Posted on April 4th, 2014

Deducting Ponzi losses

Investors who lost money in Ponzi schemes are allowed a tax deduction, but many questions need to be answered prior to actually entering the deduction on a tax return. For example, since Ponzi-scheme victims have paid tax on fictitious income, how are they to get refunds of their overpaid taxes? Amended returns would offer some relief, but refunds for many of the prior years would be barred by the period of limitations. Victims also need to know the character of the loss because if the loss is deemed to be a capital loss, the deduction would be severely restricted by the $3,000 annual deduction limit. Alternatively, perhaps the loss should be characterized as a theft loss. However, this also restricts the deduction because theft losses are generally deductible only to the extent they exceed 10% of the victim’s adjusted gross income. Even the timing of the loss is problematic: should the loss be deducted in the year the victim invested the money, or in the year the fraud was discovered? The IRS has issued pronouncements that provide answers to these and other related tax questions. This article explains and illustrates those pronouncements. 

PONZI LOSSES

DEDUCTING PONZI LOSSES

To ease the burden on Ponzi scheme victims, the IRS has attempted to simplify the deduction of Ponzi losses.

Over the past several years, many Ponzi schemes have come to light. The most famous, of course, was the Bernie Madoff scandal, but victims of other unscrupulous persons are surfacing on an almost a weekly basis.

Ponzi schemes can come in many variations, but in general the perpetrator claims to be skilled at picking low risk investments that produce above average yields. These claims, and word of mouth, cause investors to give their money to the perpetrator. Subsequently, the investors receive fictitious financial statements showing that they indeed are making above average returns. The fraud continues until investor withdrawal demands exceed the perpetrator’s ability to pay. The investors then contact law enforcement, and the resulting investigation brings the fraud to light.

Investors who lost money in Ponzi schemes are allowed a tax deduction, but many questions need to be answered prior to actually entering the deduction on a tax return. For example, since Ponzi-scheme victims have paid tax on fictitious income, how are they to get refunds of their overpaid taxes? Amended returns would offer some relief, but refunds for many of the prior years would be barred by the period of limitations. Victims also need to know the character of the loss because if the loss is deemed to be a capital loss, the deduction would be severely restricted by the $3,000 annual deduction limit. Alternatively, perhaps the loss should be characterized as a theft loss. However, this also restricts the deduction because theft losses are generally deductible only to the extent they exceed 10% of the victim’s adjusted gross income. Even the timing of the loss is problematic: should the loss be deducted in the year the victim invested the money, or in the year the fraud was discovered? The IRS has issued pronouncements that provide answers to these and other related tax questions. This article will explain and illustrate those pronouncements.

Nature of the deduction

The IRS will not treat Ponzi losses as capital losses because the perpetrator was not really investing the taxpayer’s money. Instead, the perpetrator used the money to pay other investors and to fund the perpetrator’s lifestyle; that being the case, the taxpayer was defrauded, resulting in a theft loss and not a capital loss.

Since the loss is classified as a theft loss, the annual $3,000 capital loss deduction limit does not apply.  Theft losses have their own annual limit, however; specifically, a theft loss generally may be deducted only to the extent it exceeds 10% of the taxpayer’s adjusted gross income (hereinafter referred to as the “10% rule”).  Fortunately, however, the 10% rule does not apply to activities engaged in for profit. For example, if a person’s television was stolen, the 10% rule would apply, but Ponzi scheme victims differ from that common theft example because they knowingly gave their money to the perpetrator thinking they were making an investment; thus, they entered into the transaction with the intent of making a profit. This profit motive exempts their loss from the 10% rule.

Amount of the deduction

The starting point for determining the amount of the Ponzi loss deduction is the calculation of what the IRS refers to as the “qualified investment.” To arrive at the qualified investment, follow these steps:

• Add up all the money, and the basis of any other property (such as securities), that the taxpayer invested in the scheme.
• Add any income attributable to the account that the taxpayer included in his or her taxable income. 
• Subtract any withdrawals that the taxpayer received from the account.

Example 1: In 2006, Thomas Trustworthy opened an investment account with Fred Perp and immediately deposited $800,000 in the account. All of the account income is to be reinvested by Perp for the benefit of Trustworthy. In 2007, Trustworthy deposited an additional $160,000 in the account. According to account statements and tax documents sent by Perp to Trustworthy, the account earned $80,000 per year for the years 2006 through 2011. Trustworthy paid federal income tax on all of this income. Trustworthy received money only once from the account, specifically, in 2011 when he withdrew $240,000 to fund the down payment on a vacation home that he purchased. In March 2012, Perp was indicted for running a Ponzi scheme; shortly thereafter, Trustworthy was officially informed of the indictment by a court appointed receiver.

Based on the foregoing, Trustworthy’s qualified investment is:

Amount invested $960,000

Account income 480,000

Withdrawals (240,000)

__________

Qualified investment $1,200,000

Prior to claiming a deduction, subtract the following amounts from the qualified investment:

• Any recovery received by the taxpayer (via insurance or otherwise).
• Any amounts that can reasonably be expected to be recovered in the future. 

