This issue summarizes in general terms some of the tax issues involved in attempting to claim a tax loss due to a Ponzi scheme fraud. The article is written mostly in lay terms and should not be viewed as exhausting all of the tricky tax issues concerning theft losses.
DEDUCTING THEFT LOSS IS PROBLEMATIC
Obtaining a tax deduction for a Ponzi scheme loss requires answering many questions of fact and law, including:
1. Whether the loss is an investment loss or a theft loss
2. The proper year for claiming the loss.
3. The amount of the loss
4. Whether the loss is deductible fully or only to the extent it exceeds 10% (as for personal casualty losses) of adjusted gross income for the loss year.
5. The character of the loss, that is, capital loss or ordinary loss.
6. Whether the loss is from a trade or business or non-business activity.
7. Whether a net operating loss created by the allowed loss deduction may be carried back to earlier tax years.
8. To which earlier tax years may a resulting net operating loss be carried?
9. Whether taxes paid on phantom or fictitious income from the Ponzi scheme may be recouped by filing amended returns.
10. Whether one may recoup taxes on fictitious income paid in years closed by the 3 year tax refund statute of limitations.
The answers to these questions often take years to resolve and too frequently result in litigation with IRS. Until the issues are resolved there is often the need for and expense of filing protective refund claims to preserve alternative or fallback positions.
In 2009, IRS published a Revenue Ruling explaining its positions regarding many of the above questions. Some examples of potential potholes for investors are:
1. Normally one may deduct a theft loss in the later of the year of discovery or year in which there is no longer a reasonable prospect of recovery. For most Madoff investors that would postpone the loss deduction to 2009 or later even though many investors are in dire financial straits and could use a tax refund right now. Thus, filing a claim with the Madoff receiver creates the inference of a reasonable prospect of recovery.
2. Normally, investors filing amended returns to remove phantom income would have to prove that they did not receive such income or constructively receive it by virtue of the fact that many could have received the income had they simply requested a distribution.
3. Normally, a taxpayer can file amended returns going back only three years, presently to 2005, 2006 and 2007. Case law generally has not supported equitable, claim of right or mitigation arguments attempting to breach the 3 year limitations period. Soon investors will have to file protective refund claims for 2005 as the limitations period for that year will expire on 4/15/09.
THE IRS RESPONSE – A SAFE HAROR THAT IS A DOUBLE EDGED SWORD
The safe harbor is a procedure published simultaneously with the revenue ruling explaining the law as viewed by IRS. Some advantages of adopting the safe harbor by following the IRS procedure are:
1. The loss year for Madoff investors will be 2008 (year in which criminal charges filed) regardless of recovery potentials and avoiding disputes about whether there exists a reasonable prospect of recovery.
2. The amount of the loss will be 75% of an investor’s basis for those seeking recovery from others (not the perpetrators) and 95% for those not seeking third party recovery, minus any actual recovery and SIPC recovery. This percentage does not fix the ultimate loss amount which will be adjusted by income inclusions or deductions in later years, if necessary, based on the actual recovery.
3. The amount of an investor’s basis will be the net investment in the fund (cash invested less received back) plus phantom income reported even if amended returns have been filed; but, of course not including the income removed on amended returns.
4. Ponzi schemes where some investment activity occurred like in the Stanford investigation will also be eligible for the safe harbor.
5. The loss will be ordinary and not subject to the 10 percent of AGI limitation.
6. The loss, if exceeding taxable income, will, subject to the normal NOL adjustments, create a net operating loss that can be carried back and carried over.
7. Losses for years beginning or ending in 2008 will be carried back 5 years instead of the normal 2 years under recently passed stimulus legislation.
Possible disadvantages of signing on for the safe harbor are:
1. Cannot deduct an amount greater than the safe harbor allows, i.e. 75% or 95% as the case may be.
2. Cannot filed amended returns to recoup taxes paid on phantom income.
3. Cannot use the mitigation provisions contained in Sections 1311-1314 of the IRC.
4. Cannot apply the computational relief contained in IRC Section 1341.
5. Cannot apply the doctrine of equitable recoupment with respect to taxes paid in closed years.
6. Must decide whether to accept the procedure by the election deadline of May 15, 2009.
7. Must sign a statement agreeing to the above and disclosing if amended returns have been filed that are inconsistent with the procedure.
For most, especially retired investors, the safe harbor may prove beneficial but careful calculations should be run and advantages and disadvantages considered before making a decision. For example, a high earning professional expecting large income in future years may be willing to fight with IRS about some of these matters because a carryover NOL may be worth as much as a carry-back loss. Retirees on the other hand may be facing minimal income in future years due to the loss of their investment in the Ponzi scheme.
The analysis required to determine a course of action is a legal analysis and should be conducted with the assistance of legal tax counsel. A CPA, if the lawyer is not also a CPA as am I, may also be helpful in preparing necessary calculations.