theft is deductible under §165, even though the theft is accomplished through a purported borrowing or offer to sell a security.”11 The counsel’s office relied, in part, on Revenue Ruling 71-381, as follows:12
In Rev. Rul. 71-381, the taxpayer was induced to lend money to a corporation by fraudulent financial statements provided by the corporation’s president .. . . As a result, the president of the corporation was convicted by a court for violating the state securities law by issuing false and misleading financial documents.. . . [S]ince the money was obtained by false representations constituting a misdemeanor under state law, the taxpayer was entitled to a theft loss deduction.
Citing the requirements reflected in Revenue Ruling 71-381 of 1) reliance on the part of the investor and 2) specific intent to defraud or misappropriate monies, counsel’s office withheld a finding of theft as to any particular investor in Company X without additional facts.13
In Revenue Ruling 77-18, 1977-1 C.B. 46, the IRS similarly concluded that a theft loss occurred under circumstances in which a taxpayer received shares of stock in a company (Company X) in exchange for his shares of stock in another company (Company G) pursuant to a merger agreement between the two companies. Soon thereafter, Company X filed for bankruptcy. The bankruptcy trustee reported that the “primary goal of the fraud participants was to inflate. . . the market price of X’s stock. . . by reporting nonexistent income and assets on the corporate books and failing to record liabilities.”14
The law of the state in which the taxpayer in Revenue Ruling 77-18 resided included within its definition of “theft” the obtaining of property by false pretenses. Thus, the IRS concluded as follows:
In the instant case, false representations about the financial condition of X were made to G’s stockholders with the intent to induce them to vote for the merger. The responsible X officials knew of the falsity of the financial statements they issued. The stockholders of G relied upon the false financial statements at the time they decided to exchange their stock for X stock which was worth substantially less than was represented. The exchange was a theft by false pretenses under the laws of. . . [the state] and therefore, meets the definition of theft for Federal Income tax purposes.15
A number of states include the obtaining of property by false pretenses within their definition of theft.16 Thus, in those states, circumstances that give rise (or would give rise) to a charge of theft by false pretenses would be favorable to a characterization of “theft” under I.R.C. §165.
In Vietzke v. Commissioner, 37 T.C. 504 (1961), the Tax Court upheld the taxpayer’s “theft loss” treatment for funds invested in what was purported to be an insurance company directly through the company principals. Contrary to the representations in the prospectus, the stock and the company were not properly registered. The company principals were criminally indicted on charges of violating Indiana securities law by selling unregistered securities through an unregistered agent. The Tax Court rejected the IRS’s claim that the company principals lacked criminal intent, finding as follows: “To the contrary, we view it as a blundering but intentional attempt on the part of. . . [the principals] to increase their personal resources without benefit of law. We agree with. . . [the taxpayer’s] contention that he was swindled.”17
Fortunately for the taxpayer in this case, the Tax Court found that the perpetrators were not fumbling fools, but felonious villains.
Interestingly, the Tax Court in Vietzke did not rely on the elements of the crime with which the principals were charged (i.e., the sale of unregistered securities) in concluding that the taxpayer had suffered a theft loss. Nor did the Tax Court rely on the statutory crime of theft under Indiana law, having found none denoted “theft” per se. Instead, the Tax Court pointed to the broad definition of “theft” established by the Bromberg court.18 The court was simply satisfied that, based on the facts, the principals acted with a criminal intent to deprive the taxpayer/investor of his funds.
