VIDEO: Taxation of the Clawback in a Ponzi Scheme – Maximum Tax Recovery
Total presentation time: 01:32:07

by Richard S. Lehman, Esq.

This article unfolds in an interesting fashion. Every item we cover in this article is a building block to the next item - until we come to the last portion of the presentation when it will all fit together.

Any lawyer involved in a clawback settlement agreement must, where possible, in the settlement agreement, distinguish between and earmark the two types of clawback that can happen. There can be a clawback of profits earned from the ponzi scheme or a clawback of invested principal.

As you will see there is a distinctly different tax treatment between the two clawbacks and as a general rule, clawbacks allocated to profit losses may be more valuable for larger refunds but also may be more treacherous to deal with.

One cannot understand the taxation of the clawback in a ponzi scheme without first understanding how a direct ponzi scheme loss is treated under the tax law.

The “direct ponzi scheme” loss is the loss that occurs when the scheme explodes and nothing is left as opposed to the loss that results from clawback payments. These are payments made after the Ponzi scheme becomes a bankrupt estate.

The taxpayer must also learn about what is called the “mitigation section”.

This is internal revenue code section 1341 that permits one type of the clawback payment to be taken as an ordinary income deduction in the year in which the clawback income was originally taxed even if the year is closed by the statute of limitations; while another type of claw back payment may be deductible only in the year of payment.

The taxpayer needs to know how to deal with “tax losses” from the clawback payment and how those losses can best be used, either to receive a refund from taxes paid in the past; or a “carry forward” of those losses to offset future income.

When all of this is put together you will see how effective the mitigation provision can be.

We will start with a summary of the basics.

The tax analysis of losses in a ponzi scheme and ultimately the Ponzi scheme clawback losses starts with the deduction in the internal revenue code for theft losses. In particular to the Ponzi scheme it is code section 165(c)(2). That code section states:

There shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

Limitation on losses of individuals

In the case of an individual, the [loss] deduction . . . Shall be limited to losses incurred in any transaction entered into for profit . . .

There are several IRS publications that are helpful in understanding the law of ponzi scheme losses and the clawbacks of ponzi scheme profits and principal. We will discuss them during the seminar. For a review of the basics, we will just discuss the most important, findings of those publications.

First the IRS considers a loss in a ponzi scheme as a theft loss.

Theft definition

A theft loss is any type of taking that is considered a theft under state law, and that’s a very broad definition.

A definition from one of the cases reads ;

“For federal income tax purposes, theft is a word of general and broad connotation covering any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile. A taxpayer claiming a theft loss must prove that the loss resulted from the taking of property that was illegal under the law of the jurisdiction in which it occurred, and was done with criminal intent. However, a taxpayer need not show a conviction or theft or even the bringing of an action”.

Taxation of Clawbacks

What you see in this presentation is that we must go building block - by building block - for you to understand fully the last portion of this presentation that pulls all of this together and shows how to maximize the tax value of clawback losses.

We now come to the principle of clawbacks and the taxation of the funds paid in a clawback.

What happens in ponzi schemes, is that certain parties either intentionally or unintentionally actually may make out very well in a ponzi scheme. They may receive all of their money back before the scheme explodes or may have received a profit that was distributed in cash, and never lost in the scheme.

The trustee of a ponzi scheme in bankruptcy obtains a clawback and that money is put back in the pot for the other Ponzi scheme victims.

CHART 1 is a comparison: Deduction of clawback vs Exclusion of clawback

First, we will discuss CHART I. You will understand it much better at the end of the seminar. However, it graphically shows the tax effects of the right way versus the wrong way. The effects are dramatic and will focus your attention to this technical and valuable tool.

In this chart you will see a comparison from a single example, how different the end result can be. The chart compares the cash refund of a deduction versus the refund from the mitigation section under circumstances in which a Ponzi scheme profit of $200,000 was earned in 2007 in addition to the Taxpayer’s Other Income and the clawback occurred in 2013. A deduction and its carrybacks versus relying on the mitigation section is almost one-half as valuable as the amount of the mitigation refund.

A clawback can come many years after, and what will typically happen in a clawback is, after a taxpayer has paid the clawback, there is a deduction for the money paid to make the clawback payment in the year of payment. That deduction can reduce the taxes in the year of the deduction and excess losses can be used to apply for a tax refund of prior taxes for a two-year period or the deduction can be carried forward to be used against future income for twenty years.

After the dust has settled for all of the direct ponzi scheme victims, and years later, the clawback target may not be making a lot of taxable income because they too may have lost money in the scheme.

Therefore, the tax benefit from paying the clawback funds could amount to very little if it is deducted in the year it is repaid. If one is in the 15% tax bracket in the year the clawback is paid, they are only going to get 15 cents on the dollar back as a refund. They might have paid taxes on that same income to the U.S. and the state in which they reside equal to 40% of the income.

Mitigation

We are going to thoroughly explore how to get out of this trap.

If you have made a clawback payment, what you will see is that you can get out of the trap in two different ways, depending upon (1) whether the clawback is a clawback of previous reported profits or (2) the clawback requires a payback of an investor’s principal investment to the trustee.

There is a particular section in the internal revenue code (the ‘mitigation section’) that would allow you to deduct clawed back funds that represent profits from the year in which those funds were paid to the investor and taxed.

That is typically going to be high earning years. If you qualify, the mitigation section may provide you with a much larger tax refunds.

We are going to study a unique Internal Revenue Code section that permits the clawback victim to actually be in a better position than those who lost funds directly in the ponzi.

Since the mitigation section is complicated we are going to look at each of the elements that must be met if one is to benefit from it and why a Ponzi scheme clawback meets those definitions.

One has to understand this code section to appreciate how valuable it is.

Facts

As you see in Chart 2 - The Tax Rate was 30%.

For the taxable year 2008, a corporate taxpayer reporting income on the calendar year basis had taxable income of $20,000 on which the taxpayer paid a tax of $6,000.

Included in gross income for such year was $100,000 received under a claim of right as royalties, the tax rates are calculated at 30%. For each of its taxable years 2005, 2006, 2007, 2009, 2010, and 2011, the corporation had taxable income of $10,000 on which it paid tax of $3,000 for each year.

In 2012, the corporation returns the entire amount of $100,000 of the royalties earned in 2008. In 2012 the corporation has taxable income of $25,000 for a tax of $7,500 (without taking the deduction of $100,000 into account). If the deduction is taken in year 2012, no tax is paid for 2012 and there is a net operating loss of $75,000 (taking the deduction of $100,000 into account).

The net operating loss of $75,000 for 2012 (taking into account the deduction of $100,000) is carried back under the net operating loss rules, 2 years. Taxable years (2010 and 2011) in the manner shown.

The entire taxable income for those years is eliminated by the carryback, and the corporation would be entitled to a refund of the tax for such years in the aggregate amount of $13,500 with total deduction(s) used of $45,000. The remaining $55,000 of the net operating loss for 2012 would be available as a carryover to taxable years after the taxable year 2012.

In Chart 3, as an alternative, under the mitigation section the taxpayer will deduct nothing in 2012 but will exclude $7500 from gross income for the taxable year 2008 (the year in which the item was originally included).

This results in a net operating loss of $80,000 for such year ($20,000 taxable income minus the $100,000 exclusion), thus decreasing the tax for 2008 year by the entire amount of $6,000 paid.

The resulting net operating loss of $80,000 for 2008 is available as a carryback to 2005, 2006 and 2007 and as a carryover to 2009, 2010, 2011, and 2012. Since the aggregate taxable income for these taxable years is $80,000, only $20,000 of the 2012 taxable income of $25,000, is eliminated by carryback and carryover.

This leaves tax on such remaining $5,000 of taxable income for 2012 is $1,500, thus decreasing the tax determined for such year by $6,000, ($7,500 minus $1,500).

Under section 1341 the decrease in tax for the prior taxable years exceeds the tax for the taxable year of restoration computed without the deduction of the amount of the restoration by $16,500. However, there are no additional losses carried forward

One must see why care must be taken when the mitigation section is relied to make sure that the losses that are being carried back and carried forward do not exceed all of other income that can be offset prior to the payment date as those excess losses cannot be carried forward.

If the mitigation section is used, since the computation results in an available refund of only $13,500 for the taxable years to which the net operating loss for 2012 is carried back, and since the mitigation computation results in an overpayment of $28,500, it is determined that the mitigation section applies.

Accordingly, the $28,500 is treated as having been paid on the last day prescribed by law for the payment of tax for 2012 and is available as a refund.

In today’s world we need to go even a step further and look at the alternative that becomes relevant when taxes are higher.

Finally (chart 4) we have assumed we are in the present day and that the tax rates after the clawback payment have moved up to 40%; when the loss in the year of payment and the loss carry forward might have a tax value of $37,500.

In this CHART 4 it is assumed that the taxpayer lives in a state with a state income tax, a city with a city income tax and the average tax rate is 40% between the three taxes. At that point the best choice is clearly, take the deduction in 2012. Do not carry back losses (which is an election), but carry losses forward of $75,000 for the future years will result in $37,500 in cash refunds or taxes avoided.

One can see there is potential to lose tremendous amount of money with loss carrybacks and loss carry forwards that can’t be used if it is not done right.

In the income tax situation, just the year of discovery is going to make a difference in when people can get their money, how the taxpayer can get their money, whether they get their money back at the highest tax brackets.

You need to know all of your options. That’s the heart of the tax planning. You need to have your crew of professionals so that you can scope out in numbers and hard dollars every option that you’ve got and be able to choose the best ones that have the quickest legal answers and the best financial answers for you.

The mitigation section

We have seen the refund differences by using the mitigation section of the case. Internal revenue code section 1341, (the mitigation section); was designed to allow someone who pays funds back in a clawback to be able to go back to the year that the Clawback income was earned for tax purposes and exclude that income to calculate which tax result would be more valuable. This permits the taxpayer to use the clawback; in the year in which the highest tax bracket and tax value is found.

Since this is a beneficial section for the taxpayer, the IRS is strict about making sure one qualifies for who this was intended to help.

We are going to study the mitigation section carefully to see how the Ponzi scheme clawback fits in this mitigation section.

The claim of right doctrine

The study of the mitigation section starts with “the claim of right doctrine”.

This tax doctrine states that if a taxpayer receives income in a particular year, but was forced to repay it in another year, the taxpayer cannot go back to the original year and correct the original year in which the income was earned. The original year most often was closed by the statute of limitations and it was impossible to unwind the statute of limitations.

This led to terrible inequities such as you saw in the example. The mitigation section was passed to cure this inequity.

This section has several requirements to achieve this equity and has intricate rules dealing with the loss carry back and carry forwards in the mitigation section. These need much care, or else valuable deductions can be lost.

We are going to take a good look at the “mitigation section” requirements.

The ponzi clawback meets each and every one of these requirements. As I said, we still study them as part of building blocks to appreciate the end result.

The mitigation section has four important requirements and one requirement that is outdated by now. They are:

1. An item of income must have been included in a prior taxable year.
2. Because it appeared that the taxpayer had unrestricted right to that item of income.
3. The taxpayer must be able to claim that in the year that the clawback was made, a deduction would be allowed for the payment.
4. The fourth important requirement is that it must be established after the close of the prior taxable year that the taxpayer did not have an unrestricted right to the income that was refunded.
5. The fifth requirement is that the amount of the deduction must exceed $3,000.

Item included in gross income

What we’re going to do now is explore each one of the first four important items and consider them in some detail.

The first item required for mitigation is that an item of income must have been included in gross income for a prior taxable year or years.

The word “item” is defined in the law. In the internal revenue code, there is a definition of the word item of gross income, and certain specific items are listed. However, that definition is not limited just to the specific items listed. The word “income” includes all income from whatever source it is derived.

Guidance as to what is an “item” of gross income is found in code section 61.

That code section provides a specific definition for gross income and a general one. The income ‘items’ that might be used in a ponzi could include any of the following types of fraudulent income payments.

The code section defines income as: “Except as otherwise provided . . .. Gross income means all income from whatever source derived, including (but not limited to) the following items”.

• Compensation for services, including fees, commissions, fringe benefits, and similar items;
• Gross income derived from business;
• Gains derived from dealings in property;
• Interest;
• Rents;
• Royalties;
• Dividends;
• Annuities;
• Alimony and separate maintenance payments;
• Income from life insurance and endowment contracts;
• Distributive share of partnership gross income;
• Income in respect of a decedent; and
• Income from an interest in an estate or trust

It is clear ponzi schemes can be built around any of the items.

Inventory

It is very important to keep in mind that the inventory of a taxpayer’s business or transaction entered into for profit is accounted for under its own unique set of tax principals and is not within the mitigation provisions.

Apparent, unrestricted right to such item

The next qualification that the taxpayer seeking mitigation must have is the “apparent right to the income” that the taxpayer reported in the prior year. What is the law after here?

Essentially, the legislation is designed to make sure that (1) no one can “voluntarily” use the mitigation section and (2) that income subject to mitigation was subject to the taxpayer’s unrestricted right at the time of reporting.

The mitigation section does not apply unless the taxpayer included the item in gross income in a previous year because it appeared that the taxpayer had an unrestricted right to the income. The taxpayer must have some right to the income but need not have an unchallengeable right in the year of inclusion.

The mitigation section does not apply if the taxpayer included the income item because he or she had an absolute right and must make the repayment for reasons other than a determination that no right existed to the income initially reported.

However, at least one court has stated that an apparent right to income may exist because a taxpayer reports an item as taxable income in a tax return, holding that a prima facie case is made that the taxpayer believed the income was the taxpayer’s. The court stated:

“Since [the taxpayer] took into income the item, it is clear that [the taxpayer] believed that it had a right to that income.”

The reasoning of the court is important here because the court stressed that since the mitigation provision is remedial it should be interpreted in favor of the taxpayer.

Certainly in the case of the Ponzi scheme, every objective indication is that there is an apparent right to income that is being reported by that investor. The ‘clawed back’ income is reported on the investor’s tax return, was available for distribution to investors until the crash came and, was in fact distributed to many investors. As can be seen by the many lives devastated by ponzi scheme perpetrators, the funds were counted on by all ponzi investors as real and critically important to their lives.

The claim of wrong exception to the claim of right principal

Equally important to eliminating the potential to manipulate the mitigation section was the idea that a “mitigation provision” in the law should not be available to wrongdoers.

To be entitled to mitigation, a taxpayer must not only have had an apparent right to the reported income; the taxpayer must have not wrongfully obtained that income. This means that if the taxpayer had no right at all to the income when it was received, the taxpayer could not receive mitigation treatment when later if that same income had to be refunded.

Thus the mitigation section does not apply to certainly wrongly claimed rights to funds. For example, the repayment of embezzled funds because embezzled funds may be included in gross income but there is no valid claim of right. Mitigation requires an unrestricted claim of right by the taxpayer.

The IRS position is that a taxpayer cannot have any right to income and therefore claim mitigation for its repayment, if the original income was “wrongfully obtained.”

This doctrine has been applied in cases of embezzlement, smuggling, kickbacks, and ill-gotten gains and rarely in a civil fraud setting. One thing has been clear. The “claim of wrong doctrine” cannot exist in a civil situation where there is no intentional wrongdoing such as a clawback victim.

The claim of wrong exception could not apply to the typical Ponzi scheme victim. This is a taxpayer who loaned or invested money with a highly respected and presumably trustworthy and wealthy member of the community (who turned out to be a con man). This clawback payer is a victim, not a wrongdoer.

Nonetheless, every settlement agreement should include statements about the clawback victim’s innocence and non-involvement in the Ponzi scheme.

Entitlement to deduction in year of payment

The third requirement is that the actual year of payment when the taxpayer pays the clawback, the payment must be a permitted deduction in that payment year.

Simply put, it means that clawback paid in the year 2012, for example, must be deductible in that year under a particular code section. Once that standard of deduction has been met, if the clawback represents a payment of profits earned in a prior year, the mitigation section will be available.

The mitigation section is a relief provision. It is not a tax deduction provision. It does not grant taxpayers a tax benefit for amounts that are not otherwise deductible.

Relationship between deduction and inclusion

Not only must there be a “deduction” in the year of payment, the relationship between the “deduction’ and the clawback payments are critical.

Clawback losses are not lost directly in the Ponzi scheme. Clawback losses are a repayment that was paid as profits or it is a payment of principal that was previously repaid to the Ponzi scheme investor.

