The Tax Cuts and Jobs Act of 2017 (TCJA) limited theft loss deductions, although tax professionals debate how far. I’ve commented on this issue in prior articles, including here, and therefore will not repeat those comments again. Rather, this article seeks to address questions I have received from tax professionals and taxpayers in recent weeks regarding whether taxpayers may claim theft losses post-TCJA under the “safe harbor” of Rev. Proc. 2009-20?
Theft Losses Generally
Prior to the TCJA, taxpayers could claim theft losses if they satisfied three primary requirements. First, they had to show the occurrence of a theft under federal, state, or local law. Second, taxpayers had to prove the amount of the loss, which was limited to their basis in the stolen funds or property. Third, they had to demonstrate the proper tax year to claim the theft loss, often referred to as the “discovery year.”
Although the IRS routinely challenged taxpayers concerning all three requirements, it was more common for the agency to quibble over the discovery year. In addition to providing the year the taxpayer discovered the theft, the taxpayer was also required to prove that, as of the end of such year, there was no reasonable prospect of recovery in reclaiming the stolen funds or property.
Example
Sam invests $100,000 in an online cryptocurrency platform in 2016. In 2017, Sam learns that the platform is a Ponzi scheme. In late 2018, Sam and some other investors in the platform file a lawsuit against those criminally responsible for stealing their investment funds. On these facts, the IRS may argue that Sam can’t claim a theft loss in 2017, particularly if the agency believes that Sam has a reasonable prospect of recovering some or all of the funds through litigation.
Rev. Rul. 2009-9 And Rev. Proc. 2009-20
The financial crisis of 2007-2008 exposed many Ponzi schemes. After the market fell, individuals sought to withdraw their investment funds only to discover that those funds had not been used appropriately. To provide clarity on the tax consequences of these stolen funds, the IRS issued Rev. Rul. 2009-9 and Rev. Proc. 2009-20.
Very generally, Rev. Rul. 2009-9 provides that taxpayers may claim theft losses for investments in Ponzi schemes. But the revenue ruling merely restates prior law (mentioned above) regarding the discovery year, noting that taxpayers may only claim the Ponzi-scheme losses in the year of discovery, subject also to any reasonable prospect of recovery of the stolen funds. Because many of these individuals filed suit against the fraudsters, they had open questions regarding whether they could claim the theft loss in the discovery year.
Significantly, the IRS provided a more taxpayer-friendly “safe harbor” to taxpayers who met certain requirements set forth in Rev. Proc. 2009-20. Specifically, taxpayers could claim a percentage of the theft loss in the year in which the criminally responsible person was: (i) charged by an indictment or information under state law, or (ii) the subject of a state or federal criminal complaint that has not been withdrawn or dismissed.
Based on my discussions with other tax professionals, there is some confusion regarding the terms “indictment,” “information,” and “complaint”. These terms originate in criminal law and refer to a government agency filing a document in court against the criminally responsible individual. The term “complaint” does not, as some suggest, relate to the taxpayer’s complaint, or notice to the government agency of the fraudulent conduct (e.g., an IC3 complaint). Thus, the safe harbor does not apply if the government agency has not filed a complaint in federal or state court against the fraudster.
The Safe Harbor After The TCJA
Of course, there is another potential issue related to requesting safe-harbor relief under Rev. Proc. 2009-20, at least for tax years 2018 through 2025 (and maybe later, if legislation extends the theft loss limitations). Because Rev. Proc. 2009-20 was issued on April 6, 2009, it cannot override any changes or amendments made to the theft loss rules under the TCJA. Thus, to the extent that theft losses are permitted post-TCJA, taxpayers who meet the requirements of the safe harbor may continue to use it. Conversely, if the TCJA overrides the analysis set forth in the revenue procedure, the TCJA would govern, rendering Rev. Proc. 2009-20 a nullity.
Therefore, tax professionals and tax preparers must carefully analyze the safe harbor in light of the TCJA provisions modifying the theft loss rules.
Conclusion
In sum, taxpayers who are the victims of online or cryptocurrency scams are in a difficult position when tax reporting time arrives. Tax professionals continue to debate whether theft losses are appropriate post-TCJA and, if allowed, to what extent. If taxpayers may claim theft losses post-TCJA, such taxpayers must nevertheless analyze Rev. Proc. 2009-20’s safe harbor in light of the TCJA and whether they fall within the specific requirements set forth in that revenue procedure. In more complex cases, taxpayers may need to consider whether it is appropriate to obtain a tax opinion from a tax professional to support a reporting position claiming the theft loss post-TCJA and with or without the safe harbor.
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