Tuesday, April 10, 2012
Ctreatment. (Rev Proc 2009-20, 2009-14 IRB 749)
Chief Counsel Advice 201213022
In Chief Counsel Advice (CCA), IRS has determined that Ponzi scheme losses suffered by taxpayers are theft losses under Code Sec. 165, even though the taxpayers invested through individuals other than the perpetrator. IRS found that the facts showed that there was privity between the taxpayers and the perpetrator.
Background. A taxpayer can deduct a loss suffered during the tax year and not compensated by insurance or otherwise. For an individual, a loss deduction is limited to losses incurred in a trade or business, or a transaction entered into for profit, or arising from fire, storm, shipwreck, or other casualty or from theft. (Code Sec. 165(c))
Any loss arising from theft is treated as being sustained during the tax year in which the taxpayer discovers the loss. (Code Sec. 165(e)) However, if there exists a claim for reimbursement for which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is sustained until it can be determined with reasonable certainty whether or not reimbursement will be received. (Reg. § 1.165-1(d)(2)(i))
The term “theft” includes, but is not limited to, larceny, embezzlement, and robbery. (Reg. § 1.165-8(d)) To deduct a theft loss, a taxpayer must show that “the loss resulted from a taking of property that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent.” (Rev Rul 72-112, 1972-1 CB 60) In many cases, this requires that the perpetrator have specific intent to deprive the victim of his property, which in turn requires a degree of privity between the perpetrator and the victim. (Marr, TC Memo 1995-250)
Facts. Married taxpayers were investors in Investment Fund 1, which was managed indirectly by two fund managers. Husband learned about the investment from a newsletter, which was published by an Associate of Perpetrator, and invested based on claims therein regarding Perpetrator's qualities as a money manager. He made a wire transfer to a Fund 1 investment account on Date 1 and also suggested it to Wife's father who purchased an account for her in Year 1.
The fund managers were the managing members of Management Funds 1 and 2, which they created to manage Investment Funds 1, 3 and 4. Perpetrator separately formed Management Fund 3, which he created to manage Investment Funds 2 and 5. The fund managers hired Perpetrator to serve as investment advisor to Management Funds 1 and 2.
The fund managers and Perpetrator sold interests in Investment Funds 1, 3, and 4 through multiple private placement offerings. According to the private placement memoranda, the success of the funds was dependent on the fund managers' expertise, and the memoranda touted one of the fund manager's experience in the securities industry. The memoranda stated that Management Funds 1 and 2, while relying on Perpetrator's investment advice, would make all investment decisions and had the sole responsibility for managing their respective investment funds.
Perpetrator's scheme continued through the end of Year 2. On Date 2, Perpetrator was indicted on charges of securities fraud, mail fraud, and wire fraud, and pled guilty to all counts on Date 3. On Date 4, the Securities and Exchange Commission filed a complaint for injunctive relief against the fund managers alleging reckless violations of the anti-fraud provisions of the federal securities laws, which was granted on Date 5.
Issue. The CCA addresses whether the taxpayers could claim a theft loss because, although they were victims of a Ponzi scheme, they arguably lacked privity with Perpetrator because they invested through the fund managers.
CCA allows theft loss. The CCA examines case law on the issue and ultimately concludes that the taxpayers' losses were theft losses under Code Sec. 165.
Although a number of cases disallowed theft losses based on a lack of privity between victims and perpetrators, the CCA observes that these cases typically involve taxpayers who purchase shares of stock on the open market. (See, e.g., Crowell, TC Memo 1986-314) Similarly, in Electric Picture Solutions, TC Memo 2008-212, which also involved shares purchased on the open market, the Tax Court rejected a taxpayer's attempt to show that it was defrauded by its broker where there was no evidence that the broker actually appropriated the taxpayer's property.
However, in Jensen, TC Memo 1993-393, the Tax Court found that privity existed between the taxpayers and perpetrators because “the figure through whom they invested” (in that case, a business associate) was “a conduit to the scheme.” The Court determined that it wasn't necessary for the investor to have direct contact with the entity in which he is investing in order to have privity.
The CCA finds that the taxpayers' situation was more similar to the Jensen case than to the other open market cases. Notably, the taxpayers' property ended up at the disposal of Perpetrator, they obtained their interests in Investment Fund 1 after reading about the fund in Associate's newsletter and paying money into the fund itself, and they made their investment based on Perpetrator's reputation. Further, Perpetrator effectively controlled the investment activity of each of the funds and used each as a vehicle for his scheme, regardless of whether he was officially the “investment advisor” to any given fund. There was no “intermediate step” where the fund managers invested in Perpetrators' scheme; rather, the taxpayers directly invested in the vehicles used by Perpetrator to operate his scheme, and Perpetrator clearly intended to appropriate their property.
Accordingly, the CCA found that privity existed between the taxpayers and Perpetrator, despite the fact that the taxpayers invested through the fund managers. So, their investment losses are theft losses for Code Sec. 165 purposes.
RIA observation: In general, to qualify as a theft loss under Code Sec. 165(c)(3), the taxpayer must prove that the loss resulted from a taking of property that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent. (Rev Rul 72-112, 1982-1 CB 60) However, in guidance issued by IRS following the Bernard Madoff scandal, IRS stated that a violation of federal criminal law can qualify Ponzi scheme losses for theft loss