IRS Chief Counsel Advice 201511018 provides helpful clarification regarding the tax year in which a taxpayer is eligible to deduct a theft loss incurred in connection with a Ponzi scheme. Before addressing the new ground covered by CCA 201511018, however, this blog post briefly summarizes the prior guidance regarding the timing of deductibility of Ponzi theft losses.
A theft loss is generally deductible in the tax year in which the taxpayer discovers the loss. See I.R.C. Section 165(e). The theft loss is not deductible in the year of discovery, however, to the extent the taxpayer still has a reasonable prospect of recovering that loss as of the end of that year. See Treas. Reg. Section 1.165-8(a)(2); Treas. Reg. Section 1.165-1(d)(3). In that scenario, the taxpayer cannot deduct an amount of the loss until the tax year in which it can be determined with reasonable certainty that the amount will not be recovered. See id.
In Rev. Proc. 2009-20, the IRS provided an optional safe harbor through which qualifying taxpayers can establish the tax year in which the Ponzi theft loss was deductible. Rev. Proc. 2009-20 provides that a qualifying taxpayer’s discovery year under the safe harbor is the year in which an indictment, information, or criminal complaint is filed against the Ponzi scheme promotor alleging a crime constituting a theft under the law of the relevant jurisdiction. See id., Section 4.04.
In addition, Rev. Proc. 2011-58 addresses the situation in which the Ponzi scheme promotor died prior to when the government could charge him/her with criminal theft. Rev. Proc. 2011-58 modified a qualifying taxpayer’s discovery year to include the later of: (i) the year in which a civil complaint or similar document (such as a notice or order instituting administrative proceedings or other document that the IRS designates) was filed; or (ii) the year in which the Ponzi scheme promotor died. See Rev. Proc. 2011-58, Section 4.02.
CCA 201511018 clarifies the qualifying taxpayer’s discovery year for purposes of the Rev. Proc. 2009-20 safe harbor in the situation in which a lead Ponzi scheme promotor dies in a year prior to when the government brings criminal charges against another promotor of the same scheme. The Chief Counsel’s Office concluded that the qualifying taxpayer’s discovery year was the year in which all three of the following occurred: (i) a civil complaint was filed alleging facts that comprise substantially all of the elements of a specified fraudulent arrangement conducted by the lead figures; (ii) one of the lead figures died before being criminally charged; and (iii) a receiver was appointed with respect to the Ponzi arrangement. Thus, CCA 201511018 indicates that a taxpayer’s discovery year in which the theft loss may be deducted under the Rev. Proc. 2009-20 safe harbor may be prior to the year in which criminal charges are brought against the promotors, provided that a civil complaint has been filed, a receiver has been appointed, and a lead promotor has died.
Continued Uncertainty and Need for Protective Refund Claims
There is still a great deal of uncertainty regarding the timing of deductibility of the theft loss arising from a Ponzi scheme, notwithstanding CCA 201511018 and prior guidance. For those taxpayers who do not satisfy the requirements of the Rev. Proc. 2009-20 safe harbor, their burden of substantiating the year in which the theft loss is deductible remains high. They must continue to carry the burden of proving the year in which the theft was discovered and the extent to which there is no reasonable prospect for recovering the loss.
Even for a taxpayer who is within the Rev. Proc. 2009-20 safe harbor, what is the discovery year in the situation in which the government has only filed a civil fraud complaint against the Ponzi scheme promotors but has not yet alleged criminal charges, and all of the promotors are alive? In many situations, the government opts to pursue the Ponzi promotor civilly before bringing criminal charges. Does the safe harbor require the taxpayer in that situation to wait until the civil proceeding is resolved and the criminal case has commenced in order to deduct the related theft loss?
As a result of the substantial uncertainty that often exists regarding the proper timing of a theft loss deduction under a specific set of facts, taxpayers should consider filing protective claims for refund for each of the tax years open under the statute of limitations in which the theft loss could have been sustained. By filing the protective refund claim, the taxpayer can preserve his/her right to claim the benefit of the theft loss deduction for each of those years, even when the correct discovery year is not determined until after the limitations period for claiming a refund for that year would have otherwise expired.