The IRS agreed that churning of, and unauthorized transactions in, the taxpayer’s brokerage account by his broker constituted “theft” under the applicable state law for purposes of I.R.C. §165 in Jeppsen v. Commissioner, 70 T.C.M. (CCH) 199, 1995 WL 440435 (1995).19 There, the taxpayer, a carpet installer, invested monies he was saving with a nationally recognized brokerage firm. The broker 1) falsified the taxpayer’s new account documents, labeling him an experienced investor; 2) engaged in unauthorized transactions, including purchasing stocks on margin; and 3) churned the taxpayer’s account. Although finding the conduct constituted “theft,” the court nonetheless denied the “theft loss” deduction for the year in which the taxpayer claimed it as, in that year, the taxpayer was exploring the possibility of filing a lawsuit against the brokerage firms involved. Thus, the taxpayer’s claim of a “theft loss” was premature, as he retained and was pursuing a reasonable prospect of recovering his loss.20
The Use of Judicial Estoppel to Support a “Theft” Characterization — The test for “theft” characterization under I.R.C. §165, as previously explained, is not dependent upon a criminal indictment or conviction. Rather, the test depends upon whether the conduct evidences a criminal appropriation of another’s property “by theft, false pretenses, and any other form of guile. . . without regard to the exact nature of the crime. . . . ”21Thus, there have been cases in which the IRS and courts have allowed “theft loss” treatment even in the absence of a criminal indictment or conviction of the perpetrators.22 Nonetheless, a criminal charge or conviction is helpful in supporting the specific intent required of the perpetrator.23
When there is a criminal conviction of, or a guilty plea from, the perpetrator of the fraud, the defrauded investor should be able to assert that the IRS is judicially estopped from contesting the characterization of the investment loss as a “theft loss” — if the federal government has successfully prosecuted the perpetrator for the conduct at issue. “Judicial estoppel ‘prevents a party from asserting a position in a legal proceeding that is contrary to a position previously taken in the same or earlier proceeding.’”24 The doctrine of judicial estoppel is similar to the doctrines of res judicata and collateral estoppel, which prevent parties from relitigating issues decided in prior proceedings by a court of competent jurisdiction.25 However,
[j]udicial estoppel focuses [only] on the relationship between a party and the courts and seeks to protect the integrity of the judicial process by preventing a party from successfully asserting one position before a court and then asserting a contradictory position before the same or another court merely because it is now in that party’s favor to do so.26
In Vincentini v. Commissioner, 96 T.C.M. 400 (CCH) (2008), the Tax Court applied judicial estoppel to prevent the IRS from denying that a theft occurred with respect to a taxpayer’s investment in a convoluted factoring program involving U.S. and Costa Rican participants. The federal government had successfully prosecuted the principals of the factoring program on various federal charges, including money laundering, mail and wire fraud, and aiding and assisting the filing of false income tax returns. Rejecting the IRS’s contention that the taxpayer was not a victim of theft, the Tax Court held as follows: “Because respondent’s position is inconsistent with the position asserted by the [g]overnment in the. . . criminal case, we conclude that the application of the doctrine of judicial estoppel is appropriate. Applying the doctrine, we hold that respondent is precluded from arguing that petitioner was not a victim of theft. . . . ”27
In short, because the federal government’s position in the criminal case was that the taxpayer was one of the victims of the fraud for which the government was prosecuting the principals of the factoring program, the federal government, through the IRS, was rightfully estopped from taking a contrary position in Tax Court.28
The Use of the IRS’s Safe Harbor for “Theft Loss” Treatment for Losses Resulting from Ponzi Schemes — On March 17, 2009, the IRS issued Revenue Procedure 2009-20,29 creating an optional “safe harbor” for treatment of certain investment losses as “theft losses” (think Madoff). Under this procedure, if the taxpayer elects the safe harbor, a “theft loss” is deemed to occur. The deemed theft loss, called a “qualified loss,” occurs when a taxpayer has invested in a “specified fraudulent arrangement” and one or more of the perpetrators has been criminally charged with one or more crimes that would meet the definition of “theft” for purposes of I.R.C. §165, provided certain other conditions are satisfied. This safe harbor treatment is available to losses for which the “discovery year,” as specifically defined in the procedure, is 2008 or later.
Establishing the Loss as a “Qualified Loss” — First, to utilize the safe harbor, the taxpayer must have invested in a “specified fraudulent arrangement.” A specified fraudulent arrangement is, generally speaking, a Ponzi scheme.30
Second, to utilize the safe harbor, one or more of the perpetrators must have been charged, criminally, by indictment, information, or complaint (not withdrawn or dismissed) under state or federal law. The criminal charges, as previously mentioned, must constitute “theft” under the law of the jurisdiction in which the theft occurred, consistent with the existing case law governing this issue.31 Third, if the charges are by complaint (versus indictment or information), then one of the following three factors must also be present: 1) the complaint must allege an “admission by the lead figure,” or 2)a receiver or trustee must have been appointed for the specified fraudulent arrangement, or 3) the assets of the specified fraudulent arrangement must have been frozen.32
In addition, the taxpayer must have “clean hands.” If the taxpayer had actual knowledge of the fraudulent nature of the arrangement prior to its “public outing,” the taxpayer cannot utilize the safe harbor. Nor is the safe harbor available to investors in tax shelters (as defined in I.R.C. §6662(d)(2)(C)(ii)) or to those who invested in the fraudulent arrangement through a fund or other entity.33 This latter restriction retains the IRS’s historic hostility to granting “theft loss” treatment to defrauded investors who were not in privity with the perpetrator of the fraud.
Year of Discovery of the Loss and Timing of the Deduction — Under I.R.C. §165(e), all theft losses are treated as sustained during the taxable year in which the taxpayer discovers the loss.34 Discovery of the theft, whether from a fraud, embezzlement, or other kind of misappropriation of the taxpayer’s property, has not, however, ended the query. Taxpayers also have had to grapple with the general limitation applicable to all losses subject to I.R.C. §165(a). That general limitation has required consideration of whether there exists a “reasonable prospect of recovery” from insurance or otherwise.35
If a reasonable prospect of recovery exists as to part of a theft loss, then a deduction as to that part of the loss is unavailable until the year in which it can be determined, with reasonable certainty, that no recovery or reimbursement will be received.36 These two issues — whether a “reasonable prospect of recovery” exists and whether it can be “ascertained with reasonable certainty” that no recovery or reimbursement will be received — have generated much litigation, because they are based upon the facts and circumstances of each case.
