Federal Income Tax Treatment

Fraudulent arrangements often take the form of so-called "Ponzi" schemes, in which the party perpetrating the fraud receives cash or property from investors, purports to earn income for the investors, and reports to the investors income amounts that are wholly or partially fictitious.

  • Federal Losses under IRC §165 (c)(2) per Rev. Rul. 2009-9:
    Federal income tax law governing losses from such schemes, including the nature of such losses, the amount of such losses to be allowed, and the year of deductibility;
  • Federal Safe Harbor Method per Rev. Proc. 2009-20:
    For computing a deemed theft loss in the case of a "qualified investor" with a "qualified loss" from a "specified fraudulent arrangement." A taxpayer using the safe harbor must agree not to file amended federal income tax returns to exclude or recharacterize income reported with respect to the investment arrangement in taxable years preceding the discovery year. Rev. Proc. 2009-20 applies to losses for which the discovery year is a taxable year beginning after December 31, 2007.

Federal Theft Loss not Utilizing Federal Safe Harbor Method:
A taxpayer that chooses not to apply the safe harbor treatment of Revenue Procedure 2009-20 would claim a theft loss under the provisions governing the deductibility of losses under IRC §165. The taxpayer would file or amend prior-year federal returns to exclude amounts that had been reported as income from the investment arrangement, to the extent the taxpayer can establish that such amounts did not truly constitute income that had been actually or constructively received (or accrued).


Massachusetts Income Tax Treatment:

Note: The following information is a summary of the Department's public written statement, Technical Information Release 09-15.

The Massachusetts personal income tax statute does not adopt the federal deduction for theft loss under IRC § 165 for individual investors. Thus, the federal rules described in Rev. Rul. 2009-9 and the optional federal safe harbor method for a qualified investor to claim a theft loss deduction under Rev. Proc. 2009-20 are not applicable for Massachusetts personal income tax purposes.

In a further departure from federal law, an NOL deduction is not allowable under the Massachusetts personal income tax statute. As a result, Massachusetts does not allow the federal NOL carryback or carryforward.
 

Abatements and Deductions:
Qualifying individual taxpayers who invested in a criminally fraudulent investment arrangements may be entitled to the following abatements or deductions but only if they were not complicit in the fraud, and whether or not they elected the federal safe harbor under Rev. Proc. 2009-20.

In such cases, fictitious income will generally be amounts reported to the taxpayer as part of the fraud, on Forms 1099 or otherwise, and previously included in the taxpayer's income reported for Massachusetts tax purposes, where the taxpayer establishes that such amounts did not in fact constitute actual income that had been actually or constructively received (or accrued).
  • Potential deduction for capital loss in subsequent year when actual loss is finally determined and sustained:
    A taxpayer with a "qualified loss" from a "specified fraudulent arrangement" as those terms are defined by Rev. Proc. 2009-20 may be eligible for a capital loss deduction when such loss is ultimately sustained. A loss resulting from a criminally fraudulent investment scheme as described in Rev. Rul. 2009-9 and Rev. Proc. 2009-20 will be treated as a capital loss from the disposition of an investment that is a capital asset. This treatment is available only to taxpayers who were not complicit in the fraud.

In general, a taxpayer may claim a capital loss only in that taxable year in which a capital asset is sold or exchanged. If a security which is a capital asset becomes worthless during the taxable year, the loss resulting therefrom is generally treated as a loss from the sale or exchange, on the last day of the taxable year. A loss from a criminally fraudulent investment scheme will become worthless only when there is no reasonable prospect of any recovery (or further recovery) and when the investment has no current liquidating value and no potential value. This determination of worthlessness is a question of fact, with the taxpayer bearing the burden to prove worthlessness.

A taxpayer who invested in a criminally fraudulent investment scheme will be treated as having basis in a capital asset for Massachusetts tax purposes. In determining gain or loss from the sale or other disposition of a capital asset, the taxpayer's "adjusted basis" must be calculated. The adjusted basis is the amount of the original investment and all subsequent investments minus any cash or other actual withdrawals or other recoveries, however derived. Fictitious income amounts reported for Massachusetts tax purposes on account of the criminally fraudulent arrangement, to the extent substantiated by the taxpayer and not abated in open taxable years, will be treated as reinvested amounts and added to basis accordingly.


Documentation to Submit with Abatement/Amended Tax Return:

A taxpayer seeking Massachusetts tax relief due to a criminally fraudulent investment arrangement must maintain all records substantiating the associated fictitious income or loss. Substantiation must be provided in association with any application for abatement and must be maintained to document any capital losses claimed. In general, substantiation should include, without limitation, the following:

  • Proof that the investment income previously reported in open tax years is from a criminally fraudulent investment arrangement and the extent to which it is fictitious and does not represent income actually or constructively received (or accrued);
  • For taxpayers who elected the federal safe harbor, a copy of fully executed federal Appendix A, Statement by Taxpayer Using the Procedures in Rev. Proc. 2009-20 to Determine a Theft Loss Deduction Related to a Fraudulent Investment Arrangement. Also, copies of all written documentation to support the amounts reported in Appendix A;
  • A copy of any claim submitted to the SIPC trustee and documentation of the amount of SIPC proceeds received;
  • Substantiation of the criminally fraudulent investment arrangement and the reporting thereof, such as investment statements, Forms 1099, and other tax documents relating to the open years and closed years relevant to the abatement application;
  • Proof of all contributions or other investments, distributions or other withdrawals, income reported, recoveries from SIPC, insurance, or otherwise;
  • Copies of Massachusetts personal income tax returns for both open and closed years for which the taxpayer included in gross income items of fictitious income that were fabricated by the operator of the criminally fraudulent investment arrangement; and
  • A chart or spreadsheet summarizing the investment each year since inception as follows:
    1. year
    2. cash in
    3. cash out
    4. cumulative net cash invested
    5. reported fictitious earnings from Forms 1099 or otherwise
    6. cumulative earnings over time
    7. account balance.

Massachusetts References:

Federal References:

  • IRC § 165(c)(2)
  • Rev. Rul. 2009-9; Rev. Proc. 2009-20