The purpose was, quite simply, to ensure that, when the taxpayer found itself to be the losing party in the dispute and had to turn over specific funds to the rightful owner, the taxpayer should be able to re-compute its income for the year of receipt so as to entirely reverse the tax liability due to the disputed item.

What the courts have tried to do is make sure that if one is going to use the mitigation section and get a deduction for an item paid in a later year, there must be a close relationship between the item of gross income that’s originally recorded and the item of gross income that is being refunded and for which a deduction has been claimed.

In short, where the later payment arises from a different commercial relationship or obligation, and thus is not a counterpart or complement of the item of income originally received, the same circumstances test precludes application of section.

One court’s statement about this doctrine is helpful.

“The requirement that there be a nexus is inherent in the concept of “restoration” itself”.

A few examples from the case law also describe the necessary nexus of the repayment. The tax court has held that mitigation was not available for an executor’s reimbursement of an estate’s late filing penalty because the reimbursement was not a repayment of the commissions previously included in the investor’s gross income. The court ruled that the penalty would have been required even if no commissions had been received.

In another example, it was held that a doctor who had benefited from false insurance claims made by the professional corporation that paid the doctor’s salary was not entitled to use the mitigation section because the false claims had generated income for the professional corporation and not for the doctor, explaining that the item originally included in income was the doctor’s salary, whereas the restitution payments derived from the fraudulent insurance claims were submitted by the corporation.

A great number of cases have found that obligations that arose to remedy environmental damages did not demonstrate the restoration of an item of income to an entity from whom the income was received or to whom the item of income should have been paid.

These cases have been helpful in defining the substantive nexus between the right to the income at the time of receipt and the subsequent circumstances necessitating a refund.

Many cases in the environmental field have made the point that a company’s environmental cost, or “new obligations” of cleaning up waste did not arise from the same circumstances terms and conditions as the initial failure to spend additional funds to prevent waste.

Rather the obligations were created by new circumstances terms and conditions, namely, by an intervening change in environmental legislation.

The Ponzi Scheme Clawback – Same Circumstances

It would seem that the “same circumstances” test is generally going to be satisfied on the very face of the Ponzi clawback transaction. Had it not been for the Ponzi scheme investment, there would be no tax on, or reporting and payment of, the income that is returned in a clawback. The Ponzi investment and the clawback are directly related to each other from the same circumstances. The clawbacks repayment certainly seems to be a direct result of the same circumstances and the same Ponzi scheme that caused the clawback victim to report income in the first place.

However, as we will see the Internal Revenue Service does not believe the clawback of profits is deductible as a theft loss. Instead, the service provides almost identical treatment to these clawbacks as ordinary loss deductions because they are “non theft investment losses”.

Either way, whether the loss is a “theft loss” or a non theft investment loss, the IRS has considered it is an ordinary loss. The taxpayer is satisfied either way.

Repayment because lack of unrestricted right established

If the taxpayer in the past should have never included the funds in income or if the taxpayer included the income under an absolute right and makes the repayment for reasons other than a determination that no right existed the mitigation section will not apply.

In other words, the taxpayer’s repayment must be involuntary.

The fourth requirement of the mitigation section is that income that must be restored to another person because it was established after the close of a prior taxable year (or years) is not income which the taxpayer had an unrestricted right to such item (or portion thereof).

In other words, it must be clear that the taxpayer did not voluntarily return funds in order to profit from the mitigation provisions. There was a good deal of litigation on just what was meant by the “established” requirement.

The courts clarified this significantly.

The bottom line is that the best proof of this will be a good faith settlement agreement reached with the clawback trustee.

A judicial determination adverse to the taxpayer is not a prerequisite to a conclusion that the repayment is involuntary, but the repayment must arise out of a determination that any claim pursued against the taxpayer would be resolved adversely to the taxpayer.

This part of the code section is mainly trying to distinguish between taxpayers that appear to have a legitimate right to unrestricted right to gross income, and pay the tax on it; and taxpayers who really had no actual right to the gross income that they may have reported in prior years.

Examples of this are:

In the fourth requirement, the statute requires that when the taxpayer refunded the clawback monies, it must be clear that the taxpayer did not voluntarily return funds in order to profit from the mitigation provisions.

One case states that the “established” requirement is met under the following circumstances:

The general rule is that a good faith, non collusive settlement agreement entered into to terminate litigation will “establish” a liability to return income, thereby establishing a lack of an unrestricted right to income for purposes of section 1341.

A taxpayer’s good faith efforts in the Ponzi scheme to resist repayments of money in a fraud should meet the requirement of the law.

This concept of 1341 is best understood by analyzing two landmark cases that at the same time had decided both this issue and the standard that must be met for a deduction under the “established” requirement. Some courts interpreted the Barret case and the Pike case as being in contradiction about this “doctrine of voluntary payment”.

In Barrett, the taxpayer had included profit from the sale of stock options in one year and then, in a later year, the securities and exchange commission brought administrative proceedings against the taxpayer on the basis of alleged insider trading.

The taxpayer settled the case without admitting liability and claimed that the settlement payment deserved section 1341 treatment. Barrett held that a settlement that was made at arm’s length and in good faith could satisfy the “establishment” requirement of section 1341, stating:

The source of the obligation [to repay] need not be a court judgment; however, there must be a clear showing . . . Of the taxpayer’s liability to repay.

In contrast to Barrett was the Pike case, which involved a taxpayer who bought and sold corporate stock in one year, after which an investigator found that the profit from said stock should have gone in the corporation and not the taxpayer. The taxpayer then paid the money to the corporation, without admitting that the profits belonged to the corporation, and avoiding controversy so that he did not suffer harm to his professional career.

The Pike court stated that, although “a judicial determination of liability is not required . . . It is necessary under section 1341 for a taxpayer to demonstrate at least the probable validity of the adverse claim to the funds repaid.”

Although the holding in Pike and Barrett are different due to distinguishable facts, the point of law that they stand for is not. The primary distinction is that in Pike there was no suit against the plaintiff for repayment of money, which makes it more likely that the taxpayer acted voluntarily in paying the money and less likely that the taxpayer can “demonstrate at least the probable validity of the adverse claim.” Voluntary restitution will not meet the establishment requirements.

In Barrett, an actual settlement was made with the plaintiff(s) who had filed a suit, the taxpayer denied liability when entering into the settlement, and there was no indication that the settlement was not made at arm’s length. Under these circumstances, the taxpayer has met the establishment test. This is going to be the typical scenario in a clawback situation.

The amount of the deduction must exceed $3,000

The last requirement might give you some idea of how long this section has been in the code. The minimum amount of actual tax revenue at stake, about $500.00; to bring mitigation claim is about a six months tab at Starbucks.

Summary – The clawback of Profits

So, the Ponzi scheme clawback of profits passes all of the tests of the mitigation section.

The perpetrators promise extrordinary returns in almost every one of the many types of listed income “items”. The taxpayer believes he or she has the right to take the item into income and does so, paying tax on the income.

The year in which the taxpayer pays the clawback will be a year in which the taxpayer will receive a deduction for the repayment and the successful trustee in a clawback will have established there was no right to the income.

The compliance with the $3,000 deduction minimum goes without saying.

One more bit of background before we proceed with how the “ponzi theft loss” deduction and the “mitigation section” are married together to provide the best of all worlds; we are going to review a little history in this area.

In the year 2008 the Madoff ponzi scheme erupted and the IRS was swamped with cries for professional guidance on how to deal with Madoff victims’ losses. The tax law of financial thefts was unsettled and confusing at the time and the IRS published two extremely helpful documents in 2009 that greatly clarified matters. These consisted of Revenue Ruling 2009-9 which spelled out the law of deductions for ponzi scheme losses and Revenue Procedure 2009-20 which provided an easy administrative path for injured taxpayers to recover the taxes paid on their lost funds if they met certain standards and had clear evidence of a criminal ponzi scheme loss.

Neither of these publications directly commented on the deduction of a clawback. However the earlier rulings did specifically prevent direct ponzi losses from using the mitigation section. This made sense because in direct ponzi losses, there is no “repayment” of income earned from a prior year.

There was also a revenue procedure that outlined an easy administrative process to claim refunds from direct ponzi losses only. This was called the safe harbor. We are going to talk very little about the “safe harbor” the safe harbor is very meaningful for direct Ponzi scheme victims but not for the clawback.

These publications said very little about the clawback. They did completely clarify the law on direct ponzi losses.

In clearing up a lot of the confusion, the revenue ruling came to several legal conclusions about direct Ponzi scheme losses. But, the revenue ruling and the 2009 revenue procedure both considered principally the question of how to deduct the victim’s direct losses of ponzi scheme phantom profits upon which taxes had been paid and the amount of the principal lost in the investment. The revenue ruling opined on the following about these losses.

The Law on Direct Ponzi Losses was Clear.

• Theft loss deductions. The revenue ruling defined the word “theft” for tax purposes and held that a ponzi scheme loss was a theft loss that resulted from a “transaction entered into for profit”. It was not a capital loss.
• Ordinary loss. The revenue ruling clarified the benefits of a business oriented theft loss. The ponzi scheme loss is an ordinary deduction for losses incurred in a transaction entered into for profits.
• Deduction is not subject to certain limitations on its use. As an ordinary loss, the ponzi theft loss is not subject to the limits on personal deductions or the limits on itemized deductions.
• Deductible in year of discovery. The theft loss is deductible in the year the loss is discovered.
• Amount of theft loss in a ponzi scheme.

Keep in mind this is not the standard being used in a clawback to determine amounts. The service also defined the amount of the loss that was available for the theft loss deduction by Ponzi scheme victims.

However, it is here that the definition of loss changes, since there is no “phantom income” lost in the clawback.

Loss carries over and carries back.

The last critically important IRS advice is that operating losses, arising from a theft loss, could be carried forward 20 year and carried back for 3 years. This is different from the typical loss carryback from a transaction entered into for profit or a business deduction, which is 2 years. In arriving at this conclusion the IRS also ruled that the ponzi victim’s investment was like a sole “proprietorship” and was entitled to the loss carryback as such.

The revenue ruling only considered direct losses from ponzi schemes where no additional payments were required. This is not the taxpayer’s case in a Ponzi scheme Clawback. In a Clawback situation, the losses come after the Ponzi scheme has failed and they are a result of a forced repayment, not an original payment.

The revenue ruling and the revenue procedure also considered effects of the tax law on claw backs. However, neither document presented the full picture of the deductibility of “claw backs” since the main focus of both documents was on the treatment of victims of immediate direct losses suffered when the ponzi scheme was first discovered and the investment funds and phantom profits were found to be worthless and nonexistent.

Nevertheless, even the revenue ruling implies that a clawback may very well be distinguishable from a direct theft loss that is unable to use the mitigation section because there is no “restoration of funds” in a ponzi scheme loss.

However, the revenue procedure and the revenue ruling did not give any direct IRS position or answers to the tax treatment of clawbacks.

The IRS F.A.Q.

Three years after the publication of the revenue ruling and the revenue procedure, in late 2012, as more and more clawbacks began to surface, the IRS provided some guidance for the taxation of clawbacks in a publication by the IRS entitled “frequently asked questions (F.A.Q.)”, related to ponzi scenarios for clawback treatment”.

The information was posed as two questions and answers.

Question: How does a taxpayer treat the repayment of a clawback?

Answer: Clawback repayments of amounts previously reported as income from a ponzi scheme are not additional theft loss deductions. Instead, they are repayments of claim of right income that result in either a deduction as a non theft investment loss, or a credit calculated under [the mitigation section] whichever results in lower tax.

A theft loss deduction from a ponzi scheme is not a deemed repayment of ponzi income that is eligible for the mitigation section . . . however, an actual clawback repayment is not a theft loss deduction and section 1341 treatment is not barred.
[The mitigation] . . .applies and the taxpayer would compute the tax for the year of the clawback payment (the clawback year) under two methods:

The F.A.Q. Then proceeded to show how to do the alternative calculations to use the claw back of profits either as a deduction in the year of payment or exclusion in the year the clawed back income was earned.

Method 1: figure the tax for the clawback year claiming a non-theft investment loss deduction for the clawback payment. It is not a capital loss and it is not subject to the 2% floor on miscellaneous itemized deductions.

Method 2: figure the tax for the clawback year with a credit computed as follows:

1. Figure the tax for the clawback year without deducting the repaid amount.
2. Refigure the tax for the year the clawed back income was originally reported (the income year) without including in income the amount of the clawback payment.
3. Subtract the hypothetical tax for the income year in (2) from the actual tax shown on the return for the income year. This is the section 1341 credit.
4. Subtract the answer in (3) from the tax for the clawback year figured without the deduction (step 1).

The taxpayer is entitled to the benefit of either the deduction under method 1 or the credit under method 2, whichever results in less tax (or a greater refund) for the clawback year. Note that the section 1341 credit is a refundable credit.

The second question asked and answered in the F.A.Q. :

Question: What does the taxpayer need to establish as to whether the repayment of a clawback is allowable as a deduction (or a section 1341 credit)?

Answer: usually a settlement agreement will have been entered into. The taxpayer has to establish that the clawback amount was required to be repaid to the trustee. The taxpayer would also have to substantiate that payment was made. The substantiation could include a letter from the trustee.

Clawback of the Principal of a Ponzi Scheme Investment

In the F.A.Q. The IRS provided more concrete guidance on clawbacks. However, again it was not complete guidance as it was directed at only one aspect of the clawback.

The F.A.Q. Considered only the tax treatment of the clawback of Ponzi scheme profits (“profits”), upon which taxes have been paid. Though the F.A.Q at first glance appears to encompass all clawback tax treatments, it in fact does not consider the treatment of the clawback of an investor’s principal investment.

The first paragraph of the F.A.Q. Directly states that the F.A.Q. Is dealing with “repayments of amounts previously reported as income from a ponzi scheme”.

These are profits earned by that after the fact must be repaid; to be shared by victims of the same scheme. The profits returned in a clawback are deductible as ordinary losses incurred in a transaction entered into for profit, but not as theft losses. According to the F.A.Q.

However, they do make it clear that though clawback repayments of amounts previously reported as income from a ponzi scheme are not additional theft loss deductions. Instead, they are repayments of claim of right income that result in either a deduction as a non-theft investment loss, or a credit, whichever results in lower tax.

Clawback of profits – theft loss or transaction entered into for profits losses

It would seem that the clawback of ponzi scheme profits would be deductible as repayments of previously reported income from a ponzi scheme that are treated as theft loss deductions. However, this is not the theory adopted by the Internal Revenue Service.

The F.A.Q. permits the taxpayer to have an ordinary deduction that is available for clawbacks of profits; but not as a “theft loss”. Rather the loss is permitted under what is in effect the theory that the loss is from a “transaction entered into for profit”. ²

The F.A.Q. uses the term “non theft investment loss” to describe the ordinary loss resulting from a clawback of profits. That term is not found in any tax library or on Google other than the reference in the F.A.Q.

The treatment of Clawback of invested capital (principal) withdrawn from a ponzi scheme

The F.A.Q does not deal directly with a clawback payment that pays to the trustee any original principal paid in to the ponzi scheme and has been withdrawn from the scheme.

This clawback payment represents the investor’s principal investment that is lost at a later point in time than the discovery of the theft. However, it is nevertheless lost due to a ponzi scheme theft. It is not a repayment of anything. It represents principal funds, that had they not been withdrawn and remained in the Ponzi scheme, would have been lost with the rest of the victims.

The F.A.Q. directly relates only to the clawback of ponzi scheme income. However, often a settlement may include a substantial portion of the clawback that represents the loss of investor principal.

The F.A.Q. Did not publish any materials on the tax treatment of the clawback of principal.

As a practical matter, any settlement agreement that is being reached in a ponzi scheme should include language to clarify the item being clawed back, the amount of the clawback and other tax issues. Tax counsel prior to finalization should review settlement agreements involving a clawback.

Though nothing has been published, the service has considered the issue of the treatment of a clawback that results in a taxpayer’s loss of the investor’s principal investment in the ponzi scheme.

Now is when our knowledge of the theft loss must again come back into play.

Late in may I spoke with an attorney with the chief counsel’s office of IRS he was very familiar with the F.A.Q. and advised me in no uncertain terms that the service position was to treat ponzi scheme principal losses that result from a clawback, in the same manner as the principal losses suffered by original investors. (i.e., those victims who invested principal and lost their principal funds when the Ponzi scheme was bankrupted).

This in fact means that IRS position is to permit the loss of principal in a ponzi scheme as a theft loss whether it is paid directly or as a result of a clawback.

