Perhaps as a side effect of current economic conditions, there has been a recent increase in reported thefts, embezzlements and other criminally fraudulent activity.  The confessed Ponzi scheme involving Bernard Madoff involves unprecedented losses to investors.  Other incidents appear to involve smaller losses, sometimes involving trusted employees or other insiders. 

In reaction to these events, the IRS has published a Revenue Ruling and a Revenue Procedure detailing how taxpayers can deduct theft losses.  Although these IRS pronouncements are aimed directly at Ponzi schemes, these rulings also provide guidance generally applicable to theft losses, and significantly liberalize previous IRS positions. 

Generally, the IRS Revenue Procedure provides a taxpayer-favorable method to deduct theft losses in connection with a Ponzi scheme (a Ponzi scheme is a fraudulent plan where early investors receive "returns" from later investors until the scheme collapses).  This IRS approved method permits the deductibility of a theft loss in the taxable year in which the perpetrator is indicted rather than requiring the taxpayer to wait until it is clear there will be no recovery.  The amount of deductible loss depends upon whether the investor intends to pursue third parties, such as investment advisors.  If the investor does not intend to pursue such third parties, the investor can deduct 95% of the loss, less any potential insurance or SIPC recovery.  If the investor intends to pursue third party recoveries, the deductible percentage is reduced to 75%.  Overall, this optional procedure provides taxpayer-friendly method to give victims tax relief. 

In addition, these IRS pronouncements resolved a significant number of issues generally applicable to theft losses.  These favorable positions include confirmation that, in connection with a transaction entered into for profit: 

• A loss from criminal fraud or embezzlement is a theft loss not a capital loss, entitling the taxpayer to an ordinary deduction.
• A theft loss deduction is not limited to the loss that exceeds 10% of adjusted gross income, and is not subject to the various limits on personal losses or itemized deductions.
• A theft loss is deductible in the year the loss is discovered, unless there is a reasonable prospect of recovery. 
• The amount of deductible theft loss includes reinvested income on which the taxpayer paid taxes. 
• A theft loss can create a net operating loss (NOL) that can be carried back 3 years and forward up to 20 years.  For 2008 losses, a taxpayer generally may elect either a 3, 4 or 5 year NOL carry back.

If you have any questions regarding theft losses, please contact your attorney at Williams Coulson or either of the following Williams Coulson attorneys:  Mark C. Coulson or Raymond P. Parker.