Case — Showing the Money

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TL Case Summ

THE QUESTION

Can a taxpayer take a theft loss deduction for his services to a venture later deemed to be a Ponzi scheme?

THE DISPUTE

Taxpayer Says: Revenue Procedure 2009-20 allows a loss deduction under a safe harbor for amounts not previously included in income. The safe harbor applies to the amounts owed him.

Internal Revenue Service Says: The safe harbor provision of Revenue Procedure 2009-20 permits deductions only to the extent of a “qualified investment.” The taxpayer’s services do not meet the definition and are not deductible.

THE LAW

From Internal Revenue Code Section 165: Prescribes rules for the deductibility of theft losses, including timing and amount.

From Treasury Regulation 1.165-1(c): The amount of a theft loss that is deductible generally is limited to the adjusted basis of the property taken.

From Treasury Regulation 1.705-1(a)(2): Under section 705 a partner’s basis generally is composed of contributions to the partnership (see section 722), plus his or her distributive share of partnership income (see section 703(a)), less distributions and his or her distributive share of partnership losses or expenditures (see sec. 733).

From Revenue Procedure 2009-20: The safe harbor provision of Revenue Procedure 2009-20 permits deductions only to the extent of a “qualified investment.” A qualified investment is defined as the taxpayer’s total amount of cash, or the basis of property, invested plus “the total amount of net income with respect to the specified fraudulent arrangement that, consistent with information received from the specified fraudulent arrangement, the qualified investor included in income for federal tax purposes for all taxable years prior to the discovery year, including taxable years for which a refund is barred by the statute of limitations”, minus the total cash or property that the taxpayer withdrew in all years. (Note to reader: See also revenue ruling 2009-9.)

From Hutcheson v. Commissioner, 17 T.C. 14, 19 (1951): Basis does not include the value of services performed unless and until the value of those services has been subjected to tax.

THE CAUSE OF THE DISPUTE

The US tax code provides a deduction for theft losses, including losses from investment theft such as Ponzi schemes. In 2008 and 2009, these losses increased significantly as Ponzi schemes were revealed by the economic crisis. According to the treasury inspector general for tax administration, the IRS estimated that for the 2008 filing year more than 19,200 taxpayers filed federal income tax returns claiming a combined total of more than $8 billion in casualty and theft deductions.

In response to the increase, the IRS issued Revenue Procedure 2009-20 to provide a uniform method for computing losses from Ponzi scheme investment thefts. The revenue ruling provides a safe harbor for deducting a “qualified investment” loss (see The Law section above).

In T.C. Memo. 2015-138 (Haff), the taxpayer invested in a joint venture formed to develop condominiums and townhomes.

The taxpayer made a $1 million initial investment in 2005. Between 2005 and 2010 he contributed an additional $337,690 to cover expenses. In August 2008, the Securities and Exchange Commission alleged the arrangement was a Ponzi scheme. A court appointed receiver determined that continued development of the project was not economically viable.

As a result, the taxpayer concluded that his entire investment was lost. He claimed a deduction of $2,068,476 for the 2009 tax year because of his lost investment. The deduction included the $1,337,690 the taxpayer contributed and $730,786 that he said was owed him as fees for his services in development, sales, marketing, and construction.

The IRS agreed the taxpayer was entitled to a theft loss deduction for the full amount of the $1,337,690 contribution. However, the IRS disallowed the additional $730,786, saying it was not deductible under the safe harbor provision in Revenue Procedure 2009-20 because the taxpayer never included the amount in his income.

The taxpayer disagrees. He believes the safe harbor allows a loss deduction for amounts not previously included in income.

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Right answer!
For the IRS.

The taxpayer does not argue that the additional $730,786 should be deductible under the plain text of section 165.

Rather, he asserts that Revenue Procedure. 2009-20, allows a loss deduction for amounts not previously included in income under a safe harbor and that the safe harbor applies to the amounts owed him.

Even if the revenue procedure applies, it would not permit the taxpayer to deduct the additional $730,786 on his 2009 tax return. The safe harbor provision of Revenue Procedure 2009-20 permits deductions only to the extent of a “qualified investment.” A qualified investment is defined as the taxpayer’s total amount of cash, or the basis of property, invested plus “[t]he total amount of net income with respect to the specified fraudulent arrangement that, consistent with information received from the specified fraudulent arrangement, the qualified investor included in income for federal tax purposes for all taxable years prior to the discovery year, including taxable years for which a refund is barred by the statute of limitations”, minus the total cash or property that the taxpayer withdrew in all years.

The taxpayer did not include the $730,786, or any portion thereof, as income for prior years. To constitute basis, for purposes of section 165 or Revenue Procedure 2009-20 the amounts owed must have been included in income for tax purposes previously.

Accordingly, the taxpayer is entitled to a theft loss deduction for his adjusted basis in the arrangement of $1,337,690, but is denied a deduction for the additional $730,786 he claimed was owed him but was never paid.

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