Several aspects of the law support the IRS position. The IRS has confirmed in its revenue ruling 2009-9 that investors in ponzi schemes are engaged in a “transaction entered into for profit” and entitled to “sole proprietorship” treatment for purposes of the net operating loss rules under code section 172.

The F.A.Q. ruled that the Clawback of income was entitled to be treated as a loss resulting from the transaction and the IRS has ruled that the loss of principal is unlike the loss of profits because there is no “repayment of income”, such as we had in the claw back of profits.

Therefore, the principal lost in a Clawback is not entitled to use the mitigation section for its losses.

Certainly, there is a loss as a result of a clawback of principal. This loss of principal, whether it be lost as part of the direct ponzi scheme loss or whether it be lost as a result of a clawback that forces the taxpayer to replace principal previously withdrawn, are both treated identically. Losses are both incurred directly as a result of investing in a ponzi scheme. Ponzi losses of principal and profits are both treated as ordinary losses.

Time of discovery – the theft loss and the clawback of principal

Furthermore, the theft loss of principal resulting from a clawback is not “discovered” until it was paid in full. Since certainly there will not be a “recovery” of any of the clawback, and the principal is deductible as a theft loss, it should be that the entire amount of the theft loss (or 100% of the lost principal is deductible).

Because the theft loss resulting from a ponzi scheme is permitted as an ordinary loss, the taxpayer is permitted to use the rules that permit deductions for net operating loss carry overs and carry backs to the year of the payment.

Summation

Under certain circumstances there may be more tax value in a section of the internal revenue code that corrects an injustice in the tax law. This injustice occurs if the profits being returned in the clawback are deducted in a year when they were of little value because the tax rates were low in the year of payment; and yet the income that is paid back was earned in a year in which the taxes were high.

However, this injustice is corrected only as to a loss of profit that must be paid back. They do not apply to losses of principal.

The tax value of clawed back profits may be calculated as the higher of the tax value of the deduction in the year the Clawback is paid or the value of the deduction if one assumes that the profits that were repaid as a result of the clawback; should never have been taxed in the year they were taxed in the first place.

Consequently, when dealing with clawbacks, it is important to keep the different characteristics of the two clawbacks clear and then make the most use of those separate characteristics.

1.) Profits

(a) The clawback of profits is not a theft loss. It is an ordinary loss from a transaction entered into for profit, and the losses of which can be carried back for two years and forward for twenty (20) years as a general rule.

(b) The value of this clawback is entitled to be calculated under tax rules that maximize the clawback’s tax value whether (i) it was deductible in the year it was paid; or (ii) excluded as income in the year it was first considered as taxable income.

2.) Principal

(a) The claw back of principal is deductible as a theft loss. It is an ordinary loss, deductible only in the year of discovery. It will have a three (3) year loss carryback and twenty (20) years carry forward.

The Safe Harbor and the Clawback

The second document published by the IRS, known as the “safe harbor” for Ponzi scheme losses was revenue procedure 2009-20. This in fact is an administrative procedure that the IRS undertook in order to make sure that those ponzi schemes that could be clearly described as having violated state or federal criminal laws would have a “fast track” system with the IRS for administrative approval of claimed losses.

The safe harbor has strict standards and requires taxpayers to waive certain rights. In those cases where a Ponzi scheme perpetrator does fit in the safe harbor, the loss from that particular Ponzi scheme may be deducted directly with little interference at the administrative level. However, in the first year of loss, the taxpayer agrees to deduct only 95% of the total loss.

The safe harbor has ruled that the safe harbor is not available for losses of either principal or profits resulting from clawbacks. Since this is an administrative ruling the IRS can write the rules and one must comply exactly or the administrative grace of the safe harbor does not apply.

The net operating loss rules

The net operating loss rules become very important in mitigation. Especially in clawbacks.

One must know the tax situation of the ponzi clawback victim for many years in the past. Mitigation is not quite as simple as it seems, for a taxpayer to reap the most value from the clawback. This is because the mitigation section allows the taxpayer to go back to the year the clawed back profits were earned and then carryback losses from that original year to previous years for purposes of a claim for refund.

Net operating losses arising in year of repayment

A special rule applies for a deduction of an item is repaid in a year that generates a net operating loss for that year.

1. First, the net operating loss is carried back under the normal net operating loss rules, which is usually for a period of two (2) years.
2. Second, the alternative decrease in tax is computed under the mitigation section.
3. The amount of decrease in tax liability for those prior taxable years caused by the net operating loss carryback is computed.

If the amount computed under the first step exceeds the amount computed under the second step, the taxpayer treats any remaining net operating loss in the usual manner.

If the mitigation section is applied, a deduction is not taken in the year of payment for any of the repaid funds; other than as a result of a loss carry forward resulting from the mitigation calculation.

Adjustments to a liability of previous year

In recomposing the tax liability for the year in which the income item was included under the claim of right doctrine, the taxpayer must take into account any redeterminations, deficiencies, credits, and refunds attributable to that year, in addition to the tax liability shown on the return for that previous year.

In recomposing the tax liability for the taxable year in which the income item was included under the claim of right doctrine, the taxpayer must adjust those items whose computation depends on the amount of gross income or adjusted gross income, such as charitable contribution deductions under section 170, casualty loss deductions under section 165(h), medical expense deductions under section 213, miscellaneous itemized deduction limitations under section 67, itemized deduction reductions under section 68 and similar items.

Net operating loss arising in previous year of inclusion

A special rule applies if reducing gross income for the previous year in which the income item was included under the claim of right doctrine generates a net operating loss for that year. The net operating loss for the previous year is carried back under the usual rules, and the decrease in tax is not only the decrease in tax for the previous year of inclusion but also for all the other previous years to which the resulting net operating loss is carried. Any remaining Net Operating Loss is carried forward under the usual rules.

Now we are going to turn to our Chart 1 with a much better understanding of all of those amounts and understand how certain losses can be taken to maximize cash refunds to clawback victims as opposed to loss carry forwards.

Summary

The summary starts by going back to one of the original charts. Now we will look at the chart 1 and study it more carefully.

It is extremely important that all of taxpayer’s clawback losses from the ponzi scheme (the “ponzi scheme”), be accounted for. In order to maximize the value of deductions. This includes all of the income or “profit” paid upon which the taxpayer has paid taxes (the “profit”) and the principal invested for the year of the deduction in the ponzi scheme (the “principal”). For purposes of filing the year. We will need to differentiate precisely between what is a loss of principal and what is a repayment of profits.

It is important to note that the IRS has made a distinction between losses of a clawback that is considered to be a “repayment” of profits earned in a ponzi scheme; and losses that result from invested principal that is lost as a result of a ponzi scheme clawback.

The typical victim in a ponzi scheme can have a loss of both principal and a loss of reported profits that were “reinvested” in the Ponzi scheme and never distributed to the ponzi victim, (“phantom income”). The victim for tax purposes has reported this phantom income and taxes were paid.

The direct loss in a ponzi scheme of phantom income and invested principal are both considered to be an ordinary income loss that resulted from the theft that had occurred in a transaction entered into for profit. This results in an ordinary income deduction.

This is the manner in which Ponzi scheme tax recovery works for direct losses by ponzi victims who lost their funds when it was discovered the Ponzi scheme went bad.

However, the deduction for the Clawbacks does not follow this exact pattern. Clawbacks, that require a successful investor to pay back profits, upon which taxes have been paid, are not treated as theft loss deductions by the IRS nevertheless these clawbacks are treated as ordinary losses. On the other hand, a clawback of principal is considered a theft loss deduction from a transaction entered into for profit.

A clawback of profits is treated as a “repayment” of funds that result in an ordinary loss because the ponzi scheme is a transaction entered into for profit. However, they are not considered theft losses.

The clawback of profits is treated as an ordinary loss because of the fact that investing in a Ponzi scheme means an investor has lost their profits in a “business like” investment suffered by a sole proprietor. Those losses are still treated as an ordinary loss but not considered to be theft losses.

On the other hand, the amount of the principal investment in the ponzi scheme, that has been clawed back, is not a “repayment of income”. A principal payment made in a clawback is considered the same as a direct loss of the principal lost in a ponzi scheme.

Consequently, the loss of principal in the ponzi investment as a result of a clawback receives the same theft loss treatment that is available to direct losses of principal in the ponzi scheme.

Either way, the service seems to have come to the opinion that both types of clawback losses are considered to be ordinary losses.

However, the distinction is important in terms of the loss carry back rules. Those rules differ between the two types of ordinary loss. The business loss has a two (2) year carry back period while the theft loss carry back period extends for three (3) years.

In the event that there were significant taxable earnings in 2008 from the ponzi scheme, this may become important.

Because these clawbacks are granted under two separate principals of law, the lost amount of profits and principal must be carefully defined and properly claimed as a deduction or confusion will reign with the IRS. Thank you.

---

Footnotes:

1. references to “direct ponzi losses” refer to the ponzi loss suffered when the investor first discovers the fraud and bankruptcy of the scheme. Clawbacks refer only to payments made to the trustee in repayment of profits for the forfeiture of the principal investment as part of the Clawback.
2. as a practical matter, any settlement agreement that is being reached in a ponzi scheme should include language to clarify the item being clawed back, the amount of the claw back and other tax issues. Tax counsel prior to finalization should review settlement agreements involving a Clawback.

---

This topic qualifies for CLE accredited tax law credits for Florida Attorneys.

Mr. Lehman believes in sharing his knowledge to those who are interested in the complex topic of United States taxation. These CLE credits are offered at no cost and are available on-demand to all who would like to learn more. All seminars are Florida Bar Accredited.

• Taxation of the Clawback in a Ponzi Scheme – Maximum Tax Recovery (2 CLE Credits)
  Total presentation time: 01:32:07
  Level: Intermediate
  View this presentation and resources here.

---

Ask Richard S. Lehman a question on the clawback for maximum tax recovery

by Richard S. Lehman, Esq., Tax Attorney

New tax importance is being given to a 72 year old tax deduction that has come of age with the baby boomers. This is a “theft loss” deduction that allows taxpayers to take advantage of financial losses that have resulted from certain financial frauds. This has become a major issue in light of the multibillion dollar Ponzi Schemes and similar frauds that are discovered on a daily basis.

The baby boomers will age and the fear will grow that they will outlive their remaining financial resources. After an internet bust, a real estate bust, a Wall Street giveaway, a worldwide recession and bankers now borrowing money at less than one percent while the boomers are paying 25% on their credit cards, the boomers are now prime targets for Ponzi Schemes. With that entire group seeking alternative investments to make sure that whatever they have will last; financial frauds, especially Ponzi Schemes will surely grow as the baby boomers reach their peak. Over 70 million people will be looking for the same high rates that will not exist.

In almost every case, the victims of Ponzi Schemes and similar financial frauds, will have more of the money they lost returned to them in the form of tax refunds for qualified theft losses than they will ever receive as a result of the litigation that typically follows the Ponzi Scheme debacle.

It is vitally important to know how the tax law works when it comes to these kinds of financial losses. For many, it may be the difference between receiving 50% of your Ponzi loss back in real dollars resulting from tax refunds or it may be less than 10% when it is not handled properly.

Just think about who benefits the most in a Ponzi Scheme. The victims go broke, the promoters go broke and to jail and the Internal Revenue Service wins.

One simplistic but extreme EXAMPLE to make the point.

Assume that there is $10 Billion in Ponzi Scheme losses in 2011 in states that have a city and state tax together with the Federal tax that is nearing 50%. Assume that income and principal lost in the Ponzi Scheme was taxed at that 50% rate when it was reported in the past. This results in taxes paid in the past on that lost wealth of $5.0 Billion dollars.

Assume these Ponzi losses are deducted in 2011 and used against income for the years 2008 through 2010 as loss carry backs from the theft loss deduction.

This will mean that the loss from the total investments of income and principal that have been taxed at the highest brackets will be carried back and applied against all of the income in a particular year, not just income taxed at the highest bracket. To a large extent these losses will offset income in each prior year that was earned at lower rates. Income and principal taxed at 50% might be applied to reduce taxes on income that was taxed at only 20%.

If it is assumed that the refund paid on the $5 Billion in taxes paid was based at an average 20% tax rate, (20% x $10 Billion), the refunds paid to the taxpayer would only total ($2 Billion). In this case the I.R.S. will make $3 Billion ($5 Billion in tax - $2 Billion in refunds) on a failed investment scheme. Furthermore, the I.R.S. will have kept the $5 Billion in tax revenue for years without paying interest.

The deduction allowed by the Internal Revenue Service known as the “theft loss” deduction has been in the law since the year 1939. However, after all that time it was not until the year 2009 that the law governing this deduction was clarified as to many of the important legal concepts that applied to victims of a Ponzi Scheme theft loss.

This changed dramatically in the year 2009 with the Bernard Madoff Ponzi scandal. In that year with the Internal Revenue Service expecting tens of thousands of claims for refund, (all based on unsettled legal theories that could be interpreted in many ways), the I.R.S. took it upon itself to clarify the law governing the deduction for financial theft loss on Ponzi like frauds.

The Internal Revenue Service did this with two separate documents. It issued Revenue Ruling 2009-9. This explained in detail the Internal Revenue Service’s legal position on each and every one of the critical requirements that would support a deduction for a theft loss. It confirmed that the theft loss is a valuable deduction. The taxpayer is able to take full advantage of loss carry back and loss carry forward rules and avoid various percentage limitations found in certain deductions in the Code. In short, a Ponzi Scheme theft loss is a 100% ordinary loss deduction for all of the loss that is not recovered from third parties and the perpetrator.

However, it is a deduction that must meet certain standards. First, the Ponzi Scheme must qualify as a theft under state law. Next, there are rules to distinguish a theft loss from a market loss. Finally, there are many limitations on exactly how much of the theft loss can be claimed in the year it is deductible. This is because many taxpayers do not know what they may recover from third parties in the year they should take the deduction. These rules have been made a lot clearer by the Revenue Ruling and by a second I.R.S. document.

Due to the extent of the Madoff scandal, the Internal Revenue Service published a second document to greatly aid in the administrative burden of dealing with all of the claims for refund and amended tax returns that would result from Madoff alone. Little did the IRS know that this was the start of the uncovering of hundreds of Ponzi Schemes since Madoff that continue to self destruct over the years.

The IRS in a document known as Revenue Procedure 2009-20 drafted guidelines known as a “Safe Harbor” for Ponzi Scheme victims. A Safe Harbor in IRS language means that a taxpayer whose loss meets certain specific parameters will be treated expeditiously and with administrative ease.

In practical terms, it means that the IRS will agree to an administratively easy process in refunding a victims’ money so long as the victim meets a standard that the IRS already knows would be acceptable to the courts. Put another way, many Ponzi Schemes may not fit the Safe Harbor. However, for those that do not meet the Safe Harbor requirements, the theft loss deduction is still available. Each of these cases will need their own individual attention in proving the validity of the deduction.

Using the Safe Harbor

The Safe Harbor offer will most likely be the method of choice, if it is available for the taxpayer. This article will take a quick review of what the taxpayer needs to do to be able to claim a Safe Harbor theft loss deduction from a Ponzi scheme.

The Taxpayers need to keep in mind the theft loss deduction may be available even if it does not fit in this “Safe Harbor”.

Essentially the Safe Harbor establishes criteria that must be met if the financial fraud will be treated as a Ponzi scheme. It provides a determination of the appropriate year within which to deduct the Ponzi scheme theft loss. It also provides an efficient procedure for determining exactly how much of the theft loss deduction may be taken in the year of deduction in which it is discovered by the taxpayer.

The Safe Harbor permits the taxpayer to deduct 95% of all losses unrecovered from third parties in the year of the deduction if the taxpayer’s only source of recovery is the estate of the perpetrator. This is almost always being handled by a trustee in bankruptcy. In the event the taxpayer also has the potential to recover through litigation against other third parties, the taxpayer is entitled to claim a deduction of 75% for their total unrecovered in the year of discovery. Eventually the taxpayer can deduct all 100% of the unrecovered loss.