Example 2: Continuing from Example 1, Trustworthy was informed by the receiver that a small portion of his investment would likely be recovered; the receiver, however, was not willing to estimate the dollar amount of the potential recovery. Based on information in the public domain, Trustworthy is reasonably certain that he will recover $80,000 from the court-appointed receiver and $500,000 from the Securities Investor Protection Corporation (SIPC). He, therefore, deducts a loss of $620,000 on his 2012 Form 1040 (i.e., $1,200,000 minus $580,000).

Alternatively, Trustworthy could delete some of the fictitious income by amending his tax returns for any open years (i.e., years not barred by the period of limitations).

Example 3: Assume that the court-appointed receiver informed Trustworthy that there were no investments in his account and, therefore, the account earned no income. Based on this information, Mr. Trustworthy filed amended Forms 1040 for the years 2009, 2010, and 2011. The amended returns generate tax refunds due to the elimination of the $80,000 per year fictitious income. As shown below, Trustworthy’s qualified investment would now be $960,000.

Amount invested $960,000

Account income

(after amending returns) 240,000

Withdrawals (240,000)

__________

Qualified investment $960,000

Consequently, his theft loss would be $380,000 (i.e., $960,000 minus $580,000). ¹⁰

Reporting the loss

Section B of Form 4684 is used to report the theft loss. The loss is an itemized deduction; therefore, it is carried from Form 4684 to Schedule A. Specifically, the loss is entered on line 28 of Schedule A as an Other Miscellaneous Deduction. By classifying it in this manner, the loss will not be reduced by 2% of adjusted gross income; and as explained above, it will not be reduced by 10% of adjusted gross income; and it will not be subject to the overall limitation on itemized deductions (i.e., the phasing out of itemized deductions for high-income taxpayers).

Safe harbor provision

The year of the theft loss deduction and the amount of potential future recovery may lead to disputes between the taxpayer and the IRS. As to the former, the loss must be deducted in the year the theft was discovered. The IRS and the taxpayer, however, may disagree on the discovery year. For example, the taxpayer may claim to have discovered the loss in 2012, but the IRS may take the position that the taxpayer knew of the loss in 2010. As to the potential future recovery, this amount will usually be pure guesswork. The IRS does not want to tie up its resources haggling over these issues. Therefore, it has established a safe harbor provision that taxpayers may use to determine the year of the discovery and the amount of the expected future recovery.

Under the safe harbor procedure, the discovery year is deemed to be the year in which an indictment, information, or criminal complaint is filed against the perpetrator,  and the potential future recovery is factored into the deduction by simply multiplying the qualified investment by either 95% or 75%. Taxpayers who are not going to pursue any third party recovery use 95%; and taxpayers who are pursuing, or intend to pursue in the future, third party recovery use 75%. For example, if a taxpayer is suing an intermediary who introduced the taxpayer to the perpetrator, the taxpayer would use 75%. After multiplying the amount of the qualified investment by the appropriate safe harbor percentage, the taxpayer must subtract any actual recovery received and any potential insurance or SIPC recovery. 

Example 4: Assume the same facts as in Examples 1 and 2 above, except that Trustworthy opts to use the safe harbor method to deduct his loss. His deduction year will be 2012, the year Perp was indicted, and because he is not pursuing any third party recovery, his deduction will be $640,000, calculated as follows: ($1,200,000 qualified investment × 95%) – $500,000 expected SIPC recovery = $640,000.

If the safe harbor procedure is used, the taxpayer must write “Revenue Procedure 2009-20” across the top of Form 4684, and the taxpayer must attach a safe harbor statement to his or her tax return. The amount that appears on line 10 in Part II of the safe harbor statement (i.e., $640,000 in Exhibit 1) is carried to Form 4684, Section B, Part I, line 28. 

The safe harbor procedure is optional—taxpayers do not have to use it. However, unless there is a compelling reason to the contrary, taxpayers should use the safe harbor procedure to avoid potentially costly and time consuming disputes with the IRS.

Other considerations

The following two matters also need to be considered in the context of Ponzi losses

Subsequent year adjustments.

As explained above, the Ponzi loss deduction is reduced by the amount of a taxpayer’s estimated future recovery. If a taxpayer subsequently recovers more than the estimated amount, the taxpayer will use the Code’s tax benefit rule to report taxable income in the year that the excess amount is received. Alternatively, if a taxpayer subsequently recovers less than the estimated amount, the taxpayer will claim an additional Ponzi loss deduction in the year that the amount of the recovery can be determined with reasonable certainty. 

Net operating loss.

The Ponzi loss deduction might be so large that the taxpayer ends up with negative taxable income in the year of the deduction. If that is the case, the taxpayer will have a net operating loss (NOL) that can carried back to the previous three years and used to offset taxable income in those years; if there is not enough taxable income in the prior three years to offset the entire NOL, the unused amount can be carried forward and used to offset taxable income for up to twenty years. 

Conclusion

In spite of the harsh prison sentences handed down to Bernie Madoff and his ilk, Ponzi schemes are still prevalent in our society today. In an attempt to ease the burden on the victims of such schemes, the IRS has issued pronouncements that explain and streamline the deduction of Ponzi losses. By following the guidance provided in these pronouncements, Ponzi scheme victims should get the speedy tax relief that they deserve.