Sam Bankman-Fried (Photo by Matias J. Ocner/Miami Herald/Tribune News Service via Getty Images)
On Monday, Samuel Bankman-Fried (SBF) was arrested in the Bahamas after local authorities learned that U.S. law enforcement would seek to extradite him based on then sealed criminal indictments. A day later, the sealed indictments became public showing that SBF was charged with multiple counts of fraud, conspiracy, money laundering, and violating campaign finance laws due to his activities as CEO of FTX Trading and his involvement with Alameda Research LLC. At the same time, the Securities and Exchange Commission and the Commodity Futures Trading Commission filed civil lawsuits accusing SBF of fraud.
FTX’s creditors and customers lost billions of dollars as a result of SBF’s activities. As a consolation prize, they may be entitled to enhanced tax benefits. They can claim an ordinary theft loss as an itemized deduction on their tax returns and possibly use the losses to offset income in past and future years. Normally, these losses are treated as capital losses which may not be useful for people who do not have capital gains to offset.
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According to IRS Revenue Ruling 2009-9, investors can claim a theft loss deduction if the taking of property was illegal and was done with criminal intent. For income tax purposes, theft is a word of general and broad connotation, covering any criminal appropriation, including theft by swindling, false pretenses, and any other form of guile. A conviction of theft is not necessary to claim the deduction.
Also, the IRS has ruled that since if any money is put into an investment account with the expectation of profit and is found to be fraudulent, any loss is considered a business theft loss and not a personal theft loss. This is important because prior to 2018, losses due to theft could be deducted as an itemized deduction, but the Tax Cuts and Jobs Act limited the personal theft loss deduction to losses attributable to a federally declared disaster until 2025.
SBF has repeatedly and publicly stated that he did not specifically intent to defraud anyone. But the civil complaints and the criminal indictment state that SBF and FTX misappropriated money from investors, lenders, and customers, and commingled them to purchase lavish goods, make large political contributions, and transfer the money to Alameda Research to undertake questionable investments and transactions which ultimately went sour. So it is very likely that their activities would meet the definition of theft.
Another way to claim the theft loss is through a simplified safe harbor procedure outlined in the IRS’ Revenue Procedure 2009-20. There, if an investor suffers a loss through a “specified fraudulent arrangement,” and the lead figure is criminally indicted for fraud, they can deduct 95% of the unrecoverable losses or 75% of the losses if they are pursuing recovery from a third-party without an audit challenge from the IRS. They can claim the loss on the year the indictment is filed.
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A “specified fraudulent arrangement” is where a lead figure receives cash from investors, purports to earn income for the investors, reports income amounts to the investors that are partially or completely false, makes payments, if any, of purported income or principal to some investors with money contributed by other investors, and appropriates some or all of the investors’ cash or property. Ponzi schemes would qualify as a specified fraudulent arrangement.
Since SBF was indicted this year, investors can claim the theft loss only for 2022. Any losses that exceed taxable income can be carried back or carried forward to offset prior or future income.
However, it is unclear whether SBF’s activities amount to a Ponzi scheme. The civil complaints and the indictment do not mention that he or his entities engaged in a Ponzi scheme. There is also no mention that investor money was used to pay earlier investors of FTX or Alameda Research.
SBF’s criminal indictment and the civil lawsuits against him can give aggrieved investors confidence in taking a theft loss deduction. And they can take advantage of IRS special rulings to use the theft losses to offset ordinary income.
Steven Chung is a tax attorney in Los Angeles, California. He helps people with basic tax planning and resolve tax disputes. He is also sympathetic to people with large student loans. He can be reached via email at [email protected]. Or you can connect with him on Twitter (@stevenchung) and connect with him on LinkedIn.