However, if one is going to qualify for the Safe Harbor, there is one strict requirement that must be met. The IRS does not want to have to analyze each fraud to determine if the loss is from a genuine “theft” for tax purposes. Therefore to qualify, the perpetrator of the Scheme must meet a standard that assures a theft has been committed. That standard is as follows:

Qualified Loss. A qualified loss is a loss resulting from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss –

(1) The lead figure (or one of the lead figures, if more than one) was charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for purposes of § 165 of the Internal Revenue Code and § 1.165-8(d) of the Income Tax Regulations, under the law of the jurisdiction in which the theft occurred; or

(2) the lead figure was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a [theft], and either – (a) The complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or (b) A receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

In the event the perpetrator does not meet this strict definition of a theft, then the Ponzi victim is going to have to rely on claiming the theft loss deduction on their tax return without the advantage of the Safe Harbor. They will have to meet the requirement of proving that all of the elements of the theft loss deduction have been met. In the event the Safe Harbor is not available, this task of claiming the rightful amount of the theft loss as a deduction is not as daunting as it may seem. Because the Internal Revenue Service has now clarified the law in this area, there is good guidance for taxpayers on how to meet all the requirements of the Ponzi Scheme theft loss.

Taxpayers who do not fit into the Safe Harbor are going to have to prove that even though they are seeking recovery from trustees and third parties, that they would be entitled to the same percentage of deduction as granted under the Safe Harbor.

On the other hand, the Safe Harbor requires that the taxpayer waive many rights that could lead to a more valuable recovery then that granted under the Safe Harbor under certain circumstances. Therefore, the Safe Harbor should not be elected without the benefit of qualified advice.

Value can be lost without good professional advice.

Richard S. Lehman, Esq.
TAX ATTORNEY
www.LehmanTaxLaw.com
1166 West Newport Center Drive, Suite 100
Deerfield Beach, FL 33442
Tel: 954-419-9191 (Broward)
Tel: 561-368-1113 (Palm Beach)
Fax: 954-719-2428

Press the play button to listen to Richard Lehman’s Attorney Profile.

Richard S. Lehman, has been dealing with the federal tax law for more than three decades. Mr. Lehman is a graduate of Georgetown Law School and obtained his Master’s degree in taxation from New York University. He has served as a law clerk to the Honorable William M. Fay, U.S. Tax Court and as Senior Attorney, Interpretative Division, Chief Counsel’s Office, Internal Revenue Service, Washington D.C.

Mr. Lehman has also created these websites to help United States Taxpayers better understand their options.

NEW - Just Launched
United States Taxation Seminars
These seminars are free to everyone and contain vital information for individual taxpayers, corporations and professionals in the domestic and international areas of tax law. These seminars also offer 5.5 hours Continuing Education Credits available to attorneys, accountants and other professionals, for free.

Ponzi Scheme Tax Loss
A gathering point for tax matters relating to ponzi scheme tax losses.

Foreign Investors Taxation of United States Real Estate
Tax planning for foreign investors investing in U.S. real estate, and is translated in many languages.

United States Taxation of Foreign Investors
This web site provide the foreign investor, both corporate and individual, with a basic introduction to the tax laws of the United States as they apply to that foreign investor.

Pre Immigration Income Tax
Tax planning for the non-resident alien who is immigrating to the U.S.

Settling with the IRS
In hard times, Americans with tax liabilities may be able to make their best settlements.

1. Gurudeo “Buddy” Persaud

Ponzi Scheme Information

• Orlando broker
• astrology-based investment methods
• reportedly told his clients that he would be investing their money in debt, stock, futures, and real estate markets. In reality, he has subscribed to the idea that gravitational forces affect human behavior and, in turn, the stock market
• worked with at least 14 investors between July 2007 and January 2010 and according to the SEC complaint, he told them that the fund was risk-free.
• he misappropriated around $415,000 — nearly half of the investment money — for his own personal use. The claim goes on to say that Persaud worked in “typical Ponzi scheme fashion” by repaying earlier investors with money he brought in from new investors.
• White Elephant Trading Company

References

• http://www.sec.gov/news/press/2012/2012-118.htm
• http://www.huffingtonpost.com/2012/06/22/astrology-ponzi-scheme-sec-files-charges-_n_1618909.html
• http://www.sec.gov/litigation/complaints/2012/comp-pr2012-118.pdf

2. James Davis Risher

Ponzi Scheme Information

• victims were spread out across eight US states and Canada, although most were concentrated near Lakeland, Florida.
• sentenced to 19 years and 7 seven months in federal prison for mail fraud, money laundering, and engaging in an illegal monetary transaction
• court also ordered Risher to forfeit a 2007 Lexus, a 2008 Lexus, a 2008 Smart Car, ten pieces of diamond and other jewelry, and a painting, which are traceable to proceeds of the offenses
• court also entered a money judgment in the amount of $12.4 million - proceeds obtained by Risher, as part of the charged criminal conduct
• Risher pleaded guilty on September 9, 2011
• private equity fund, referred to as the Preservation of Principal Fund.
• funds would be held at Penson Financial Services, Inc.
• At least 106 victim-investors transmitted more than $21 million for investment in the purported fund.
• http://www.justice.gov/usao/flm/press/2011/dec/20111207_Rischer.html
• http://www.sec.gov/news/press/2011/2011-171.htm
• http://www.fbi.gov/tampa/press-releases/2011/convicted-felon-sentenced-for-his-role-in-more-than-21-million-ponzi-scheme

3. Norman Adie

Ponzi Scheme Information

• $530,000 from a number of cinema-loving backers for his apparently fake plans to update and expand the Heights moviehouse and two others he owned in Pennsylvania.
• he used the money on personal expenses and to keep his struggling theaters afloat
• http://www.brooklynpaper.com/stories/33/48/bh_heightscinema_2010_11_26_bk.html
• http://www.stopfraud.gov/news/news-11232010.html

4. Allen and Wendell Jacobson

Ponzi Scheme Information

• operate from a base in Fountain Green, Utah
• offer investors the opportunity to invest in limited liability companies (LLCs) in order to share ownership of large apartment communities in eight states
• SEC alleges that the Jacobsons represent that they buy apartment complexes with low occupancy rates at significantly discounted prices. They then renovate them and improve their management, and aim to resell them within five years
• Investors are said to share in the profits derived from rental income at the apartment complexes as well as the eventual sales.
• the Jacobsons raised more than $220 million from approximately 225 investors through a complex web of entities under the umbrella of Management Solutions, Inc.
• http://www.sec.gov/news/press/2011/2011-266.htm
• http://www.sec.gov/litigation/litreleases/2011/lr22195.htm

5. Dunya Predovan

Ponzi Scheme Information

• bilked investors out of about $450,000 over six years
• http://www.forbes.com/sites/halahtouryalai/2012/05/14/the-latest-in-ponzi-schemes-pretend-you-know-george-soros/
• http://www.northjersey.com/news/bergen/051412_Woman_accused_of_Ponzi_scheme_in_Bergen_County.html

6. Frederick Darren Berg

Ponzi Scheme Information

• sentenced in U.S. District Court in Seattle to 18 years in prison, and three years of supervised release for Wire Fraud, Money Laundering and Bankruptcy Fraud
• The amount of restitution, $140 million
• founder of the Meridian Group of investment funds. The funds represented that $245 million in investor money was invested in real estate contracts and real estate
• http://www.justice.gov/usao/waw/press/2012/feb/berg.html
• http://www.fbi.gov/seattle/press-releases/2012/mercer-island-man-sentenced-to-18-years-in-prison-for-ponzi-scheme-and-bankruptcy-fraud

7. Mark Feathers

Ponzi Scheme Information

• SEC alleges that more than 400 investors were attracted to the funds by promises that profits from mortgage investments would yield annual returns of 7.5 percent or more.
• Small Business Capital Corp.
• raised $42 million by selling securities issued by Investors Prime Fund LLC and SBC Portfolio Fund LLC - two mortgage investment funds they controlled.
• http://www.sec.gov/news/press/2012/2012-125.htm

8. Scott Rothstein

Ponzi Scheme Information

• Florida lawyer sentenced to 50 years in prison for running a $1.2 billion ponzi scheme
• http://www.bloomberg.com/news/2012-01-03/convicted-ex-lawyer-scott-rothstein-says-that-funds-didn-t-warn-investors.html
• http://www.fbi.gov/miami/press-releases/2010/mm060910.htm

9. (14 ) sales agents : Bryan Arias, Hugo A. Arias, Anthony C. Ciccone , Salvatore Ciccone, Jason A. Keryc, Michael D. Keryc, Martin C. Hartmann III , Laura Ann Tordy, Christopher E. Curran, Ryan K. Dunaske, Michael P. Dunne, Diane Kaylor, Anthony Massaro, Ronald R. Roaldsen Jr.

Ponzi Scheme Information

• misled investors and illegally sold securities for a Long Island-based investment firm at the center of a $415 million Ponzi scheme.
• http://www.floridastockfraudblog.com/2012/06/ponzi-scheme—south-florida-fraud-and-misrepresentation-finra-arbitration-and-litigation-attorney.shtml
• http://www.sec.gov/news/press/2012/2012-112.htm
• http://www.fbi.gov/newyork/press-releases/2012/former-agape-world-inc.-account-representatives-charged-in-new-york-with-massive-ponzi-scheme

10. Stanley Shew-A-Tjon

Ponzi Scheme Information

• raised approximately $16 million from more than 9
• http://www.fbi.gov/washingtondc/press-releases/2012/florida-man-sentenced-to-96-months-for-ponzi-scheme-that-defrauded-more-than-900-victims-of-8-million

11. George Levin/Frank Preve

• http://www.sec.gov/news/press/2012/2012-100.htm

12. R. Allen Stanford

• http://www.fbi.gov/houston/press-releases/2012/allen-stanford-gets-110-years-for-orchestrating-7-billion-investment-fraud-scheme

13. Brian Ray Dinning

• http://www.fbi.gov/norfolk/press-releases/2012/virginia-attorney-charged-in-south-african-ponzi-scheme

14. Martin B. Feibish

• http://www.fbi.gov/boston/press-releases/2012/investment-broker-sentenced-in-5m-ponzi-scheme
• http://www.justice.gov/usao/ri/news/2012/april2012/feibish.html

15. George Elia

• http://www.sec.gov/litigation/litreleases/2012/lr22319.htm
• http://www.fbi.gov/miami/press-releases/2012/fort-lauderdale-investment-advisor-arrested-in-las-vegas
• http://www.fbi.gov/miami/press-releases/2012/south-florida-investment-advisor-indicted-for-investment-fraud-scheme

16. Ray Bitar

• http://www.fbi.gov/newyork/press-releases/2012/manhattan-u.s.-attorney-and-fbi-assistant-director-in-charge-announce-the-arrest-of-full-tilt-poker-ceo-raymond-bitar

17. Keith Franklin Simmons

• http://www.fbi.gov/charlotte/press-releases/2012/ponzi-scheme-mastermind-sentenced-to-50-years-in-prison
• http://www.justice.gov/usao/ncw/pressreleases/Charlotte-2012-05-23-simmons.html

18. Alan G. Flesher, Nancy Carol Khalial

• http://www.fbi.gov/losangeles/press-releases/2012/three-plead-guilty-in-41-million-ponzi-scheme-based-in-ventura-county-that-promised-profits-in-ad-toppers-video-advertisements

19. Thomas E. Kelly

• http://www.fbi.gov/albany/press-releases/2012/thomas-kelly-sentenced-for-ponzi-investment-scheme

20. Wayne L. Palmer and his firm, National Note of Utah, LC

• http://www.sec.gov/news/press/2012/2012-119.htm

21. Samantha Delay-Wilson

• http://www.fbi.gov/anchorage/press-releases/2012/anchorage-woman-sentenced-to-seven-years-in-prison-for-running-ponzi-scheme

22. Anthony John Johnson

• http://www.fbi.gov/newyork/press-releases/2012/westchester-investment-manager-sentenced-to-10-years-for-operating-a-multi-million-dollar-ponzi-scheme

23. Jason Bo-Alan Beckman, Gerald Joseph Durand, Patrick Kiley

• http://www.fbi.gov/minneapolis/press-releases/2012/federal-jury-convicts-three-individuals-in-connection-with-trevor-cook-ponzi-scheme
• http://carlsoncaspers.com/OurExperience/SECvJasonBoAlanBeckmanetal

24. Richard H. Nickles

• http://www.fbi.gov/losangeles/press-releases/2012/orange-county-investment-advisor-sentenced-to-12-years-in-federal-prison-in-ponzi-scheme-that-caused-nearly-7-million-in-losses

25. Andrew S. Mackey, Inger L. Jensen

• http://www.fbi.gov/atlanta/press-releases/2012/two-new-york-residents-convicted-of-operating-12-million-ponzi-scheme-that-victimized-numerous-atlanta-investors

26. Joseph Blimline

• http://www.fbi.gov/dallas/press-releases/2012/dallas-man-sentenced-in-half-billion-dollar-ponzi-scheme

27. Anthony C. Morris

• http://www.fbi.gov/seattle/press-releases/2012/pastor-sentenced-to-40-months-in-prison-for-ponzi-scheme

28. Robert G. Tunnell, Jr.

• http://www.fbi.gov/sanfrancisco/press-releases/2012/san-francisco-man-sentenced-to-prison-for-running-multi-million-dollar-ponzi-scheme

29. Daniel Wise

• http://www.fbi.gov/phoenix/press-releases/2012/scottsdale-man-indicted-for-operating-66-million-ponzi-scheme

30. Steven Bartko

• http://www.fbi.gov/sandiego/press-releases/2012/ponzi-scheme-operator-sentenced-to-24-months-in-prison

31. Shervin Neman

• http://www.sec.gov/news/press/2012/2012-64.htm

32. Ephren W. Taylor II

• http://www.sec.gov/news/press/2012/2012-62.htm

33. Timothy Melvin Murphy

• http://www.fbi.gov/losangeles/press-releases/2012/orange-county-man-pleads-guilty-to-ponzi-style-investment-fraud-scheme

34. Brett A. Amendola

• http://www.fbi.gov/washingtondc/press-releases/2012/ashburn-man-pleads-guilty-to-ponzi-scheme-involving-purchase-of-beacon-hill-golf-course

35. C. Tate George

• http://www.fbi.gov/newark/press-releases/2012/former-nba-player-and-ceo-of-the-george-group-indicted-in-ponzi-scheme
• http://www.justice.gov/usao/nj/Press/files/George, C. Tate Indictment News Release.html

36. Kenneth Alfred Scudder

• http://www.fbi.gov/houston/press-releases/2012/woodlands-man-sentenced-in-ponzi-scheme
• http://www.justice.gov/usao/txs/1News/Releases/2012 March/120312 Scudder.html

37. Lauren Baumann

• http://www.fbi.gov/losangeles/press-releases/2012/promoter-of-christian-rock-concerts-sentenced-to-nearly-five-years-in-federal-prison-in-ponzi-scheme-that-took-1-million-from-victims

38. William Wise, Jacquline Hoegel

• http://www.fbi.gov/sanfrancisco/press-releases/2012/two-indicted-in-129-million-ponzi-scheme-case
• http://www.tklaw.com/millennium_bank_receivership.cfm

39. John Terzakis

• http://www.fbi.gov/sanfrancisco/press-releases/2012/vesta-strategies-majority-owner-pleads-guilty-to-25-million-ponzi-scheme

40. Jonathan D. Davey, Chad A. Sloat, Michael J. Murphy, Jeffrey M. Toft

• http://www.fbi.gov/charlotte/press-releases/2012/four-hedge-fund-managers-indicted-in-40-million-ponzi-scheme
• http://www.justice.gov/usao/ncw/pressreleases/Charlotte-2012-02-28-hedge.html

41. Ira J. Pressman

• http://www.fbi.gov/philadelphia/press-releases/2012/bala-cynwyd-man-sentenced-to-eight-years-in-6-million-ponzi-scheme

42. Joseph Mazella

• http://www.fbi.gov/philadelphia/press-releases/2012/bala-cynwyd-man-sentenced-to-eight-years-in-6-million-ponzi-scheme

43. Richard Pettibone

• http://www.fbi.gov/washingtondc/press-releases/2012/former-alexandria-businessman-pleads-guilty-to-1.5-million-ponzi-scheme-and-sentenced-to-36-months

44. CHARLES MICHAEL VAUGHN

• http://www.fbi.gov/atlanta/press-releases/2012/atlanta-man-sentenced-for-operating-ponzi-scheme

45. Laurie Schneider

• http://www.fbi.gov/newyork/press-releases/2012/oceanside-woman-indicted-for-operating-ponzi-schemes

46. Gregory Viola

• http://www.fbi.gov/newhaven/press-releases/2012/orange-resident-admits-operating-multi-million-dollar-ponzi-scheme

47. Ronald W. Shepard

• http://www.fbi.gov/kansascity/press-releases/2012/former-lees-summit-man-indicted-for-3-million-ponzi-scheme

