Possible Refuge for Investors Following the Fall of FTX

Sam Bankman-Fried, the founder of FTX Trading Ltd., has been indicted on eight criminal charges. These charges include wire fraud and conspiracy by misusing customer funds, per an indictment from the US Southern District of New York. He was arrested Monday, December 12th in the Bahamas and legal proceedings are ongoing.

The IRS provides guidance for the income tax treatment of losses stemming from incidents of this nature through Rev. Ruling 2009-09, along with Rev. Procedure 2009-20, which provides information for safe harbor treatment when computing the losses and the timing for deduction.

The Revenue Ruling provides that the investor is entitled to a theft loss, as opposed to a capital loss, if specified parameters are met. A theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments. Under normal circumstances, the loss deduction is limited to $3,000 per year when it exceeds capital gains from investments. This does not apply as funds lost to FTX should be classified as a theft loss. Investors can claim a loss not only for the net amount invested, but also for the fabricated income that the promoter of the scheme credited to the investor’s account that was then reported as income on the investor’s tax returns for years prior to the discovery of the theft. As with any fight with the IRS, it is not necessarily easy to prove the parameters of a theft loss are met; said parameters are detailed below.

1. The revenue procedure provides that the IRS will deem the loss to be the result of theft if: a) the promoter was charged under state or federal law with the commission of fraud (which is true in the case of FTX); b) the promoter was the subject of a state or federal criminal complaint alleging the commission of such a crime; c) there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.
2. There does not need to be a criminal conviction of the scheme promoter to establish a theft loss, though justifying a claimed theft loss can be difficult because determining the extent of the evidence can be burdensome.
3. The theft loss is deductible in the year the taxpayer discovers the fraud, except to the extent there is a claim with a reasonable prospect of recovery. Determining the year of discovery and whether a reasonable prospect of recovery exists is subject to interpretation and can be controversial. The IRS will generally accept a safe-harbor approach for reporting Ponzi-type theft losses. A safe-harbor approach would be considered “taken” if the loss is deducted in the year of discovery with 95% of their net investment reduced by the amount of any actual recovery in the year of discovery and the amount of any recovery expected from private or other insurance.

Based on the indictment of the founder of FTX, investors in FTX and its related entities should qualify for an itemized deduction on his or her 2022 tax return of 95% of their basis, if the rules set forth above are followed correctly.

As always, please reach out to us with any questions.