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On March 17, 2009, the Internal Revenue Service issued Revenue Ruling 2009-9 and Revenue Procedure 2009-20, clarifying the rules for deducting losses sustained by victims of convicted financier Bernard Madoff, as well as those defrauded by similar Ponzi investment schemes. The clarifying guidance is both timely and welcome, resolving substantially all of the tax questions confronting clients seeking tax refunds for their Madoff-related losses.

In the revenue ruling, the IRS confirmed that the losses sustained by an investor in a Madoff-style scheme are ordinary theft losses, and not capital losses. The IRS further confirmed that the losses should be classified as investment-related and not personal, which means that the losses are not subject to the 10 percent adjusted gross income limitation of section 165(h). Nor are the losses subject to reduction under the itemized deduction limitations of sections 67 and 68. The losses are deductible in the year of discovery, which, in the case of Madoff losses, means they are deductible on 2008 returns. Madoff's scheme was revealed, and criminal charges filed against him, in December 2008.

The amount of the deductible Madoff loss is calculated as follows, according to the IRS:

The amount of a theft loss … is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims as to which there is a reasonable prospect of recovery. If an amount is reported to the investor as income in years prior to the year of discovery of the theft, the investor includes the amount in gross income, and the investor reinvests the amount in the arrangement, this amount increases the deductible theft loss.

Two key points should be emphasized here. The first is that the amount of the loss must be reduced by any claim as to which "a reasonable prospect of recovery" exists. In its 2009 Revenue Procedure, which provides a safe harbor procedure for claiming a Madoff loss, the IRS requires that an investor who directly invested with Madoff reduce his or her loss by SIPC investment account or other insurance coverage. The 2009 Procedure additionally requires that the investor claim only 95 percent of the resulting loss, on an arbitrary presumption that the 5 percent not deducted for 2008 is reasonably recoverable. And if the investor is pursuing any claim against investment advisors and similar third parties, the investor may claim only 75 percent of the loss.  If less than 5 percent (or 25 percent) is ultimately recovered, the amount not recovered will be deducted as a theft loss in the year it is clear that no further recovery will be collected. If more than the amount is later collected, the excess is included in income in the year or years collected.

The second key point is that the IRS includes in the 2008 total theft loss any phantom income reported by Madoff to an investor in years prior to 2008, which the investor was taxed on in those years but which the investor had not withdrawn from Madoff. As a result, an investor need not file amended returns for pre-2008 years that remain open to claim refunds for "erroneously reported" income and is not faced with the concern that refund claims for phantom income reported in closed years might be barred.

If the amount of the Madoff theft loss exceeds the investor's 2008 income, the excess will be deductible as a net operating loss that the investor may carry back up to three years and forward up to 20 years. In its 2009 Revenue Ruling, the IRS reached the beneficial conclusion that some investors may have the option of electing a four- or five-year NOL carryback for a 2008 Madoff theft loss under newly enacted carryback rules for an "eligible small business." The section 172(b)(1)(H) rules for determining whether a Madoff investor (or for that matter, any taxpayer with a 2008 NOL) can be quite complex and are beyond the scope of this report. It is a determination that we recommend any client with a 2008 NOL undertake, because more persons may qualify as an "eligible small business" than may be apparent from a quick review of the new carryback rules.

As mentioned, the 2009 Revenue Procedure provides a safe harbor for claiming Madoff (or other Ponzi scheme) losses on 2008 returns. In our opinion, the chief disadvantage of relying on the safe harbor is the 5 percent (or 25 percent) cutback in the amount of the theft loss deductible for 2008. The benefit is that the potential that the IRS will audit any theft loss claimed under the 2009 Procedure and seek to reduce the amount of the 2008 loss should be vastly reduced.