48. ALGIRD M. NORKUS

• http://www.fbi.gov/chicago/press-releases/2012/former-sugar-grove-man-sentenced-to-63-months-in-federal-prison-for-mail-fraud-in-operating-a-9-million-ponzi-scheme

49. Jenifer Devine

• http://www.fbi.gov/newark/press-releases/2012/bergen-county-woman-sentenced-to-more-than-three-years-in-prison-for-8-million-ponzi-scheme

50. Douglas F. Vaughan

• http://www.fbi.gov/albuquerque/press-releases/2011/douglas-f.-vaughan-pleads-guilty-to-federal-wire-and-mail-fraud-charges-involving-ponzi-scheme

51. Johnny “Mickey” Brown

• http://www.fbi.gov/portland/press-releases/2011/vacuum-cleaner-distributor-sentenced-to-130-months-in-ponzi-scheme

52. GEOFFREY A. GISH, MYRA J. ETTENBOROUGH

• http://www.fbi.gov/atlanta/press-releases/2011/georgia-couple-sentenced-for-running-ponzi-scheme-that-cost-investors-18-million

53. Richard Elkinson

• http://www.fbi.gov/boston/press-releases/2011/framingham-man-sentenced-to-102-months-for-17-million-ponzi-scheme

54. Louis J. Borstelmann

• http://www.fbi.gov/portland/press-releases/2011/california-man-sentenced-to-108-months-in-prison-for-18-million-ponzi-scheme

55. David Lincoln Johnson

• http://www.justice.gov/usao/cac/Pressroom/2012/088.html

56. Celia Gallardo

• http://www.fbi.gov/losangeles/press-releases/2012/san-fernando-valley-woman-arrested-in-million-dollar-real-estate-ponzi-scheme-run-through-companies-in-santa-clarita-valley

57. Miko Dion Wady

• http://www.fbi.gov/phoenix/press-releases/2011/man-sentenced-to-prison-and-ordered-to-pay-over-30-million-in-restitution-for-multiple-concert-promotion-ponzi-schemes

58. Edward P. May

• http://www.fbi.gov/detroit/press-releases/2011/edward-p.-may-sentenced-for-orchestrating-350-million-ponzi-scheme

59. Daren Palmer

• http://www.fbi.gov/saltlakecity/press-releases/2011/idaho-falls-man-sentenced-in-29-million-loss-ponzi-scheme

60. Kurt Branham Barton

• http://www.fbi.gov/sanantonio/press-releases/2011/federal-jury-convicts-former-triton-president-and-ceo-in-ponzi-scheme

61. Dante DeMiro

• http://www.fbi.gov/detroit/press-releases/2011/investment-adviser-sentenced-to-10-years-in-ponzi-scheme

62. Wifredo A. Ferrer

• http://www.fbi.gov/miami/press-releases/2011/ponzi-scheme-defendant-receives-1712-year-sentence

63. Martin T. Sigillito, James Scott Brown, Derek J. Smith

• http://www.fbi.gov/stlouis/press-releases/2011/sl050411.htm

64. Jeremiah C. Yancy

• http://www.cftc.gov/PressRoom/PressReleases/pr6077-11

65. Timothy Durham

• http://www.nytimes.com/2011/03/17/us/17durham.html?_r=1

66. Francisco Illarramendi

• http://www.sec.gov/litigation/litreleases/2011/lr21970.htm
• http://www.justice.gov/usao/ct/Press2011/20110307.html

67. Frederick H.K. Baker, Mark W. Akin

• http://durangoherald.com/article/20110304/NEWS01/703049915/0/s/2-suspected-in-Ponzi-scheme-in-Durango
• http://www.heraldextra.com/news/state-and-regional/utah-man-in-ponzi-scheme-gets-months/article_8e0ac695-4e03-5b0f-8297-4ed3c5ee963a.html?comment_form=true

68. Paul Cirigliano

• http://www.justice.gov/usao/iln/pr/rockford/2011/pr1027_01.pdf
• http://www.dailyherald.com/article/20110226/news/702269938/

69. Anthony Eugene Linton

• http://www.cftc.gov/PressRoom/PressReleases/pr5970-11
• http://www.cftc.gov/PressRoom/PressReleases/pr6174-12
• http://www.justice.gov/usao/az/press_releases/2012/APR/PR_05152012_Linton.html

70. Richard Saunders

• http://www.justice.gov/usao/moe/press_releases/archived_press_releases/2012_press_releases/march/saunders_richard.htm
• http://www.kmov.com/news/local/Local-man-charged-for-operating-4-million-Ponzi-scheme-114820989.html

71. Lawrence Hamel

• http://articles.sun-sentinel.com/2011-03-10/news/fl-boca-raton-ponzi-20110310_1_ponzi-scheme-baron-federal-cour
• http://www.palmbeachpost.com/news/news/crime-law/suburban-lake-worth-man-accused-of-running-2-mil-1/nLpkq/

72. Christopher Jackson

• http://www.fbi.gov/sacramento/press-releases/2010/sc111510.htm
• http://www.justice.gov/usao/cae/news/docs/2011/02-03-11JacksonIndictment.html

73. Shaine Joseph Lavoie

• http://blogs.ocweekly.com/navelgazing/2011/02/shaine_joseph_lavoie_ezekiel_f.php
• http://www.ocregister.com/articles/lavoie-287365-felony-counts.html

74. Larry Benny Groover

• http://www.cftc.gov/PressRoom/PressReleases/pr5986-11
• http://www.cftc.gov/PressRoom/PressReleases/pr6165-12

75. Kent R.E. Whitney

• http://www.fbi.gov/chicago/press-releases/2011/former-chicago-options-trader-sentenced-to-44-months-in-prison-for-investment-fraud-scheme/
• http://www.cftc.gov/PressRoom/PressReleases/pr5952-10
• http://www.fbi.gov/chicago/press-releases/2011/cg021611.htm

76. Victoria Scardigno

• http://articles.cnn.com/2011-02-16/travel/continental.employee.fraud_1_vouchers-airline-tickets-sales-agent?_s=PM:TRAVEL
• http://www.justice.gov/usao/nys/pressreleases/July11/scardignovictoriasentencingpr.pdf

77. Brian Kim

• http://articles.nydailynews.com/2011-02-15/news/28619620_1_million-ponzi-scheme-cnbc-separate-theft
• http://www.nypost.com/p/news/business/kim_admits_scam_YkdA8h7gihllGmFdDeiCxM

78. Michael Hudspeth , Timothy Bailey

• http://www.cftc.gov/PressRoom/PressReleases/pr5983-11

79. Monroe L. Beachy

• http://www.washingtonpost.com/wp-dyn/content/article/2011/02/16/AR2011021607415.html
• http://www.nytimes.com/2012/02/26/business/in-amish-country-accusations-of-a-ponzi-scheme.html?pagewanted=all

80. Peter Sbaraglia

• http://www.financialpost.com/news/Ontario+part+Ponzi+scheme/4348848/story.html
• http://www.osc.gov.on.ca/en/Proceedings_soa_20110224_sbaraglia.htm

81. Josh Gould

• http://blogs.riverfronttimes.com/dailyrft/2011/03/josh_gould_orthodox_jewish_securites_broker_ponzi_indicted.php
• http://www.fbi.gov/stlouis/press-releases/2011/sl030311a.htm

82. Jeanette and Elliott Berney

• http://newyork.cbslocal.com/2011/03/03/monsey-mother-and-son-accused-in-10-million-ponzi-scheme/
• http://www.nypost.com/p/news/local/elderly_upstate_ny_woman_son_charged_5cRC0EzGsyUQaR7hcnPOfL

83. Larry Michael Parrish

• http://www.sec.gov/litigation/litreleases/2011/lr21881.htm

84. Dale Edward Lowell

• http://www.bonnercountydailybee.com/news/local/article_9f759d34-715c-11e0-bf59-001cc4c002e0.html
• http://www.cdapress.com/news/local_news/article_069fc4b4-372b-11e1-b6c8-001871e3ce6c.html

85. Ibis Febles, Giancarlo Giuseppe

• http://www.nysenate.gov/press-release/two-long-island-city-residents-charged-ponzi-scheme-which-31-victims-allegedly-lost-mo

86. Michael Crook, Roderick Rieman

• http://www.justice.gov/usao/iln/pr/chicago/2011/pr0408_01.pdf

87. Garry Bradford

• http://www.justice.gov/usao/cae/news/docs/2011/08-12-11BradfordGuiltyPlea.html

88. Royce Newcomb

• http://www.news10.net/news/article/134775/2/Granite-Bay-man-charged-with-Ponzi-scheme
• http://www.dailyrepublic.com/real-estate/roseville-man-gets-3-years-for-ponzi-scheme/

89. Steven Bingaman

• http://www.sec.gov/litigation/admin/33-8179.htm
• http://newsandinsight.thomsonreuters.com/Legal/News/2011/05_-_May/New_York_man_indicted_on_Ponzi_scheme_charges/

90. Michael Morawski and Frank Constant

• http://www.examiner.com/article/two-charged-with-ponzi-type-scheme-palatine-illinois
• http://chicago.cbslocal.com/2011/05/10/palatine-businessmen-charged-in-real-estate-ponzi-scheme/
• http://www.justice.gov/usao/iln/pr/chicago/2011/pr0510_01a.pdf

91. Nicholas Cox

• http://www.cftc.gov/PressRoom/PressReleases/pr6130-11

92. John S. Dudley

• http://www.fbi.gov/saltlakecity/press-releases/2011/slc053111.htm
• http://www.justice.gov/usao/ut/press/releases/Dudley indicted in ponzi scheme case.pdf

93. Michael Kratville, Jonathan W. Arrington, Michael J. Welke

• http://www.cftc.gov/PressRoom/PressReleases/pr6045-11

94. Steven White, Martin Kinsey

• http://www.ifaonline.co.uk/ifaonline/news/2076425/british-advisers-named-gbp10m-ponzi-scheme-trial

95. Spero X. Vourliotis, Carey Michael Billingley

• http://www.asc.state.al.us/News/2011 News/6-3-11 Ponzi scheme Vourliotis.pdf

96. Anthony Cutaia

• http://www.palmbeachpost.com/news/news/crime-law/well-known-radio-host-charged-with-running-ponzi-1/nLs65/

97. Victor E. Cilli

• http://www.cftc.gov/PressRoom/PressReleases/pr6053-11
• http://www.stopfraud.gov/news/cilli-victor-complaint.pdf

98. Juneval Eduardo Machado

• http://www.cftc.gov/PressRoom/PressReleases/pr6057-11

99. Christopher Blackwell

• http://www.courthousenews.com/2011/06/24/37662.htm

100. Fidel Bermudez

• http://www.vcstar.com/news/2011/jun/27/miami-man-charged-with-ponzi-scheme-targeting/

101. Jamie Campany

• http://articles.sun-sentinel.com/2011-06-28/news/fl-gold-bullion-campany-20110628_1_global-bullion-exchange-jamie-campany-ponzi-scheme
• http://www.nbcmiami.com/news/local/Founder-of-Buy-Gold-Firms-Admits-to-30M-Ponzi-Scheme-126850328.html
• http://www.justice.gov/usao/fls/PressReleases/111118-02.html

102. Wayne Ogden

• http://www.sltrib.com/sltrib/money/52101634-79/ogden-investors-money-wayne.html.csp

103. Shawon McClung

• http://www.cftc.gov/PressRoom/PressReleases/pr6236-12
• http://www.cftc.gov/PressRoom/PressReleases/pr6063-11

104. Edward Allen, David Olson

• http://www.sec.gov/litigation/litreleases/2011/lr22019.htm
• http://www.wytv.com/content/news/local/story/Suspect-in-14M-Ponzi-Scheme-Changes-Plea/274G6d24rUuGIsfSWALBQg.cspx

105. Robbie Dale Walker

• http://www.kxan.com/dpp/news/crime/man-arrested-for-alleged-ponzi-scheme

106. Richard Dalton

• http://www.huffingtonpost.com/2010/11/23/richard-dalton-ponzi-sche_n_787613.html

---

If you are involved in a Ponzi Scheme that is not listed on this page - contact Richard S. Lehman, Esq.

The U.S. Government Accountability Office (GAO) is an independent, nonpartisan agency that works for Congress. Often called the “congressional watchdog,” GAO investigates how the federal government spends taxpayer dollars.

Friday, October 5, 2012
Subject: GAO Madoff report

Dear Mr. Lehman,

I know it’s been a while since we spoke, but I wanted to follow up with you and send a copy of our recent report.

I’d like to thank you again for the help you gave us. In this case, your assistance helped produce instant results – as a direct result of the conversations we had with private sector tax professionals, the IRS issued new guidance on treatment of clawbacks. We were prepared to recommend the agency do so, but when they saw what we were going to report, they immediately issued the guidance on their own.

It doesn’t often happen that change comes so quickly, and this wouldn’t have been possible if you didn’t lend us some of your expertise.

Thanks again, and best regards,

CHS

—————————————————————
Christopher H. Schmitt
Senior analyst
U.S. Government Accountability Office
441 G Street NW
Washington, DC 20548

 

---

If you have a question for Mr. Lehman, please submit it below.

To Members of the Bar and other Professionals.

In this ever expanding global world; consider Richard S. Lehman, Esq., and LehmanTaxLaw.com as your in-house international tax law office. Don’t lose clients because you cannot supply the “tax law” piece of the puzzle. Lehman Tax Law has mastered the art of providing international tax advice by internet and will travel where warranted. Arrangements can be made for simultaneous translations and speedy delivery of translated documents in 10 languages to best help service your client.

Mr. Lehman understands professionals are now frequently dealing with alien individuals or foreign corporations investing in, doing business in, or moving to the United States; and/or Americans investing and doing business outside of the United States, or emigrating from the United States. This means that more and more professionals are going to deal with the U.S. tax laws and the world.

The best rule to follow in the field of tax law is to plan legal matters and obtain precision advice in advance to insure commercial endeavors are completed at minimum tax costs and personal lives are minimally disrupted. This is even more the case in the international field.

Mr. Lehman has been around long enough and experienced enough to know that the world of commerce is far from a perfect world. He knows how to apply his knowledge, experience and relationships just as effectively to resolve the unplanned and unexpected legal obstructions that arise in transactions that often lead to failure if not dealt with correctly. It is important to know – Mr. Lehman is just as good in cleaning up the legal mess of others – as making sure a legal mess does not happen in the first place.

For 37 years Richard S. Lehman has been a resource of knowledge in the area of United States taxation. After graduating Georgetown Law School, the New York University Law School Masters program in Taxation and serving as a law clerk on the U.S. Tax Court and with the Chief Counsel’s Office in the Internal Revenue Service in Washington D.C., Lehman has practiced U.S. tax law for 37 years with an emphasis on its international aspects. He has served clients from over 50 countries.

Please contact Mr. Lehman if you require his tax law expertise.

by Richard S. Lehman

The taxation of the Clawback in Ponzi Schemes and certain other financial theft losses.

Now that the Ponzi Schemes, after Madoff have started to mature, they have become more numerous and trustees are clawing back billions from innocent investors who may have profited from their investment in the fraud. The largest recovery for people who must pay Clawbacks, will be from tax refunds. A taxpayer in California or New York City might receive more than 50% of their money back just in tax losses.

We are working on a new seminar “Realizing the maximum value in losses suffered from Ponzi Scheme Claw Back payments”

This online seminar will include a presentation from a seasoned litigation attorney with extremely good credentials who will explain the nature of the Clawback in Ponzi Scheme frauds from a litigator’s standpoint.

This will be of great help to this new class of victims who are targets of a Clawback and do not know where to turn for help.

If you would like to be alerted when this seminar becomes available - please “like” us on Facebook. Or fill out the form on the bottom of the page.

REPORT TO CONGRESS:

• The U.S. Government Accountability Office (GAO) report on the Customer Outcomes in the Madoff Liquidation Proceeding. Download full 80-page report .

New IRS RULING: http://www.irs.treas.gov/uac/FAQs-Related-to-Ponzi-Scenarios-for-Clawback-Treatment

• The most recent Internal Revenue Service ruling allows clawback victims of Ponzi schemes to maximize their tax refunds and deduct their losses in years that would otherwise be closed by the Statute of Limitations. This is in the event the deductions are more valuable in the earlier years for purposes of tax refunds. The article below describes completely the advantages of how to make use of Code Section 1341.

---

By Richard S. Lehman, Esq. (download this article as a .pdf)

Most of us are familiar with the concept of the Ponzi Scheme. An investment built on phony profits that crashes and burns, financially devastating many.

