The painful process of recovering from investment fraud is being eased by recently issued IRS guidelines that accountants and tax experts say will greatly benefit fraud victims.
Issued in the spring, the rules are expected to draw close attention over the next two months, as taxpayers who filed for an extension face an Oct. 15 deadline to report their 2008 income.
The guidelines, Revenue Ruling 2009-9 and Revenue Procedure 2009-20, are “very favorable” for those who were victims of a Ponzi scheme, said David Earley, tax senior manager for New York-based Deloitte LLP.
In fact, the Internal Revenue Service implemented the guidelines in direct response to last year's high-profile Ponzi schemes, most notably the one orchestrated by New York financier Bernard L. Madoff.
In testimony before the Senate Finance Committee in March, IRS commissioner Doug Shulman noted that the Madoff scandal “has affected a very large and diverse pool of investors” and has caused “numerous tax and pension implications for the victims.”
Under the IRS' revised rules, investors defrauded in any Ponzi scheme after Jan. 1, 2008, can declare their net operating loss from the investment a “theft loss,” which may be carried back five years instead of two, which was the case under the old rule.
That is important, Mr. Earley said, because a theft loss is considered an ordinary loss that allows taxpayers to offset other types of income fully.
“It's a very beneficial loss,” he said. “If you have to take a loss, that's the kind of loss you want to have.”
For that very reason, Mr. Earley added, previous IRS rules made determining a theft loss much more complicated and lengthy.
Allowing the theft loss to be carried back for five years is very good news for fraud victims, said Barry Newman, a certified public accountant and partner in Lehman Newman & Flynn PC of New York.
“It's important because the loss that people will probably incur will wipe out more than two years of income. It's extremely beneficial,” said Mr. Newman, whose clients include several victims of Mr. Madoff's Ponzi scheme.
Taxpayers have one year after they have filed their 2008 taxes to file their carry-back claim, Mr. Newman said.
However, fraud victims need to make sure that they find “capable tax advice” when dealing with the new guidelines, said David Selznick, who is a CPA, an attorney and principal of Selznick & Co. LLP in Armonk, N.Y.
“A tax adviser should know how to properly file the 2008 return with the appropriate theft loss forms and disclosures,” he said.
For example, Mr. Selznick pointed out, in order to claim a theft loss for five years, the taxpayer must make an election to do so.
“I reviewed a return today that did not have such an election,” he said.
Fraud victims also need to document meticulously all their paperwork involving the fraudulent investment, said Wayne Titus, principal of Plymouth, Mich.-based AMDG Financial Services.
“It's really important to make sure that you document everything to support your position,” said Mr. Titus, whose clients include victims of a limited partnership scam.
Proper documentation will help establish when the investment loss occurred, which is a critical issue, he said.
If the loss occurred before Jan. 1, 2008, the loss gets “totally different” treatment by the IRS, said Mr. Titus, who is also a CPA.
“Under the guidelines before 2008, investors have to wait for the resolution of the litigation, which could last for 10 years,” he said.
AMENDED FORM
Family members of fraud victims who face estate tax issues should file an amended estate form to claim a refund for estate taxes that have already been paid, Mr. Newman said.
However, the IRS hasn't issued final guidelines for estates involved in Ponzi schemes after Jan. 1, 2008.
Some investors in fraudulent securities or a Ponzi scheme may have received money that wasn't the result of a legitimate investment but that in fact came from others who came into the scheme after they did.
Investors who have received those additional funds may be asked to give up at least some of the money in a legal process known as disgorgement.
In addition to facing lawsuits, Mr. Titus said, those investors “may not be able to determine what their theft loss truly is, because the disgorgement issue has not been settled.”
However, investors who received the funds “in good faith and had no idea what was going on are likely to be in a position to make a reasonable claim to keep the funds,” said attorney Therese Pritchard, a partner in Bryan Cave LLP in Washington.
Tax issues for investors in Madoff and other Ponzi schemes who lost money indirectly through feeder funds remain unresolved, Mr. Earley said.
For the time being, he said, it appears that to prove a theft loss, they will have to “default” to the IRS rules applicable before Jan. 1, 2008.
E-mail Charles Paikert at [email protected].