For victims of Ponzi schemes who choose the safe harbor provisions of Revenue Procedure 2009-20, the uncertainty concerning the timing of the deduction is eliminated. Under the procedure, the year of discovery of the loss of a “qualified investment” is also the year that the “amount to be deducted” can be deducted. The “discovery year” is the year in which occurs the previously described criminal indictment, information, or complaint.37
The amount deductible in the discovery year is determined by simply applying one of two fixed percentages to the “qualified investment.” Subject to certain exclusions, “qualified investment” generally means all amounts (cash or basis of property) invested in the fraudulent arrangement, plus income from the arrangement previously included in income for federal tax purposes over amounts of cash or other property withdrawn from the arrangement, whether designated principal or income.38
If recovery is not pursued against “potential third parties,” 95 percent of the qualified investment is considered in the year of discovery. If recovery is being, or intended to be, pursued from “potential third parties,”39 then 75 percent of the “qualified investment” is considered in the year of discovery. The product of whichever of the foregoing formulas applies is then reduced by the following: 1) any actual recovery, 2) any actual or potential claim for reimbursement under the qualified investor’s insurance policy, 3) any actual or potential claim for reimbursement under contractual arrangements (other than insurance), and 4) any actual or potential insurance recovery from SIPC.40 The resulting amount is then available as a deduction in the year of discovery.41
If a taxpayer electing safe harbor treatment later recovers amounts in excess of the amount of qualified investment deducted under the safe harbor, that excess amount is includible in income under the tax benefit rule. Likewise, an additional deduction may be available in a later year provided that the additional deduction has been determined, with reasonable certainty, to be nonrecoverable.42 Unfortunately, as previously mentioned, the application of the “determined with reasonable certainty” test is fact-intensive and troublesome. Fortunately, under the safe harbor, the taxpayer escapes this troublesome query for much of the theft loss.
Special Filing Requirements — A taxpayer qualifying for, and electing, the safe harbor treatment of Revenue Procedure 2009-20 must complete a statement in the form of the statement attached as Appendix A to the revenue procedure. The statement is filed with the taxpayer’s federal income tax return for the discovery year, along with IRS Form 4684 (casualties and thefts), which is to be completed in accordance with §6.01 of the revenue procedure. Lastly, taxpayers who elect not to apply the safe harbor treatment of Revenue Procedure 2009-20 are subject to all of the requirements for establishing a theft loss under existing law.43
Investment fraud has dire consequences for those defrauded. It can mean the loss of a lifetime of savings, the burden of unpaid bills, and the prospect of working well beyond an age of physical capability. Whether it occurs through the unauthorized churning of an investor’s account, the presentation of fraudulent financial statements, or the “stealing from Peter to pay Paul” found in the classic Ponzi scheme, it is right for the IRS to provide investors robbed in this fashion the same relief provided other victims of theft. Unfortunately, many more situations fall outside of the safe harbor of Revenue Procedure 2009-20 than fall within it. It is incumbent upon the taxpayer taking a “theft loss” resulting from an investment arrangement, whether within or without the safe harbor, to be sure that the “theft loss” deduction is well supported.
1 I.R.C. §1211(b).
3 See I.R.C. §1221.
4 I.R.C. §165(a),(c). In addition, in Rev. Rul. 2009-9 (March 17, 2009), the IRS announced its position that “theft losses” resulting from investment transactions are deductible under I.R.C. §165(c)(2) rather than (c)(3) and, thus, not subject to the limitations of I.R.C. §165(h), limiting certain losses to the excess of $100 and 10 percent of adjusted gross income. The IRS also took the position that “theft losses” resulting from investments are not subject to the limitations on itemized deductions found in I.R.C. §§67 and 68.
5 Bromberg, 232 F.2d at 110-11(emphasis added).
6 Treas. Reg. §1.165-8(d).
7 MTS International, Inc. v. Commissioner, 169 F.3d 1018, 1021 (6th Cir. 1999); Bromberg, 232 F.2d at 111.
8 Nichols v. Commissioner, 43 T.C. 842, 884-85 (1965) (emphasis added). See also Vincentini v. Commissioner, 96 T.C.M. 400 (CCH), 2008 WL 5137345 at *4-5 (Dec. 8, 2008) (“A violation of a [f]ederal criminal statute may also establish that a theft occurred for purposes of section 165.”).