What is less familiar is the fact that an investor in a Ponzi Scheme cannot only lose all of their investment. Investors in Ponzi Schemes can also be forced to pay back additional moneys earned from the Ponzi Scheme years before it exploded. This is what is known as a clawback.

As the baby boomers age, the fear grows that they will outlive their remaining financial resources. After an internet bust, a real estate bust, a Wall Street giveaway, a worldwide recession and banks now borrowing money at less than one percent while the boomers are paying 25% on their credit cards, the boomers are now prime targets for Ponzi Schemes. Multi billion dollar Ponzi Scheme failures are announced with regularity and the list will grow.

With the entire group of baby boomers seeking alternative investments to make sure they are secure, financial frauds, especially Ponzi Schemes will surely grow as the baby boomers reach their peak. Over 70 million people will be looking for the same high rates that will not exist. The term “clawback” will become more familiar as those Ponzi Schemes self destruct.

The definition of a Ponzi Scheme is provided by the I.R.S. and the legal principles governing such a scheme are found at Rev. Proc. 2009-20 at Section 4.01 and Rev. Rul. 2009-9. The I.R.S. calls a Ponzi Scheme a Specified Fraudulent Arrangement.

Specified fraudulent arrangement. A specified fraudulent arrangement is an arrangement in which a party (the lead figure) receives cash or property from investors; (ii) purports to earn income for the investors; (iii) reports income amounts to the investors that are partially or wholly fictitious; (iv) makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and (v) appropriates some or all of the investors’ cash or property.

A Ponzi Scheme will by its very nature reward certain innocent investors to prove the scheme works; and ultimately crash on those investors that left their funds in the scheme to keep earning the large returns or new investors who came in just before the crash. Certain investors will receive their principal and outsized profits while some lose it all.

Once the Ponzi Scheme crashes, there are insufficient funds to meet the obligations and a Trustee is appointed for the Estate of the perpetrators of the Ponzi Scheme. The Trustee is in fact the continuing entity of the perpetrators. However, this Trustee has very broad powers to recoup funds for the general estate so that the Trustee can provide equity among the investors who all have been in the same investment but some have lost while others have won. This is the clawback.

Clawback is a term used to describe the power that a trustee has to regain assets of a debtor that should have been available as part of the bankruptcy estate, but were removed or hidden from the Trustee by the debtor by means of preferential or fraudulent transfers.

The Bankruptcy Code authorizes the trustee to reach back 2 years to recover fraudulent conveyances. There are two general types of fraudulent conveyances (a) a transfer made with actual intent to hinder, delay or defraud creditors (i.e. an actual fraudulent transfer) and (b) a transfer made for less than reasonably equivalent value or fair consideration by an entity that is insolvent or undercapitalized (i.e. a constructive fraudulent transfer).

The Trustee has varying powers in this situation to recoup funds. Without explaining these laws in detail, suffice it to say, the Trustee may recoup profits earned by an innocent investor in a Ponzi Scheme. The Statutes governing this case are very much like strict liability where the innocent investor, (the “Taxpayer”), does not need any wrong intention to be liable. There is liability imposed on the innocent Taxpayer because the Ponzi Scheme perpetrator and not the defrauded Taxpayer ran a Ponzi Scheme. Nevertheless, the Taxpayer was paid from the scheme and can be liable for the return of profits and principal.

As an example, assume Mr. Jones invested $1.0 Million in a Ponzi Scheme and earned $1,500,000 in securities income. The income was distributed to Mr. Jones and Mr. Jones paid tax on the income. The balance of the income was spent by Mr. Jones. Assume the Ponzi Scheme collapses with Mr. Jones holding a balance in his account of $1.0 Million that is lost. Since Mr. Jones’ cash out exceeded his cash in, he may be forced to repay certain income to the Trustee, in spite of his $1.0 Million loss of principal.

The Tax Law

When this “clawback” occurs, generally the income clawed back from the Taxpayer will be deductible by the Taxpayer in the year it is paid. However, often the deduction in the year the clawback is paid may occur at a much lower tax bracket than the tax bracket that was applicable to the income when it was included in income.

To provide for tax equity under specific circumstances, the Internal Revenue Code permits a taxpayer who includes an item in gross income in one tax year and pays tax on that item and who is compelled to return the item in a subsequent year, to calculate the deduction on the amount that is returned in a unique way. This is known as the “Mitigation” section and is found in Section 1341 of the Internal Revenue Code. (the “Code”). The Mitigation provision permits a Taxpayer to calculate the refunded money either as a deduction in the year the refund is paid or a higher tax rate in the year that the refunded sum may have been included in income.

The answer to whether a Taxpayer may recover under the Mitigation Section starts with the legal principle known as the “claim of right doctrine”. It was enunciated in 1932 by the Supreme Court and stands for the proposition that income received in a particular year is subject to tax when received even though it may be returned in a later year.

If a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income [on] which he is required to [pay tax], even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.

The Mitigation provision was needed to cure the inequities caused by this rule. Since the passage of the Mitigation provision, several judicial doctrines have evolved and controversies still exist in interpreting the Mitigation section. Some of these have lasted for over 50 years. There are still different judicial views of certain of the requirements that needed to be met to enjoy the benefits of Code Section 1341.

The case of Pennzoil, Quaker State, that was first decided in the Taxpayer’s favor by the Federal Court of Claims in 2004 and later reversed by the Federal Court of Appeals in 2008 clarified matters in this area of the law a great deal but also, to some extent continued the controversy. Together, the two courts defined the five separate requirements that must be met to enjoy the benefits of the Mitigation section and the judicial doctrines that have developed to clarify the law. The two analyses by these courts are helpful in better understanding this Mitigation section. The two courts together explored each requirement of the section thoroughly.

The Requirements of § 1341(a)

A clawback may require both a repayment of the Taxpayer’s previously taxed income earned from the Ponzi Scheme and can also require a repayment of a Taxpayer’s principal investment.1/

The courts in the Pennzoil case considered the availability of Code Section 1341 to a situation where the Pennzoil Company refunded certain amounts of money to independent crude oil producers for alleged price fixing.

Pennzoil ultimately settled the lawsuit for $4.4 Million which it tried to deduct in the prior years when the crude oil was sold instead of the year of payment. Because of the particular facts of Pennzoil, the court in Pennzoil had to deeply analyze each one of the first four requirements of Code Section 1341 to determine its applicability in the Pennzoil situation.

The first court ruled in favor of Pennzoil, the Taxpayer, and permitted the deduction and the Mitigation treatment of Code Section 1341. However, the Appellate Court eventually found in favor of the I.R.S. and that Pennzoil could not use Code Section 1341. Ultimately the higher court in Pennzoil decided that though Pennzoil may have met many of the requirements of Code Section 1341, it was not entitled to 1341 treatment. The discussion of the requirements by the two courts is invaluable.2/ The Pennzoil Courts both stated that the language of §1341 requires the Plaintiff to prove that five factors have been met: The emphasis supplied below was the Courts.

(1) an “item” must have been “included in gross income for a prior taxable year (or years)”;

(2) “because it appeared that the taxpayer had an unrestricted right to such item”;

(3) a “deduction” must be “allowable for the taxable year” in which the item is repaid;

As will be discussed, a divided Appellate Court’s with one dissent believed the main reason for denying Pennzoil the benefits of the Mitigation section was under a different exception to the Mitigation provision.

(4) “because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item”; and

(5) “the amount of such deduction” must exceed $3,000.

These requirements seem to be relatively straight forward and certainly there can be no question about the interpretation of the fifth requirement. However, several of these requirements are not as straight forward as they look. Each has to be understood within the tax world, where often there are exceptions to make sure special provisions, like the Mitigation provision, applies only to those that are legally deserving of them.

The fact that two very learned courts, the Court of Claims (the “Lower Court”) and the Court of Appeals (the “Appellate Court”) differed on whether the requirement of an “item” of income has been met, shows how technical this section is. This is in order to insure that only a certain category of Taxpayer receives this Mitigation.

1. THE FIRST REQUIREMENT FOR MITIGATION IS THAT AN “ITEM” MUST HAVE BEEN INCLUDED IN GROSS INCOME FOR A PRIOR TAXABLE YEAR (OR YEARS)

Both Courts in Pennzoil addressed this two part question, first by determining whether the Taxpayer possessed an “item”, and next whether that item was “included in gross income.” I.R.C. § 1341.

Guidance as to what is an “item” of gross income is found in the I.R.S. Code Section 61. That Code Section provides a specific definition for gross income and a general one. Another Code Section, Section 161, provides an allowance for deductions that are also specifically listed in the Code. The income “items” that might be included in income in a Ponzi Scheme might include any of the following found in Code Section 61.

Except as otherwise provided . . . . gross income means all income from whatever source derived, including (but not limited to) the following items:

1. Gross income derived from business;
2. gains derived from dealings in property;
3. interest;
4. rents;
5. royalties;
6. dividends;
7. annuities;
8. income from life insurance and endowment contracts;
9. pensions;
10. income from discharge of indebtedness;
11. distributive share of partnership gross income;
12. income in respect of a decedent; and
13. income from an interest in an estate or trust.

It seems that there may actually be different tax treatments insofar as the Mitigation provision is concerned. The “profits” that create the false Income in some Ponzi Schemes could very well be excluded from the Mitigation problem because they are a result of phony “inventory sales”. However, it is generally going to be more likely that “phantom income” (income that never really existed) will consist of interest, dividends or many of the other items listed as income in the Code Section.

The issue of whether a clawback payment represents an “item” of gross income for purposes of Mitigation goes a step further than simply qualifying under Code Section 61. In addition, the courts will review the “item” to determine whether the item resulted from the same circumstances as those of the original inclusion. This is known as the “same circumstances” test.

The Lower Court in the Pennzoil case found that the requirement that the Taxpayer’s $4.4 Million obligation to repay suppliers as a result of Pennzoil’s alleged price fixing was from the same circumstances as the original inclusion of funds. However, the Appellate Court reversed the Lower Court and differed as to whether Pennzoil’s refund met the same circumstances test. The Court defined the test as follows:

“The claim of right” interpretation of the tax laws has long been used to give finality to [the annual accounting] period, and is . . . deeply rooted in the federal tax system” Section 1341 is an exception to the claim of right doctrine. The “same circumstances” test, formulated by the Tax Court, “provides appropriate, workable limits” to that exception. The limitations are that “the requisite lack of an unrestricted right to an income item permitting deduction must arise out of the circumstances, terms and conditions of the original payment of such item to the taxpayer.”

Several examples were shown of this principle. In the Bailey case, the taxpayer received dividends, salary, and bonuses as the officer of a corporation, and later paid a civil penalty for violating an FTC order in the work he did for the company. The taxpayer claimed that his payment of the penalty restored an item of income included in his gross income in previous years. The Court then invoked the “same circumstances” test to deny 1341relief, reasoning that the FTC penalty “arose from the fact that Bailey violated the consent order, and not from the circumstances, terms and conditions of his original receipt of salary and dividend payments: and that “the amount of the penalty was not computed with reference to the amount of his salary, dividends and bonuses, and bears no relationship to those amounts.”

In other examples it was shown that the Court barred application of § 1341 where the item included in income (medical fees from Blue Cross) “did not arise out of the same circumstances, terms and conditions” as taxpayer’s restitution payment for fraud to Blue Cross. The Court denied Mitigation relief where corporation’s revenues in prior taxable years “bore no relationship to the amount of the obligation to pay for environmental clean-up” in later years and the court denied the Mitigation provisions to a taxpayer’s settlement of claims for negligence and breach of fiduciary duty arising out of her business because they had “no connection” to consulting fees she received after selling the business.

In short, where the later payment arises from a different commercial relationship or legal obligation, and thus is not a counterpart or complement of the item of income originally received, the “same circumstances” test preludes application of § 1341.

It would seem that the “same circumstances” test is generally going to be satisfied on the very face of the Ponzi clawback transaction. Had it not been for the Ponzi Scheme Investment, there would be no tax on or reporting of income transactions that would comprise a clawback.

All income in a Ponzi Scheme is reported as a direct result of the Scheme. The clawback obligation is a direct result of that scheme and the payment from the scheme.

As a practical matter, any Settlement agreement that is being reached in a Ponzi Scheme should include language to clarify the “item” being refunded. For that matter, any settlement agreement including a clawback should be reviewed by tax counsel prior to finalization.

Included in Gross Income

The second part of the first requirement for Mitigation is that the “item” must have been included in gross income for a prior taxable year. This in fact means included in gross income and subject to taxation in that prior years. This is typically not controversial in the case of a Ponzi Scheme as the income from the scheme, whether actual or phantom, will have been reflected in the tax returns.

2. It Appeared that the Taxpayer had an Unrestricted Right to Such Item.

The next item requires that the Taxpayer had an apparent right to the gross income that the taxpayer reported in the prior year. For quite a while prior to the Pennzoil case, there were differences of opinion that separated this requirement into three different areas. Did the taxpayer have an “apparent right”, did the taxpayer have an “actual right” or did the taxpayer have “no right” at all?

As to the first two of these items, some courts embraced a distinction between an actual right and an apparent right, while others found that an “apparent right” encompassed an “actual right”. The Lower Court in Pennzoil found this distinction to be meaningless. The rationale was not challenged by the Pennzoil Appellate Court.

The Pennzoil lower court found that the Mitigation statute was ambiguous in defining an “apparent right” to the included income. There was no binding case law regarding the actual and apparent dichotomy. The Court therefore turned to the legislative history of § 1341. The legislative history does provide guidance as to the meaning of the term “apparent” in § 1341. In the House and Senate Committee Reports, the legislature states that § 1341 will apply “[if] the taxpayer included an item in gross income in one taxable year, and in a subsequent taxable year he becomes entitled to a deduction because the item or a portion there is no longer subject to his unrestricted use.” Pennzoil held that due to this, an actual right must be included in the definition of an apparent right for purposes of § 1341.

Though the Pennzoil Court of Claims case was reversed, it was not reversed as to this finding and the Court’s analysis is still very helpful.

This reasoning of the Court is important here because the Court stresses that since the Mitigation Provision is remedial it should be interpreted in favor of the Taxpayer. Therefore, § 1341 should be interpreted broadly to effectuate congressional goals. Any doubts regarding the plain meaning of the statute must be resolved against the government and in favor of the taxpayer.

Section § 1341 is a relief provision . . . This would encourage taxpayers to return funds they may have received in appropriately by neutralizing all negative tax impacts of the prior taxation. It should be remembered that Section 1341 is not a tax deduction provision. It does not grant taxpayers a tax benefit for amounts that are not otherwise deductible.

Pennzoil may even stand for the proposition that when a taxpayer reports an “item” as taxable income in a tax return; a prima facie case is made that the taxpayer believed the income was the Taxpayer’s. As the court in Pennzoil put it:

Since Quaker State took into income the [item] it is clear that Quaker State believed that it had a right to that income”.

Certainly in the case of the Ponzi Scheme every objective indication is that there is an apparent right to income that is being reported by that investor. It is stated on the investor’s tax return, available for distribution to them until the crash comes and as can be seen by the many lives devastated by Madoff and others, counted on by the Ponzi investor as real.

The Claim of Wrong Exception

To be entitled to the Mitigation, a Taxpayer must not have only had an apparent right to the reported income; the Taxpayer must have not wrongfully obtained that income.

Intertwined in this issue of an “apparent right” to the income is a doctrine known as the claim of wrong exception. This means that if the Taxpayer had no right at all to the income when it was received, it could not receive Mitigation treatment if later that income was refunded. It is often raised by the I.R.S. to deny the Mitigation section.

Like the “same circumstances” doctrine, the claim of wrong doctrine originates in the case law arising out of the claim of right deduction. The I.R.S. position is that a taxpayer cannot have any right to income for purposes of Code Section 1341, even an “apparent” right to income, if the original claim of the income was “wrongfully obtained. This doctrine has been applied in cases of embezzlement, smuggling, kickbacks and ill gotten gains and rarely in a civil fraud setting.

One thing that is clear about the “claim of wrong doctrine”; is that the doctrine cannot exist in a situation where there is no intentional wrongdoing. It certainly does not exist in the typical Ponzi Scheme victim Taxpayer where lending or investing money with a highly respected and presumably trustworthy and wealthy member of the community (who turned out to be a con man) cost the Taxpayer financial loss and sometimes even their life’s fortunes. The Court in Pennzoil explained the claim of wrong in this fashion:

. . . [I.R.S.] argues that [Taxpayer’s] alleged price-fixing means that it could not have believed [the Taxpayer] had an unrestricted right to the income it earned between 1981 and 1995. [This] position is buttressed by the Federal Circuit’s decision in Culley, in which the court held that a plaintiff could not have believed that he had an unrestricted right to income, since the income was gained through an intentional wrongdoing. [Pennzoil] has been neither indicted nor convicted, and [Pennzoil] asserts that it “believed at the time it made the payments to the independent oil producers that it paid them a fair and honorable sum.” In fact, in the antitrust settlement, [Pennzoil] did not even admit liability.

