The Tax Impact of Ponzi Scheme Investments
Victims of Ponzi schemes run by fraudulent investment brokers may not realize for several years that the brokers are fraudulently reporting earned income. In a typical Ponzi scheme, the broker represents to the investor that these dividends are being reinvested. Thus, victims are likely to report such income (e.g., interest) as gross income when filing taxes. When the scheme inevitably collapses, and the victims are left with nothing from their investments, the Internal Revenue Code provides multiple ways for them to receive deductions for the loss sustained in the fraudulent scheme, and to recapture some of the taxes they paid on “phantom income”[1]—that is, taxes on money that they never made in the first place.
When a defrauded investor in a Ponzi scheme discovers the fraud, she can claim the loss of her investments as theft loss under IRC § 165(e) as long as there is no reasonable prospect of recovery.[2] Whether a reasonable prospect of recovery exists is a factual inquiry dependent on all the relevant facts and circumstances.[3] Courts have held that victims have a reasonable prospect of recovery when they have bona fide claims for recoupment against third parties, and there is a substantial likelihood that such claims will be decided in favor of the victims.[4] As described by Revenue Ruling 2009-9, the amount of theft loss that the victim can claim is (1) any amount invested in the fraudulent enterprise, less amounts withdrawn, and (2) phantom income.[5]
Due to the highly factual and uncertain nature of determining theft losses, the IRS issued Revenue Procedure 2009-20 to provide a safe harbor for defrauded investors.[6] Under this safe harbor, the IRS will not question the facts of theft losses claimed by qualified investors.[7] Victims can calculate the amount of theft loss under this provision by multiplying the amount of the investment by 95% (if the victim is not going to seek recovery from a third party) or 75% (if the victim is going to seek recovery from a third party), then subtracting from this product actual recovery or anticipated insurance recovery.[8] Taxpayers that elect to seek recovery under the safe harbor can claim theft loss even when they have a reasonable prospect of recovery.
Clawbacks on Ponzi Scheme Income
IRC § 1341 applies in situations where a taxpayer includes an item in gross income that the taxpayer thought she had an unrestricted right to, but finds out later to that she had no such right.[9] An example of this scenario would be a taxpayer whose profits in a Ponzi scheme are clawed back to be distributed to other victims of the scheme. The taxpayer, thinking she has a right to the profit, withdraws it and reports that amount as income to pay taxes on it, despite the fact that she is later forced to forfeit that amount once the scheme collapses.
Taxpayers in this situation may be entitled to a deduction or credit for this amount in the year that they pay it back.[10]When the amount of this deduction exceeds $3,000, which it usually does in a Ponzi scheme scenario, the deduction allowed is the lower of (1) the tax for the clawback year computed with such deduction, or (2) the difference between the tax on the clawback year without this deduction, and the decrease in tax for the year the clawed-back income was originally reported that results from the exclusion of the Ponzi scheme income from gross income.[11] In other words, the taxpayer can either deduct the clawback payment from her income in the year the clawback is repaid, or she can claim a credit in the clawback year in an amount equal to the total tax in the clawback year (with the clawed-back amount included as income) minus the difference between what the taxpayer actually paid in taxes when she originally reported the Ponzi scheme income and what she would have paid in taxes had she never reported the Ponzi scheme income. This ensures that taxpayers get some recovery for clawbacks since they cannot claim them as theft-loss.[12]
Section 1341:
(a) General rule
If—
(4) For purposes of determining whether paragraph (4) or paragraph (5) of subsection (a) applies—
(5) For purposes of this chapter, the net operating loss described in paragraph (4)(A) of this subsection, or the net operating loss or capital loss described in paragraph (4)(B) of this subsection, as the case may be, shall (after the application of paragraph (4) or (5)(B) of subsection (a) for the taxable year) be taken into account under section 172 or 1212 for taxable years after the taxable year to the same extent and in the same manner as—
[1] COMMITTEE ON SALES, EXCHANGES & BASIS, 2009 ABATAX-CLE 0508038.
[2] Kaplan v. United States, 2007 U.S. Dist. LEXIS 59684, at *14-15 (M.D. Fla. Aug. 15, 2007) (citing 26 C.F.R. § 1.165-1(b)); see IRS Rev. Rul. 2009-9, 2009 I.R.B (April 6, 2009), at 3-4 [hereinafter “Revenue Ruling”].
[3] Revenue Ruling at 7.
[4] Vincentini v. Comm’r of Internal Revenue, 2011 U.S. App. LEXIS 14349 (6th Cir. July 12, 2011).
[5] See Beacon Assocs. Mgmt. Corp. v. Beacon Assocs. LLC I, 725 F. Supp. 2d 451, 462 (S.D.N.Y. 2010); Revenue Ruling at 8.
[6] Rev. Proc. 2009-20, 2009-1 C.B. 749 (I.R.S. March 17, 2009) at 2.
[7] Id. at 7-8.
[8] Id. at 8.
[9] See IRC § 1341(a)(1); Revenue Ruling at 10.
[10] See id. at § 1341(a)(2).
[11] Id. at § 1341(a)(3)-(5); Revenue Ruling at 11.
[12] Revenue Ruling at 13.
White Collar Defense Attorneys
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