Q1: In many criminally fraudulent investment schemes, a court-appointed trustee or receiver is assigned to recover and sell assets derived from the scheme and distribute the proceeds to victims as a full or partial recovery of their theft losses. Is a taxpayer who receives such a recovery required to include the amount in income for federal income tax purposes?
A1: Whether a taxpayer who recovers amounts lost in a fraudulent investment scheme is required to include the recovery in income depends on whether the taxpayer claimed a tax deduction for the theft loss in any prior year. A taxpayer who has not yet claimed a tax deduction for the theft loss is not required to include in income a recovery from the trustee or receiver. Instead, the recovery will reduce the amount a taxpayer may eventually claim as a loss. A taxpayer who claimed a tax deduction for the theft loss, however, may be required to include the recovery in income, depending on the extent to which the theft loss deduction created a ¡°tax benefit¡± for the taxpayer.
Q2: How does a taxpayer who claimed a tax deduction for a theft loss determine the amount of a subsequent recovery that he or she must include in income?
A2: Under a provision of law known as the tax benefit rule, a taxpayer must include in income the recovery of any amount deducted in a prior taxable year to the extent the prior year¡¯s deduction reduced the taxpayer¡¯s tax liability for that year (or created a net operating loss carryback or carryover). For example, if a taxpayer properly deducts a $100 theft loss in 2009, and the deduction reduces the taxpayer¡¯s 2009 income tax liability, a recovery of $100 received in 2011 is includible in full in the taxpayer¡¯s income in 2011 under the tax benefit rule. Similarly, if the 2009 theft loss exceeds the taxpayer¡¯s 2009 taxable income and creates a net operating loss carryback or carryover, a recovery of $100 received in 2011 is includible in full in the taxpayer¡¯s income in 2011. The recovery is ordinary income and not capital gain.
Q3: May a taxpayer amend a prior year¡¯s income tax return to reduce a properly claimed theft loss by the amount of a recovery received in a subsequent year?
A3: No. If a taxpayer properly claimed a theft loss deduction and in a later year recovers a portion of the amounts lost, the taxpayer may not amend the prior year¡¯s income tax return to reduce the theft loss deduction by the amount of the recovery. Instead, the recovery is includible as tax benefit income in the year received.
Q4: Using the optional safe harbor provided in Rev. Proc. 2009-20 PDF, a taxpayer claimed a deductible theft loss in 2009 equal to 95% of the total qualified investment, reduced by amounts the taxpayer reasonably expects to recover from insurance or from the Securities Investor Protection Corporation (potential insurance/SIPC recovery). In 2011, the taxpayer receives the expected insurance/SIPC recovery. Does the taxpayer have income under the tax benefit rule in 2011?
A4: No, the taxpayer does not have income in 2011 under the tax benefit rule. As the taxpayer properly reduced the deductible theft loss by the potential insurance/SIPC recovery in 2009, when those amounts are recovered in 2011 the taxpayer does not have to report the recovery as income under the tax benefit rule.
Q5: If, under the optional safe harbor provided in Rev. Proc. 2009-20, a taxpayer claimed a deductible theft loss in 2009 equal to 95% of the total qualified investment (assume the taxpayer had no potential insurance/SIPC recovery), and in 2012 the taxpayer recovers 4% of the taxpayer¡¯s total qualified investment, does the taxpayer have income under the tax benefit rule in 2012?
A5: No, the taxpayer does not have income in 2012 under the tax benefit rule. The 4% recovery is treated as first reimbursing the portion of the theft loss for which the taxpayer did not claim a deduction in 2009 (i.e., the 5% portion of total qualified investment that was not deductible under the safe harbor). Because the 4% recovery is a recovery of an amount that was not previously deducted, it is not income under the tax benefit rule. The taxpayer may have an additional theft loss deduction for the remaining 1% loss that has not been recognized or recovered. This loss is properly deductible in the year it is determined that there is no reasonable prospect of recovering this remaining 1%.
Q6: If, under the optional safe harbor provided in Rev. Proc. 2009-20, a taxpayer claimed a deductible theft loss in 2009 equal to 95% of the total qualified investment (assume the taxpayer had no potential insurance/SIPC recovery), and if the taxpayer recovers 4% of the taxpayer¡¯s total qualified investment in 2012 and 3% of total qualified investment in 2013, does the taxpayer have income under the tax benefit rule in 2013?
A6: Yes, the taxpayer will have income under the tax benefit rule in 2013. As discussed in Q&A 5, the taxpayer would not have income under the tax benefit rule in 2012 upon receipt of the 4% recovery because the 4% recovery does not exceed the unrecovered portion of the theft loss for which the taxpayer did not claim a deduction. As of the end of 2012, the taxpayer has deducted 95% of the total qualified investment, and recovered 4%. Accordingly, only 1% of the unrecovered total qualified investment remains for which the taxpayer has not claimed a deduction. In 2013, the 3% recovery is treated as first reimbursing the remaining unrecovered portion of the theft loss for which the taxpayer has not claimed a deduction (1%). The remaining 2% is income in 2013 under the tax benefit rule.
For example, assume the taxpayer¡¯s total qualified investment is $200X, and the taxpayer, consistent with Rev. Proc. 2009-20, claimed a deductible theft loss of $190X (95% of the total qualified investment) in 2009 (assume the taxpayer had no potential insurance/SIPC recovery). In 2012, the taxpayer recovers $8X. In 2013, the taxpayer recovers $6X. The amount includible in income in 2013 under the tax benefit rule is computed as follows:
2009
|
Total qualified investment |
$200X |
|
Deductible theft loss (95%) |
$190X |
|
Remaining unrecovered total qualified investment (5%) |
$ 10X |
2012
|
Recovery of 4% of total qualified investment |
$ 8X |
|
Remaining unrecovered total qualified investment (1%) |
$ 2X |
None of the $8X recovery is includible in income in 2012 under tax benefit rule because the $8X recovery does not exceed the unrecovered portion of the theft loss for which the taxpayer did not claim a deduction ($10X).
2013
|
Recovery of 3% of total qualified investment |
$ 6X |
Because the $6X recovery exceeds the remaining unrecovered portion of the theft loss for which the taxpayer did not claim a deduction ($2X), the excess ($4X) is includible in income in 2013 under the tax benefit rule.
For further information see the section entitled ¡°Insurance and Other Reimbursements¡± in Publication 547 PDF and the section entitled ¡°Recoveries¡± in Publication 525 PDF.
A trustee or receiver may use this information to respond to questions from investors and may include a copy of these questions and answers with any distributions sent to investors.