The Taxpayer who is subject to a clawback in the typical Ponzi Scheme is much more pristine than Pennzoil. The Taxpayers who invest money are paid interest or other types of income for their loans or investments, receive their funds, pay tax on them and have given it all back through no fault of their own.

3. THE THIRD REQUIREMENT FOR MITIGATION IS THAT A DEDUCTION MUST BE ALLOWABLE FOR THE TAXABLE YEAR IN WHICH THE ITEM IS REPAID

The third requirement is that in the actual year of payment that the Taxpayer pays the clawback, the payment must be a permitted deduction that is allowable for the taxable year in which the repayment is made. Simply put, it means that a clawback paid in the year 2011, for example, must be allowed as a deduction for that payment in the year 2011. If the payment presents Ponzi profits paid to a Taxpayer and reported for tax purposes in 2006 it will not be allowed to be deducted at the rates applicable for 2006 unless a deduction is permitted in 2011, the payment year.

Whether a loss from a Ponzi Scheme is deductible is a question already decided in the affirmative by the Internal Revenue Service. In the year 2009, the I.R.S., in response to all of the pending claims for refund generated by the Madoff situation, produced two public documents; Rev. Procedure and Rev. Ruling. Those documents make it clear that victims of a Ponzi Scheme are entitled to a deduction for their loss relating to that Ponzi Scheme. The Ponzi Scheme which is ultimately responsible for a clawback is the same Ponzi Scheme that caused any of the other losses.

This is the law since the I.R.S. has found that a Ponzi Scheme is a transaction entered into for profit. There is no question that the Taxpayer’s investment in a Ponzi Scheme is an investment entered into for profit. Revenue Ruling 2009-9 makes it clear that Code Section 165 (c)(2) applies to Ponzi Schemes as transactions entered into for profit. A deduction for a theft loss would be available in 2011. The clawback payment should not be any different.

The Deduction - The Safe Harbor – The Waiver Of The Mitigation Provisions?

The Revenue Procedure that the I.R.S. issued in 2009 outlined an easy administrative procedure to obtain deductions resulting from a Ponzi Scheme loss. A Taxpayer may find that he or she wishes to use the Safe Harbor and may also be subject to a Clawback. A Taxpayer should not use the Revenue Procedure if they are expecting a clawback without professional advice.

The Safe Harbor requires the Taxpayer to waive the right to use Code Section 1341. The question is whether the waiver of Code Section 1341 is a waiver only of that right to use 1341 on a direct Ponzi theft loss, or is it a waiver of the right to use Code Section 1341 for Clawback payment in that year also?

It is not settled whether this waiver in the Safe Harbor applies only to Ponzi Scheme loss claims or also to clawbacks in general. The IRS Revenue Ruling 2009-9, which legally justifies a theft loss deduction for Ponzi Schemes in the year of discovery, also addresses the use of Code Section 1341 by Ponzi Scheme victims applying for a direct theft loss deduction on their Ponzi Scheme losses. The Revenue Ruling says that the Code Section 1341situation does not apply. However, that Revenue Ruling implies that a “Clawback” may very well be distinguishable from a direct theft loss and may not be prohibited by the waiver of Code Section 1341that is required by the Safe Harbor. This is because there is no “restoration of funds” in a Ponzi Scheme loss. Whereas; in a Clawback just such a restoration of funds does exist.

To satisfy the requirements of § 1341 . . . a deduction must arise because the taxpayer is under an obligation to restore the income.

When A incurs a loss from criminal fraud or embezzlement by B in a transaction entered into for profit, any theft loss deduction to which A may be entitled does not arise from an obligation on A’s part to restore income. Therefore, A is not entitled to the tax benefits of § 1341 with regard to A’s theft loss deduction.

This is an accurate statement of the law on Ponzi losses. However, Revenue Ruling 2009-9, in denying that Code Section 1341 would apply to “theft losses” from Ponzi Schemes, did not consider theft losses that result from payments from “Clawbacks”.

These are the same type of losses and they are directly related to the fact that the Ponzi Scheme investor invested in a fraudulent scheme.

In fact the Revenue Ruling seems to confirm that Code Section 1341 would apply to clawbacks since all that was missing according to the Revenue Ruling was an “obligation to restore”. This is exactly what is present in a Clawback, the restoration of funds. The Revenue Ruling only considered direct losses from Ponzi Schemes where no additional payments were required. That is not that Taxpayer’s case in a Ponzi Scheme clawback.

In a clawback situation, the losses come after the Ponzi Scheme has failed and they are a result of a forced repayment, not an original payment.

4. THE FOURTH REQUIREMENT FOR MITIGATION TREATMENT IS THAT THE FUNDS MUST BE RESTORED “BECAUSE IT WAS ESTABLISHED AFTER THE CLOSE OF SUCH PRIOR TAXABLE YEAR (OR YEARS) THAT THE TAXPAYER DID NOT HAVE AN UNRESTRICTED RIGHT TO SUCH ITEM OR TO A PORTION OF SUCH ITEM”

In the fourth requirement the Statute requires that when the Taxpayer refunded the clawback monies, it must be clear that the Taxpayer did not voluntarily return funds in order to profit from the Mitigation provisions.

There was a good deal of litigation on just what was meant by the “established” requirement. This also was clarified in the Low Court in the Pennzoil case. The bottom line is that funds cannot be “voluntarily repaid” and the best proof of this can be a good faith settlement agreement reached with the clawback trustee.

The fourth requirement of Section 1341 is that income is restored to another person because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item (or portion thereof)”. Pennzoil states that the “established” requirement is met under the following circumstances:

. . . The general rule is that a good faith, non collusive settlement agreement entered into to terminate litigation will “establish” a liability to return income, thereby establishing a lack of an unrestricted right to income for purposes of Section 1341.

The Pennzoil case analyzed the two landmark cases deciding this issue and the standard to meet the “established” requirement. The Pennzoil case analyzed both the Barrett case and the Pike case that some courts had indicated were in contradiction. However, Pennzoil pointed out there was no contradiction. In doing so, Pennzoil clarified another “doctrine” that has developed in the Mitigation provision. The doctrine of “voluntary payment”.

The Pennzoil case clarified that doctrine in this area of law also and in so doing makes it perfectly clear that the Taxpayer’s good faith efforts in the Ponzi Scheme to resist repayments of money in this fraud should meet the “established” requirement of the law.

In Barrett, the taxpayer had included profit from the sale of stock options in one year, and then in a later year, the Securities and Exchange Commission brought administrative proceedings against him on the basis of alleged insider trading. The taxpayer settled the case without admitting liability and claimed that the settlement payment deserved § 1341 treatment. Barrett held that a settlement made at arm’s length and in good faith can satisfy the “establishment” requirement of § 1341, stating:

“The source of the obligation [to repay] need not be a court judgment; however, there must be a clear showing . . . of the taxpayer’s liability to repay.”

Barrett also noted that this result “fostered the legal policy of peaceful settlement of disputes without litigation.

In contrast to Barrett was the Pike case that involved a taxpayer who bought and sold corporate stock in one year, after which an investigator found that the profit from said stock should have gone to the corporation and not the taxpayer. The taxpayer then paid the money to the corporation, without admitting that the profits belonged to the corporation, and avoiding controversy so that he did not suffer harm to his professional career. The Pike court stated that, although “a judicial determination of liability is not required … it is necessary under section 1341 for a taxpayer to demonstrate at least the probable validity of the adverse claim to the funds repaid.”

Although the holdings in Pike and Barrett are different due to distinguishable facts, the point of law that they stand for was not. The primary distinction is that, in Pike, there was no suit against the plaintiff for repayment of money, which makes it more likely that the taxpayer acted voluntarily in paying the money and less likely that the taxpayer can “demonstrate at least the probably [sic] validity of the adverse claim.” Voluntary restitution will not meet the establishment requirements.

In Barrett, (1) an actual settlement was made with the plaintiff(s) who had filed suit; (2) the taxpayer denied liability when entering into the settlement; and (3) there was no indication that either settlement was not made at arm’s length. Under these circumstances, the Taxpayer has met the establishment test. This is going to be the typical scenario in a clawback situation.

Private Letter Ruling 200808019, though not authority, is an excellent statement of the law on this issue. It also establishes standards that were all met in the Taxpayer’s case.

Footnotes:

1/ The Mitigation does not seem applicable to a clawback of a principal payment invested in a Ponzi Scheme, since the principal payment does not represent the Taxpayer’s “income” from the Ponzi Scheme. This article focuses only on the clawback of “income items” reported by a Taxpayer that arises from a Ponzi Scheme.

2/ The two Pennzoil cases were ultimately decided on two principles, one of which was the “inventory exception”. There is an exception in Code Section 1341 that does not permit that section to apply to refunds of items related to “inventory income”. This is because the income tax treatment of “inventory items” have their own tax framework to allow for corrections. That overpriced oil sold by Pennzoil was inventory. All of the Appellate Court Judges agreed that the repayment by Pennzoil was a cost to Pennzoil that would be reflected in its inventory accounting.

Download this article as a .pdf

DO YOU HAVE ADDITIONAL QUESTIONS - CONTACT RICHARD S. LEHMAN TODAY! :

NEW U.S. TAX LAW Seminar Series: 5.5 hours FREE Continuing Education Course Credits

These seminars cover a complete range of topics dealing with legal and practical advice for foreign investors that invest in United States businesses, United States real estate and United States securities; and aliens that immigrate to the United States. This includes income, estate and gift tax planning for nonresident alien individuals and foreign entities such as foreign corporations, foreign trusts and foreign partnerships. Special sections are devoted to foreign investors in United States Real Estate, Tax Planning and Pre Immigration Tax Planning.

Also included in this group of seminars is a thorough study of the United States tax laws governing the tax deductions and tax refunds available for victims of Ponzi Schemes and other theft losses under the Internal Revenue Code Section 165. www.ustaxlawseminars.com

WATCH A SHORT OVERVIEW OF SEMINAR FORMAT:

by Richard S. Lehman

In March of 2009, the IRS issued two documents to explain the “theft loss” deduction for tax purposes and to ease the administrative burdens for those claiming tax deductions and refunds for theft losses from Ponzi Schemes.

One document known as Revenue Ruling 2009-9, (the “Revenue Rule”) spelled out in detail, the general law of theft loss deductions and Ponzi Schemes in particular.

The second I.R.S. document spelled out certain conditions under which I.R.S. would allow theft loss deductions for Ponzi Schemes without audits and administrative slow down. This document was known as Revenue Procedure 2009-20 and it spells out a tax concept known as a “Safe Harbor”. If the Taxpayer stays within the conditions of the Safe Harbor, their tax deduction was safe.

A Safe Harbor is a tax position spelled out by the I.R.S. defining guidelines within which the I.R.S. will not challenge a Taxpayer’s tax position, so long as the tax position fits within certain parameters demanded by the I.R.S. The I.R.S. knows that the Taxpayer would win in court within the parameters set in the Safe Harbor. Therefore, the I.R.S. says, let’s not fight it but rather formalize it.

However, there are many reasons a Taxpayer victim of a Ponzi Scheme will either not fit in the Safe Harbor or will be forced to waive valuable tax rights in the event they choose the Safe Harbor. Therefore it makes sense to study how to deal with the I.R.S. if you have a theft loss and you will not or cannot use the Safe Harbor.

I. No Access to Safe Harbor?

The best example of when a Taxpayer-victim will not be entitled to the Safe Harbor for not meeting a “Safe Harbor” rule is found at Section 4.02 of the Safe Harbor which holds that there is no “theft” for purposes of the (Safe Harbor) unless:

(1) The lead figure (or one of the lead figures, if more than one) was charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime, that, if proven, would meet the definition of theft for purposes of § 165 of the Internal Revenue code and §1.165-8(d) of the Income Tax Regulations, under the law of the jurisdiction of which the theft occurred; or

(2) The lead figure was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a crime described in Section 4.02(1) of the Revenue Procedure, and either -

(a)The complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or

(b) A receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

This part of the Safe Harbor in essence defines the status of the level of proof that the I.R.S. must see to be sure a “theft” has been committed before allowing the tax deduction. However, there are many Ponzi thefts that are entitled to a “theft loss deduction” that never reach this level of prosecutorial attention.

The definition of a “theft” for tax deduction purposes is spelled out in the Revenue Rule as follows. As one can see the definition of “theft” under the law is much broader than the I.R.S. definition of theft for the Safe Harbor. The I.R.S. defines a deductible theft as:

For federal income tax purposes, “theft” is a word of general and broad connotation, covering any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile . . . “theft” includes larceny and embezzlement. A Taxpayer claiming a theft loss must prove that the loss resulted from a taking of a property that was illegal and had criminal intent under the law of the jurisdiction in which it occurred. A taxpayer need not show a conviction for theft.

Many taxpayers fit this legal definition of “theft loss” for tax deduction purposes but do not fit into the Safe Harbor.

Refusing the Safe Harbor – Waiver of Amended Returns

There are also reasons why a Taxpayer may not want to use the Safe Harbor even if the Taxpayer qualifies. A major drawback of the Safe Harbor is that the Safe Harbor requires a Taxpayer to waive the right to file amended returns for prior years and eliminate only the Ponzi income in each of those years. Instead, the Taxpayer must claim the theft loss as a deduction only in the year of discovery and then carryback or carryover any excessive theft loss not applied in the year of discovery to other full taxable years.

There is a big difference between eliminating Ponzi income only, from a prior tax return and taking a theft loss for the Ponzi income in the year of discovery. It could be financially significant. After claiming a full deduction for a theft loss in the year it is discovered, losses in excess of those deducted against the income earned in the year of discovery can be carried back and carried forward. When a loss carryback or carryover is used to claim a refund it must be applied against the entire amount of income earned in the year of carryback.

The theft loss is applied against a full year’s taxable income in the carryback year or carryover year. This may average out to be a 20% tax rate for refund purposes in the year of the carryback and the actual Ponzi income (“Phantom Income”) may have been taxed at the thirty-five percent (35%) tax rate in the year it was taxed. A Taxpayer with a $1,000,000 Ponzi Scheme loss filing an amended return eliminating Phantom Income only; versus a return that claims a theft loss on that Phantom Income of One Million Dollars can mean an increase to the Taxpayer’s tax refund from $200,000 (20%) to $350,000 (35%).

Legal Support for Amended Returns

The Internal Revenue itself has recognized under certain circumstances that it is correct to amend one’s tax returns and eliminate the “Phantom Income” only from the taxable year being amended, thus making use of a tax deduction in the highest bracket.

Therefore the Taxpayer must think the calculations through before waiving the right to file an amended return that will eliminate only the Ponzi Scheme income.

Claw Backs

Another reason not to accept the Safe Harbor is if the Taxpayer is concerned that the Taxpayer may be subject to a “Clawback” as part of a Ponzi Scheme mess. If so, the Taxpayer must waive another valuable tax right in order to take advantage of the Safe Harbor. The Taxpayer is required to give up his or her rights to use Code Section 1341.1/

The Safe Harbor insists that the Taxpayer waive their right to make use of the Internal Revenue Code Section 1341 in the event they must repay money in a Clawback. Code Section 1341 gives the Taxpayer that paid tax on income from a Ponzi Scheme in a prior year who is required to pay that income back in a different year as a Clawback, a choice. The Taxpayer may take the theft loss deduction in the year that the deduction is most tax beneficial to the Taxpayer. That could be either in the year in which the payback or claw back was paid or in the year that the income that was clawed back was taxed. This is the case even if the statute of limitations is closed in the year that the original tax was paid.

This is a valuable right that the Taxpayer must waive for the benefit of the Safe Harbor.

1/ A Clawback is when the Trustee in a Ponzi Scheme after the collapse, seeks recovery against fellow Ponzi Scheme participants that may have “profited” (in a cash sense) from their participation as investors in the Scheme. For example, Mr. X invested $1,000,000 in Madoff and reported and paid tax on another $1,000,000 in Phantom Income. He also took cash distributions over the years of $1,200,000. The Trustee may wait to “claw back” the $200,000 to pay investors in the scheme that actually lost on a cash invested basis.

