Crypto Losses Are Not All Alike Part III

Post SBF Conviction -- Does This Make a Difference?

Now that Sam Bankman-Fried has been convicted on all counts for fraud, conspiracy to commit wire fraud and conspiracy to commit money laundering -- does this change the landscape for claiming “investment theft loss” under IRC Sec. 165(c)(2), as posited on previous articles?

This type of loss is not subject to the moratorium on claiming theft losses that lasts until after 2025, but does have certain requirements that need to be fulfilled to qualify. In addition, the IRS has previously issued Rev Rul 2009-09 and Rev Proc 2009-20 dealing with the Madoff Ponzi scheme and outlined conditions under which investment losses can be taken even before finalization in bankruptcy court. These rules are important as they allow losses even before a final accounting has been made and the ultimate final loss determined by the bankruptcy court.

In summary, those IRS releases allowed a “safe harbor“ election of taking either a 95% deduction for losses if no claims for reimbursement are filed or 75% of losses if claims are filed. It is well understood that although those releases dealt with Madoff-type Ponzi schemes, they are equally applicable to all type of investment-theft losses by individuals if the loss meets certain criteria. In addition, the loss can be claimed in the year the loss is discovered, which means the year the indictment was filed. That was December of 2022 with superseding indictments filed in February 2023.

In 2023, while the indictments were for fraud, it was not known whether these actions rose to the level of “theft” for purposes of IRC Sec. 165. The regs at 1.165-8(d) define theft to be as a result of “…larceny, embezzlement or robbery.” In 2023, it was unclear whether SBF engaged in these activities or was merely negligent in his handling of customer deposits. The indictments do not specify “theft.” It is only with the testimony that emerged that it became clear that SBF was using a “back door” to remove cash from FTX and sending it to Alameda to support its losses. This would seem to rise to the level of theft as contemplated by the regulations. Of note is that the Madoff indictments also did not specify theft; only fraud and money laundering.

Further questions arise. For instance: When did the theft begin? Were the accounts opened by depositors with the expectation of profit or merely as custodial accounts? Is the expectation of capital gains sufficient to satisfy the requirement of expectation of profit? Does a direct taking of the depositors’ funds have to be shown, where funds are intermingled?  There are many similarities to the Madoff embezzlement but it is not exactly the same. We need the IRS to issue guidance as to these issues as well as timing of the deduction, amending returns, and more. The other shoe has dropped; it’s time for the IRS to give directions.