March 11, 2009

Tax Issues to Consider If You Have Been a Victim of Investor Fraud

Arnold & Porter Advisory

By Gary P. Kaplan

There is uncertainty concerning the tax implications of investment frauds. Madoff investors, for example, have asked the IRS for specific guidance but the IRS has so far declined — perhaps because as in all tax situations, each particular investor's circumstances are critical to determining the proper tax consequences and perhaps because the IRS doesn't want to favor one investor group with helpful tax advice in an environment where so many investors have lost money.

Many Madoff victims will report their losses as "theft losses" in 2008 (i.e., the year in which the loss was discovered). However, a theft loss cannot be taken so long as the victim has a reasonable prospect of recovery. In addition to Securities Investor Protection Corporation (SIPC) reimbursement (up to $500,000), additional amounts could be collected in litigation or bankruptcy from Madoff (and other potential defendants) in future years. Notwithstanding the likelihood of some recovery, each victim of investment fraud should reasonably estimate the maximum amount likely to be recovered (including SIPC) and report the balance (the nonrecoverable amount) as a loss on his or her 2008 tax return.

A technical question is what limitations on tax losses apply to an investment fraud loss. A theft loss, for example, is only deductible to the extent it exceeds 10% of the investor's adjusted gross income. To avoid the 10% limitation, an investor may claim the loss was suffered in connection with a for-profit transaction (rather than a theft loss) but in that case the loss must be reported in the years it was sustained (not the year discovered) and some or all of these years could be closed by the statute of limitations. In addition, a theft loss is treated as an ordinary loss, while a loss on a for-profit transaction is treated as capital in this case.

Investors may also file amended returns to reverse nonexistent income and gains from prior years. The general IRS position is that prior returns should not be amended based on subsequently-learned facts. However, as it is unfair for investors to pay taxes on phantom income, notwithstanding the general IRS position, investment fraud victims should consider filing amended returns for all years (not barred by the statute of limitation).

There are obviously a myriad of issues — from the appropriate tax analysis to the proper tax reporting. As we counsel victims of investment fraud on tax issues, we encourage you to contact us with your questions.

If you have questions about any of the issues raised in this article, please contact Gary P. Kaplan or your usual Howard Rice attorney.

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