I. The Alternatives to the Safe Harbor

This is just a few examples of when the Safe Harbor does not fit. If it does not fit for the Taxpayer, what is the next step if one believes they have a theft loss? The best way to analyze the Taxpayer’s position is to actually compare the Revenue Ruling and the Safe Harbor rules. By studying the Safe Harbor and the law together one can see how to claim the benefits of the Safe Harbor without the Safe Harbor.

Actually, the reader will see that the two documents are really not that far apart and there is in fact complete agreement upon several points between the two documents. First we will examine where the documents differ and how to deal with the differences so that a theft loss deduction can be claimed outside of the Safe Harbor. Then we will see where they agree.

Defining Theft Loss

The two documents differ regarding the definition of the “theft” that will support a deduction. This we have already discussed. In order to use the Safe Harbor, the “theft” must be shown by a state or Federal indictment, etc. The Revenue Ruling recognizes clearly that for income tax purposes the word “theft” has a broader definition. The Safe Harbor, however, requires not only that for there to be a theft, it must result from conduct by individuals charged by an indictment, information or complaint that has been filed against the perpetrator of the theft.

This author has found that when the theft does not reach the level established in the Safe Harbor but is a theft for state criminal purposes, it is time to turn to a criminal lawyer in the state in which the theft occurred. If the incident is a theft under state law the Taxpayer should obtain a legal opinion from a criminal lawyer under the laws of that particular state that the taking of property amounted to a criminal theft under that state’s law. This is strong proof of the theft for tax purposes.

The law is clear that a taxpayer need not show a conviction for theft in order to obtain a theft loss deduction.

Year of Discovery

There are two other places where the Safe Harbor sets standards different from the law as described in the Rev. Ruling. These are the definitions for the Year of Discovery and the Amount of Deductibility of the Theft Loss in the Year of Discovery.

Both the Revenue Ruling and the Revenue Procedure are in agreement that the law requires that the theft loss deduction must be taken in the year of discovery. However, the two documents differ on defining the “year of discovery”

To enjoy the benefits of the Safe Harbor, the Taxpayer must accept that the year of discovery is directly related to the year in which the indictment, information or complaint against the perpetrator which led to the theft has been filed. Therefore, under the Safe Harbor, a fixed “year of discovery” is tied directly to the Federal or state actions against the perpetrator.

This can be a very important difference. Keep in mind that in many business and theft loss cases there will be no indictment, etc. as required by the Safe Harbor to prove theft. The Taxpayer, not in the Safe Harbor, must not only be able to prove a theft loss, he or she needs to show the year in which the theft was discovered. The “year of discovery” is proven by gathering the pertinent evidence to the year of discovery. Evidence must be preserved that shows when the fraud was first discovered. This can be such things as notices of the collapse of the investment, meetings with lawyers or other professionals regarding the collapse, letters to perpetrators, income tax returns that prove the Taxpayer either still believed in the Ponzi Scheme at a particular point in time and any other facts.

The courts in deciding the year of discovery of a theft have agreed on several principles that provide further guidance. In determining the reasonableness of a taxpayer’s belief of loss at a particular time, the courts recognize they must be practical and take the individual facts of each case on its merits.

The relevant facts and circumstances are those that are known or reasonably could be known as of the end of the tax year for which the loss deduction is claimed. The only test is foresight, not hindsight. Both objective and subjective factors must be examined.

The law provides good guidance on the year of discovery and it is very much the year in which the ordinary reasonable person knew they had a loss from the collapse of investment.

In this regard it would seem that the Safe Harbor leaves no room for flexibility whereas the case law of the Rev. Rul. are not as exacting on the determination of the year of deductibility. Proof will be the key.

Amount of Deductibility in the Year of Discovery

The only other major concept where the Safe Harbor differs from the law is in dealing with exactly how much of a theft loss can be recognized and deducted and taken advantage of in the year that it is discovered.

TO BEGIN WITH, BOTH DOCUMENTS AGREE THAT THE TOTAL AMOUNT OF A THEFT LOSS IS EQUAL TO THE TAX BASIS OF THE LOSS.

This discussion deals with how much of that loss can be taken as a deduction in the year of discovery only. There are other standards that determine the timing on the deduction for those losses not claimed in the year of discovery.

The standard that defines exactly how much of that total amount is deducted in the year that the theft is discovered is defined as the total amount of the loss reduced by any amount that represents a “reasonable prospect for a recovery”. To the extent there is a reasonable prospect of recovery, there will be no deduction in the year of discovery.

The Taxpayer’s legal rights as of the end of the year of discovery are all important and need to be studied to make a proper decision. One of the facts and circumstances deserving of consideration is the probability of success on the merits of any claim brought by the Taxpayer. This is because the filing of a lawsuit may give rise to an inference of a reasonable prospect of recovery. However, the inference is not conclusive or mandatory. The inquiry should be directed to the probability of recovery as opposed to the mere possibility. A remote possibility of recovery is not enough; they must be a reasonable prospect of recovery at the time the deduction was claimed, not later.

In the event the deduction is not taken in the year of discovery, it will eventually be taken as a deduction in later years. However, if the theft loss is not taken in the year of discovery it must meet a higher standard of proof to be deductible in any other year. Eventually at that point in time when the Taxpayer can “ascertain with a reasonable certainty” that there is no prospect of recovery, any unclaimed theft losses may be taken. This could be a significant long period of time to delay deduction for theft losses.

Safe Harbor – Fixed Percentages

The Safe Harbor has definitely delivered the Taxpayer a favor in clarifying the amount of the theft loss deductible in the year of discovery by clearly defining certain percentage amounts that can be deducted under varying circumstances in the year of discovery to account for “contingent recoveries”.

Prior to the establishment of these fixed percentages by the I.R.S., the Taxpayer has always been dependent upon case law and accounting presentations to prove the amount of the deduction available in the year of discovery.

There are three groups of potential recoveries that both documents agree will reduce a theft loss in the year of discovery. That is three groups that represent a “prospect of recovery” in the year of discovery.

1. Recoveries from Insurance, Guarantees and Agreement to Limit Losses.
Essentially the Safe Harbor and the Rev. Rul. both agree that any amount of the loss claimed in the year of discovery as a deduction must be reduced by amounts actually recovered in the year of discovery or amounts that will be recovered as a result of insurance policies of any other contractual arrangements or guarantees that would repay the taxpayer for any of the theft loss claimed. This also includes government insurance companies such as the Securities Investors Protection Corp.

However, “all reasonable prospects of recovery” cannot be so easily quantified. THIS IS WHERE THE SAFE HARBOR IS MOST HELPFUL. THE SAFE HARBOR PROVIDES TWO (2) FIXED PERCENTAGES FOR THE TWO GROUPS THAT QUANTIFY THE BALANCE OF POTENTIAL UNKNOWN AND CONTINGENT RECOVERIES THAT COULD OTHERWISE REDUCE THE AMOUNT OF THEFT LOSS IN THE YEAR OF DISCOVERY.

Those two potential contingent amounts of recovery are as follows:

2. Recovery from those Responsible for the Ponzi Scheme. “The Responsible Group”. The Safe Harbor states that if the only people from whom the Taxpayer expects recovery of the Taxpayer’s total theft loss are the people who perpetrated the crime, then in the year of discovery the Taxpayer may deduct 95% of the total theft loss.

It is presumed by the I.R.S. that the Taxpayers will not recover more than 5% of the Taxpayers’ loss from the actual perpetrators.3/

If the Taxpayer is not in the Safe Harbor the Taxpayer will still be able to deduct 95% or more of the total loss. However, without the Safe Harbor the Taxpayer is going to have to prove his or her case. There is at least one case that supports that the 5% reduction in the loss, in the event the perpetrator is the only source of recovery, is acceptable to the courts.

3/ This “concession” of 5% that is reflected in the Safe Harbor Standard obviously reflects the long history of case law and experience that shows that recovery from the perpetrators of the Ponzi Scheme’s themselves will rarely be more than 5% as recovery towards the overall loss. As major fees and litigation are involved in obtaining this recovery. These fees reduce the recovery.

The Taxpayer will need to establish that he or she is not seeking any other source of recovery than from the Perpetrators and that the chances of receiving a refund from the perpetrators is no more than 5%. The Taxpayer will need to provide the proof necessary to establish that the amount (most likely from the Trustees own records), that they will recover from the Perpetrators will be no more than 5% of their loss.

The big difference here to be overcome by the Taxpayer who cannot use the Safe Harbor is that the Taxpayer must be responsible to provide proof that the Trustees’ recovery will not be significant. This can be done with good accounting.

3. Recovery from Third Parties. The Safe Harbor also provides the Taxpayer with a percentage amount to quantify another unknown potential recovery that could reduce what a Taxpayer may claim as a deduction in the year of discovery. The Safe Harbor provides that if a Taxpayer is also seeking recovery from third parties by litigation such as the major brokerage firms or accounting firms, etc. that may be responsible for the fraud; in this situation, the Safe Harbor will reduce the amount of theft loss deduction in the year of discovery by an additional 20% of the total amount of the theft loss to account for the potential recovery loss.

In other words, if a Taxpayer is suing third parties and depending upon distributions from a Trustee representing the perpetrators, the Taxpayer must reduce their total theft loss by 25% in the year of discovery until these issues are resolved.

Again, the Taxpayer who cannot rely on the Safe Harbor is going to have to prove their case. It is here where good forensic accounting may make a major difference and where a taxpayer may be able to prove that their “third party recovery” will amount to certainly no more than and possibly even less than the 20% amount allowed under the Safe Harbor rules.

DOCUMENTS IN AGREEMENT

As we stated, there are also many places where the Safe Harbor and the law agree.

Phantom Income as a Basis for Theft Loss.

The Rev. Rul. And the Safe Harbor do not disagree on the legal point that Phantom Income, which has been taken in as income and upon which tax has been paid by a Ponzi victim, may be the subject of a theft loss and becomes part of the tax basis that is deductible as a theft loss.

In order to be prepared to establish that tax has been paid on Phantom Income, all Taxpayers should include in their claim for refund, every tax return upon which Phantom Income appears as part of any submission to the I.R.S. There is no reason not to include each and every one of the Taxpayer’s income tax returns and any other vital information relevant from previous years to prove Phantom Income. There will be many other records that will support the payment of taxes on Phantom Income. All of this needs to be preserved.

Finally, both documents are in agreement on certain legal points that make life easier for the Taxpayer. These are:

Ordinary Income Deduction

Both documents agree that the theft loss deduction is a deduction of ordinary income and is entitled to be used as a net operating loss carry back or carry forward.

A Business Deduction

Both documents agree the theft loss deduction in a Ponzi Scheme is a business deduction that is not reduced by any of the percentage dollar limitations applicable to other types of casualty and theft losses.

Pass Through Entities

Both the Rev. Rul. and the Safe Harbor Agree those Taxpayers in “pass through entities” such as limited liability companies and partnership will be entitled to take their portion of any of the theft loss directly in spite of the fact the loss is in the name of the entity.

Summary

In summary, the Safe Harbor is just the starting point for those who are victims of Ponzi Schemes and other business and investment related theft loss that do not meet its conditions. Tax refunds can be obtained without the Safe Harbor; sometimes it is even more valuable without it.

The road towards a tax refund will be slower and the Taxpayer is advised to gather the most evidence one can get their hands on to prove the “year of discovery”, the amount of the “Phantom Income” and the actual “reasonable prospects of recovery” in the year of discovery.

With the right evidence and the law on your side, theft losses from Ponzi schemes can lead to the same refunds as the Safe Harbor and even more, since interest will be paid on the refund from the time the taxes were paid in certain situations. This might not occur under the Safe Harbor, the Taxpayer may be better off without the Safe Harbor in many situations.

Personal Comments

I have always said the Ponzi Scheme is one of the best things that has happened to the I.R.S. in a long time. The reader will have heard the names Madoff, Sanford, Nadell, etc. Let’s assume that all together they created $200 Billion Dollars of Phantom Income, almost all of which was taxed by the I.R.S. in the 35% tax bracket. In other words I.R.S. made $70 Billion from the Ponzi Schemes. (35% x $200 Billion)

I have seen in my practice that a tremendous amount of this valuable theft loss tax deduction is not being used properly or at all by individual Taxpayers. It is going completely to waste because it

(i) it is not properly being used before the death of the Taxpayer, or

(ii) it can be used only against income that is taxable in the 15% tax rate because the Taxpayer’s income is now so low due to their Ponzi Scheme loss; or

(iii) deductions are being wasted by poor professional advice or lack of knowledge.

I believe the average total amount of Ponzi Scheme refunds that will be made by the I.R.S. will be at a tax rate that averages less than 15%. The I.R.S. will receive $70 BILLION in taxes from “Phantom Income” and after holding the Taxpayers’ money for ten years will return about $25 BILLION in refunds.

DO NOT GET CAUGHT IN THAT TRAP. SEEK PROFESSIONAL ADVICE.

OCTOBER 2012 UPDATE:

Report to Congress: The U.S. Government Accountability Office (GAO) report on the Customer Outcomes in the Madoff Liquidation Proceeding. Download full 80-page report.

---

By Richard S. Lehman, Tax Attorney

The headlines are now informing Madoff and other Ponzi Scheme victims about the most recent piece of bad news. That is the word “claw back”. In short, investors who received cash investment returns from a Ponzi Scheme in excess of the actual invested funds are being forced to pay that excess cash back. HOWEVER, THESE “CLAW BACK” PAYMENTS WILL BE TAX DEDUCTIBLE.

Those victims that are hit by a “claw back” may or may not have a choice about when they can deduct any moneys they repay as a “claw back”. Whether they have this choice could mean a big difference in the amount of money in tax refunds that will be payable to the “Claw Back” victim.

As an example, assume the following:

Mr. Smith invests $500,000 in 2005 and earns and pays U.S. income taxes on $125,000 in 2005, $125,000 in 2006 and $125,000 in 2007. In 2008 Mr. Smith withdraws all $875,000 from his Ponzi Scheme account and closed the account. Assume Smith paid in the 35% tax bracket on his $375,000 in earnings for total taxes paid of $131,250. Assume Mr. Jones made the same investment but never withdrew any funds. Jones loses $875,000. Assume that the $375,000 of “earnings” is “clawed back” from Mr. Smith but not paid back by Mr. Smith until 2011 when all the litigation was settled.

The law is clear that moneys clawed back from Mr. Smith, for which he had paid taxes on, would be deductible by Mr. Smith in the year 2011 when they were paid back. But what if Mr. Smith had very little income for 2008 and 2009 and 2010 and 2011 and used and carried back his $375,000 in losses in those four years, where would he be? The value of Mr. Smith’s tax refunds for the deducted repaid amounts in those years might be based on tax brackets that average 18%. In that case Mr. Smith would receive a tax refund of $67,500 even though Mr. Smith has paid taxes of $131,250 in prior years on the claw back income.

The Choice

There is a solution that will provide for a full return of all of the taxes paid by Mr. Smith of $131,250 plus interest. However, that solution may not be available to any Taxpayers that have filed previously and received tax refunds while making use of the “Safe Harbor” rules published by the Internal Revenue Service in Rev. Proc. 2009-20. The “price” of enjoying the Safe Harbor rules was to waive the Taxpayer’s rights to make use of a particular Code Section in the Internal Revenue Service that provides for this tax fairness.

Code Section 1341 of the Internal Revenue Code provides that under certain circumstances

Taxpayers who have received funds that they have reported as taxable income that must be paid back at a future time will have a choice.

They can deduct the funds that must be paid back in the year in which the payment is actually made, or go back to the years that the income that is being repaid was reported.

This refund is determined by calculating the actual year of income and excluding the repaid amount. It eliminates the repaid income from the Taxpayers’ taxable income for that year, thus recalculating the amount of taxes due and providing for a refund of excess taxes paid on the money returned from prior years.

This Code Section is very valuable in the event a Ponzi Scheme victim must pay back funds in a year in which the victim is in a very low tax bracket and those same funds had been reported in a prior year in a very high tax bracket, like Mr. Smith.

Those Taxpayers who did not rely on Rev. Proc. 2009-20 should be able to rely on Code Section 1341 to increase the amount of their refund, if appropriate.

Furthermore, refunds paid pursuant to Code Section 1341 will carry interest from the prior year’s date for the amount of the overpayment. This will be an extremely useful tool to investors suffering from claw backs in a Ponzi Scheme.

The use of Code Section 1341 can increase tax refunds and interest payments by 100% and more.