Indirect Recovery for Ponzi Scheme Investors Under Rev. Proc. 2009-20 Safe Harbor

The IRS recently issued Rev. Proc. 2009-20, 2009-14 I.R.B. 749, which offers an optional safe harbor for victims of Ponzi-like investment schemes, such as the one run by Bernard Madoff, that are determined to be criminally fraudulent. The procedure provides that investors in such schemes will be entitled to claim a theft loss under §165 rather than a capital loss. However, recovery by investors who invested in Ponzi schemes indirectly through intermediaries may be limited by the definition of “qualified investor” as set forth in Rev. Proc. 2009-20, as well as by legal action taken by intermediaries against third parties.

The IRS created the safe harbor for victims meeting certain conditions because it recognized that eligibility to claim a theft loss under the Code and Rev. Rul. 2009-9, 2009-14 I.R.B. 735, is a highly factual and uncertain determination. Accordingly, in Rev. Proc. 2009-20, the IRS stated that it will not challenge a theft loss deduction if a taxpayer complies with the requirements of the procedure. Taxpayers who opt not to use the safe harbor to deduct investment fraud losses will be subject to the more rigorous evidentiary requirements for theft losses under §165 and Rev. Rul. 2009-9.

The fact pattern in Rev. Rul. 2009-9 involves a taxpayer that invested directly with a Madoff-type perpetrator. Similarly, only “qualified investors” who made direct transfers of cash or property to a “specified fraudulent arrangement” may avail themselves of the safe harbor set forth in Rev. Proc. 2009-20. Investors who put their money into an intermediary “feeder” fund that in turn put the money into a Ponzi arrangement do not qualify for the safe harbor.

Section 4.03 of Rev. Proc. 2009-20 defines a “qualified investor” as a U.S. person under §7701(a)(30) that generally qualifies to deduct theft losses, that did not have actual knowledge of the fraudulent nature of the investment arrangement before it was publicly disclosed, and that transferred cash or property to a “specified fraudulent arrangement” which is not a tax shelter under §6662(d)(2)(C)(ii). Specifically, §4.03(4) of the revenue procedure provides: “A qualified investor does not include a person that invested solely in a fund or other entity … that invested in the specified fraudulent arrangement. However, the fund or entity itself may be a qualified investor within the scope of the this revenue procedure.”

Accordingly, the fund can use the safe harbor to determine its total losses. If the fund is a partnership, it will report a share of the losses to each investor on Schedule K-1. Thus, taxpayers who invested in the Madoff scheme indirectly through a feeder fund will not report the tax loss directly. Instead the feeder fund will report the loss and taxpayers will report their allocable shares of the loss on their individual tax returns.

Qualified investors may deduct up to 95% of qualified losses from a specified fraudulent arrangement. However, the amount of recovery is limited to 75% if the qualified investor is pursuing or intends to pursue any potential third-party recovery. Thus, the recovery of an investor who invested in a Ponzi arrangement through an intermediary may be limited by the intermediary's decision or intention to sue a third party.