9 Skolnik v. Commissioner, 55 T.C. 1055, 1062 (1971); Martin v. Commissioner, 55 T.C.M. (CCH) (1988).
10 IRS Chief Counsel Advice, 2008 WL 686354 (March 14, 2008).
11 Id. (citations omitted).
12 Rev. Rul. 71-381, 1971-2 C.B. 126 is obsolete as the result of Rev. Rul. 2009-09 to the extent that it finds theft losses associated with transactions entered into for profit deductible under §165(c)(3) rather than §165(c)(2).
13 CCA 200811016 (emphasis added).
15 Id. (emphasis added).
16 See, e.g., Cal. Penal Code §584.
17 Vietzke, 37 T.C. at 510-511.
18 Id. at 511.
19 Jeppsen, 1995 WL 440435 at *4-5.
20 Id. at *6, aff’d, 128 F.3d 1410 (10th Cir. 1997).
21 Bromberg, 232 F.2d at 110-11.
22 See, e.g., Rev. Rul. 77-18 (theft loss from stock exchanged pursuant to merger in reliance on false statements and representations
regarding merged company’s financial condition).
23 Rev. Rul. 72-112, 1972-1 C.B. 60.
24 Hall v. GE Plastic Pacific PTE LTD, 327 F.3d 391, 396 (5th Cir. 2003).
25 See 47 Am. Jur. 2d, Judgments §464 (2006).
26 Vincentini, 96 T.C.M. 400 (CCH), 2008 WL 5137345 at *5.
27 Id. at *6.
28 Id. The taxpayer in Vincentini lost on the issue of the timing of his “theft loss” deduction. He failed to establish that, in the year that he took his deduction, he was without a reasonable prospect of recovery.
29 Rev. Proc. 2009-20, 2009 WL 678785 (March 17, 2009).
30 Id. at §4.01.
31 See Rev. Rul. 2009-9 (citing Bromberg’s broad definition of “theft”).
32 Rev. Proc. 2009-20, §4.02.
33 Rev. Proc. 2009-20, §4.03. Presumably, investors who invested in Ponzi schemes through flow-through entities would be able to benefit from a pass-through of a theft loss deduction, a topic beyond the scope of this column.
34 This “discovery rule” puts theft losses on par with casualty losses, as a theft loss from, for example, fraud, might not be discovered until years after the actual wrongdoing. See Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795, 808-812 (March 25, 1974).
35 Id.; Treas. Reg. §1.165-1(d)(3).
36 Treas. Reg. §1.165-1(d); Johnson v. U.S., 80 Fed. Cl. 96, 119-121 (2008).
37 Rev. Proc. 2009-20 at §4.04.
38 Id. at §4.06.
39 Excluded from the definition of “potential third-party recovery,” are actual or potential claims against various sources of recovery, including 1) the investor’s insurance company, 2) the Securities Investor Protection Corporation (SIPC), 3) other entities or parties contractually bound to cover the loss, 4) the perpetrators of the fraud, and 5) receiverships or similar arrangements established with respect to the perpetrators of the fraud. Id. at §4.10. Thus, it is possible to pursue claims against the foregoing excluded sources and still deduct 95 percent of the qualified investment, subject to reductions for actual recovery and potential insurance or SIPC recovery.
40 Rev. Proc. 2009-20 at §5.02.
41 See also Rev. Rul. 2009-9 for issues relating to the taxpayer’s basis and other related issues.
42 Rev. Proc. 2009-20 at §5.03.
43 One “gift” from the IRS to defrauded investors who either do not elect or qualify for safe harbor treatment is the IRS’s newly pronounced position on “phantom income.” Phantom income is income reported as income by the fraudulent arrangement, but not income in reality because the monies labeled “income” were derived from other investors and not from a return on the investment. If a defrauded taxpayer included the phantom income in income for purposes of federal taxes, the amount included will increase the taxpayer’s basis in the amount allowable as a theft loss. Id. at §8.02.
Jeffrey P. Coleman, president of the Coleman Law Firm since 1997, earned his law degree from Exeter University Law School, Exeter, England, and Marshall-Wythe at the College of William and Mary in 1985. He represents defrauded investors in cases involving securities fraud, misrepresentations, unauthorized transactions, unsuitable investments, inadequate due diligence, and “selling away,” among other cases of investment fraud and wrongdoing. He is also experienced in addressing tax issues related to cases involving securities and investment fraud.
Jennifer Newsom is an associate of Coleman Law Firm and a member of The Florida Bar Tax Section. She received her J.D., cum laude, from the University of Toledo, where she was a member of law review and received her LL.M. (taxation) from the University of Florida College of Law, Graduate Tax Program.
This column is submitted on behalf of the Tax Section, Frances D. McCoid Sheehy, chair, and Michael D. Miller and Benjamin Jablow, editors.