26 CFR: § 1.165-8: Theft losses.
(Also: §§ 63, 67, 68, 172, 1311, 1312, 1313, 1314, 1341)
Rev. Rul. 2009-9
(1) Is a loss from criminal fraud or embezzlement in a transaction entered into for profit a theft loss or a capital loss under § 165 of the Internal Revenue Code?
(2) Is such a loss subject to either the personal loss limits in § 165(h) or the limits on itemized deductions in §§ 67 and 68?
(3) In what year is such a loss deductible?
(4) How is the amount of such a loss determined?
(5) Can such a loss create or increase a net operating loss under § 172?
(6) Does such a loss qualify for the computation of tax provided by § 1341 for the restoration of an amount held under a claim of right?
(7) Does such a loss qualify for the application of §§ 1311-1314 to adjust tax liability in years that are otherwise barred by the period of limitations on filing a claim for refund under § 6511?
A is an individual who uses the cash receipts and disbursements method of accounting and files federal income tax returns on a calendar year basis. B holds himself out to the public as an investment advisor and securities broker.
In Year 1, A, in a transaction entered into for profit, opened an investment account with B, contributed $100x to the account, and provided B with power of attorney to use the $100x to purchase and sell securities on A’s behalf. A instructed B to reinvest any income and gains earned on the investments. In Year 3, A contributed an additional $20x to the account.
B periodically issued account statements to A that reported the securities purchases and sales that B purportedly made in A’s investment account and the balance of the account. B also issued tax reporting statements to A and to the Internal
Revenue Service that reflected purported gains and losses on A’s investment account.
B also reported to A that no income was earned in Year 1 and that for each of the Years
2 through 7 the investments earned $10x of income (interest, dividends, and capital gains), which A included in gross income on A's federal income tax returns.
At all times prior to Year 8 and part way through Year 8, B was able to make distributions to investors who requested them. A took a single distribution of $30x from the account in Year 7.
In Year 8, it was discovered that B’s purported investment advisory and brokerage activity was in fact a fraudulent investment arrangement known as a “Ponzi”
3 scheme. Under this scheme, B purported to invest cash or property on behalf of each investor, including A, in an account in the investor’s name. For each investor’s account,
B reported investment activities and resulting income amounts that were partially or wholly fictitious. In some cases, in response to requests for withdrawal, B made payments of purported income or principal to investors. These payments were made, at least in part, from amounts that other investors had invested in the fraudulent arrangement. When B’s fraud was discovered in Year 8, B had only a small fraction of the funds that B reported on the account statements that B issued to A and other investors.
A did not receive any reimbursement or other recovery for the loss in Year 8. The period of limitation on filing a claim for refund under § 6511 has not yet expired for
Years 5 through 7, but has expired for Years 1 through 4.
B's actions constituted criminal fraud or embezzlement under the law of the jurisdiction in which the transactions occurred. At no time prior to the discovery did A know that B's activities were a fraudulent scheme. The fraudulent investment arrangement was not a tax shelter as defined in § 6662(d)(2)(C)(ii) with respect to A.
LAW AND ANALYSIS
Issue 1. Theft loss.
Section 165(a) allows a deduction for losses sustained during the taxable year and not compensated by insurance or otherwise. For individuals, § 165(c)(2) allows a deduction for losses incurred