2008 was a watershed year for disclosures of Ponzi schemes, with Bernard Madoff ’s being the most notable. However, fraudulent investment schemes continue and claiming tax losses resulting from these schemes can be quite complex.
For example, consider the following hypothetical scenario. In 2005, Jim Smith invests $50,000 in a fund. Over the next two years, he receives annual tax reporting documents reflecting $15,000 in earnings. He decides to invest an additional $50,000. During the following four years, the earnings increase to a rate of $50,000. In 2011, Jim’s fund balance is now $330,000. Jim has never elected to take any distributions from the fund.
In the summer 2011, Jim learns the fund sponsor admitted the fund was a scam. He is able to secure $30,000 from insurance, but is left with a
$300,000 loss representing his original and subsequent investments and cumulative reported phantom taxable earnings. Jim concludes his chances of further recovery are remote.
Ponzi schemes present difficult tax issues. Jim is able to confirm his investment was lost in 2011 and he would like to recover the taxes paid. If he were to amend his earlier returns, the resulting tax refunds could draw interest, whereas a deduction claimed in 2011 will not.
Refund claims of the earlier years may be barred by the statute of limitations. If amended returns are filed, the IRS may challenge them, asserting that Jim has a burden of proof to establish the legitimate amount of earnings in each amended return year as well as an inability to recover some or all of his investment had he closed his account or requested a distribution during the year. Jim would like to avoid a controversy with the IRS.
In response to Madoff ’s Ponzi scheme, the IRS issued Revenue Ruling 2009-9 in which it laid out the general tax law provisions applicable to theft losses and, in particular, to Ponzi schemes. In Revenue Procedure 2009-20 safe-harbor approaches were provided relative to reporting tax deductions for losses arising from “qualified Ponzi schemes.” Under the safe- harbor provisions, taxpayers may deduct a material portion, but not all, of a loss resulting from a qualified loss in the year that that the loss is discovered. To qualify, Jim must be able to establish that he did not have actual knowledge of the fraudulent nature of the scheme prior to it becoming public. The promoter must have been charged by indictment or similar circumstances with the commission of fraud, embezzlement or etc., constituting a theft loss for tax purposes. Or, the promoter must have been the subject of a state or federal criminal complaint alleging fraud, embezzlement or etc., with a receiver or trustee appointed or the assets frozen.
Jim has a qualified loss and may elect safe harbor treatment for 2011, the year in which the loss is discovered, and be assured that the IRS will not challenge whether the loss is a deductible theft loss. If Jim has decided by the end of 2011 that he will not pursue any claims for recovery (other than possible insurance and Securities Investor Protector Corporation recoveries or actual or potential claims against the sponsor group) he will be entitled to a loss deduction of $285,000 (under the safe-harbor provisions, this is 95 percent of his net $300,000 unrecovered loss). If Jim were still pursuing recovery claims outside of the above exceptions at the end of 2011, his deduction would be limited to $225,000 (75 percent of the unrecovered loss). Jim may be required to report income in a future year should additional recoveries exceed the 5 or 25 percent thresholds applied in determining the 2011 deduction. Alternatively, Jim may be entitled to an additional future deduction should his ultimate future recoveries fall short of such levels. In order to take advantage of the safe-harbor provisions, Jim must agree to not file amended returns for pre-discovery years (years prior to 2011).
The prospect of taking a 5 or 25 percent “haircut” and giving up the right to file amended returns for pre-discovery years in return for a level of certainty for deductions and avoiding potential controversy with the IRS may be appealing to many taxpayers. The safe-harbor provisions are, however, elective and some taxpayers may choose to take their chances with amended returns.
Individuals who find themselves in this situation should carefully consider the relevant facts and circumstances.