The information below should not be used in any actual transaction without the advice and guidance of a professional tax adviser familiar with all the relevant facts. Although the information below is presented in good faith and believed to be correct, it is general in nature and is not intended as tax advice. The information below may not be applicable to or suitable for an individual's specific circumstances and may require consideration of other matters.
The IRS has confirmed that victims of the PFGBest fraud can access the optional safe harbor mechanism set forth in Revenue Procedure 2009-20 so that victims can claim their losses as theft losses. Responding to the CCC's request for guidance, the IRS stated in a letter:
...the PFGBest scheme qualifies as a "specified fraudulent arrangement" within the meaning of Revenue Procedure 2009-20. Thus, investors who otherwise meet the requirements of Revenue Procedure 2009-20 may use the safe harbor, following the procedures as set forth in that revenue procedure.
The full response is posted below, along with the documents necessary to utilize this mechanism. Please note: it is not required that PFGBest victims use this procedure. It may not provide the best solution for your particular tax situation. Claimants in the PFGBest case are urged to consult their tax professionals as soon as practicable to determine if it is appropriate and wise to seek relief under the safe harbor deduction for theft losses. You may need to provide the following documents to your tax advisor:
- IRS Response to CCC
- Revenue Ruling 2009-09: HTML Version | PDF Version
- Revenue Procedure 2009-20: HTML Version | PDF Version
- CCC Request to IRS
- Wassendorf Plea Agreement
- Wassendorf Judgement
There are several mechanisms through which the IRS can clarify the application of tax law to particular factual situations. One of these is a Revenue Ruling. Revenue Rulings are public administrative rulings by the IRS in which the IRS clarifies its position on a given set of facts. A Revenue Procedure will generally provide filing instructions relating to the issues in a Revenue Ruling. Unlike a private letter ruling in which a taxpayer seeks advice for his particular tax situation, these rulings can be relied upon as precedent by all taxpayers, should their factual situation meet the elements established in the ruling.
The IRS issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20 in response to uncertainty surrounding the tax treatment of losses incurred as a result of the Madoff Ponzi scheme. Some CCC members thought there may be a tax benefit for some PFGBest victims if they were able to use Revenue Procedure 2009-20 for their losses, but it was uncertain if the fact pattern of the PFGBest fraud met the standards of Revenue Ruling 2009-9. The CCC wrote a letter to the IRS requesting clarification on the matter and had a conference call with staff of the Office of General Counsel of the IRS.
Our conversation with IRS staff revealed that the IRS intended Revenue Ruling 2009-9 to apply generally to all kinds of Ponzi-type financial frauds. The IRS intended the language to be broad and inclusive so they would not have to issue separate rulings for every instance in which a taxpayer finds himself or herself the victim of a Madoff or Wassendorf. We appraised IRS staff of the facts of the PFGBest case and they responded with the letter at the bottom of this email, indicating that PFGBest victims could use Revenue Procedure 2009-20 when filing their taxes if they chose to do so. They are not required to do so.
How the Revenue Procedure May Have Helped Some Madoff Victims
In Revenue Ruling 2009-9, the IRS concludes that the losses of Madoff's victims are theft losses characterized as ordinary losses, rather than capital losses. These losses are considered to be incurred in a transaction entered for profit. As a result, Madoff losses were deductible under Section 165(c)(2) of the Internal Revenue Code of 1986, and are not subject to certain limitations on deductions based on a victim's adjusted gross income.
The safe harbor mechanism established in Revenue Procedure 2009-20 generally applies to U.S. taxpayers who are eligible to deduct theft losses, made direct investments in criminally fraudulent investments and had no knowledge of the fraud before it was exposed. Investors that made indirect investments (through funds) are not entitled to utilize the safe harbor, although the fund itself may be so entitled. Depending on the tax character of such fund or entity, the loss it claims may flow through to its investors.
Using the safe harbor, the deduction for the theft loss is taken in the taxable year of the investor in which a complaint is filed against the perpetrator of the fraud. That was 2008 for Madoff victims and would be 2012 for PFGBest victims. If an investor does not pursue a lawsuit to recover losses, the safe harbor theft loss deduction is 95% of the difference between: the sum of the total investment plus net income included in income for federal tax purposes for all years prior to 2008 (including years closed by the statute of limitations), and the total amount withdrawn in all years, any actual recovery in the year of the complaint from any source, and any potential insurance or Securities Investor Protection Corporation (“SIPC”) recovery. For victims who pursue or intend to pursue a lawsuit to recover their Madoff losses, the safe harbor theft loss deduction is 75% of this amount. There is no SIPC protection afforded to PFGBest claimants.
The amount of the deduction is not reduced by potential recoveries against the fraud perpetrator or by other potential recoveries other than those against SIPC or insurance in the absence of the pursuit of a lawsuit or the intention to pursue a lawsuit. A victim who recovers in a later year more or less than the anticipated SIPC recovery or the 5% or 25% disallowance may have income or an additional deduction in that later year.
A victim who qualifies for the relief and wishes to elect the safe harbor treatment must follow certain specified procedures with respect to its tax return, including attaching a signed statement (provided in the Revenue Procedure) to its tax return which certifies that the victim is entitled to the safe harbor deduction claimed and agrees to comply with the conditions and agreements set forth in Revenue Procedure 2009-20. A victim claiming the safe harbor deduction agrees, among other things, not to file amended returns to exclude or recharacterize amounts previously included in taxable income and not to apply the alternative computation provided in Code Section 1341 with respect to the theft loss. Special procedures apply to victims wishing to claim the safe harbor deduction that have already filed a return that is inconsistent with the Revenue Procedure.
Is the Safe Harbor Required?
No, Madoff victims were not required to utilize the safe harbor provision of Revenue Ruling 2009-20 and neither are victims of PFGBest's fraud. A taxpayer who chooses not to apply the safe harbor treatment is subject to all of the generally applicable provisions governing the deductibility of losses under Code Section 165. Revenue Ruling 2009-9 and Revenue Procedure 2009-20 provided an expedient solution for Madoff investors, but perhaps not the one that provided the best results.
The CCC would like to thank the staff of the IRS Office of General Counsel for being so responsive on this issue. We would also like to thank our members who helped us pursue this effort. Again, we urge you to consult your tax professional as soon as is practicable to determine if it is appropriate and wise to seek relief under the safe harbor deduction for theft losses.