Posts Tagged ‘Code Section 1341’

July 2013 Update

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.

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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. Multibillion 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.

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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.

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

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.

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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.

By Richard S. Lehman, Esq., of Richard S. Lehman; Boca Raton, FL

In last week’s column, we established that today’s business climate is extremely treacherous for all sizes and types of business. Whether a suit is won or lost, frivolous or legitimate , there are major distractions. Time is spent defending actions, while revenue-generating activities are curtailed. Similarly, large sums of money can be spent on defense.

In the first article, we analyzed a variety of asset protection entities. In this final segment, we will look at protected forms of investment. Business owners, directors of public companies, management and individuals should consider making use of these various methods of investment as another protection against liabilities.

Exemption equals protection.

Not only can there be protection from creditors by choosing the proper entity in which to hold assets, many types of investment assets are also protected from creditors by virtue of state and federal exemptions.All states have “exemptions” to designate categories of property interests that are immune from forced sale or seizure. Florida law provides an assortment of such exemption:

• Annuity and insurance contracts. Florida law protects the cash surrender values of life insurance policies and the proceeds of annuity contracts issued upon the lives of residents of the state. Creditors of the insured or the beneficiary cannot seize the assets unless the policies or contracts were for the benefit of the creditor.
• Life insurance trusts. Consideration of the life insurance trust provides an asset protection opportunity that makes use of the trust concept, the exemption concept and also provides for major estate and gift tax benefits. This type of trust, formed to handle life insurance proceeds, is similar to the domestic trust described in the previous article. Asset protection may be afforded by providing limitations on the beneficiaries’ interest. Under Florida law is also protection from creditors due to the exemption, and it also provides for the estate tax-free payment of life insurance death benefits to beneficiaries.

By placing the policy in a separate irrevocable trust, rather than owning the policy, the insured retains no “incidence of ownership.” The death benefits payable from the policy will not be included in the insured’s estate. If the insured does not use a trust or another person as the owner of the policy and retains any incidence of ownership, all of the death benefits will be subject to estate taxes.

All states have exemptions to designate categories of property interests that are immune from forced sale or seizure. Florida law provides an assortment of such exemptions. Homestead and other exemptions.

• Homestead protection. Florida provides unlimited protection for the homestead property and improvements. The limit on the size of protected property is up to one-half acre in a city or 16 acres in the country.
• Earnings of a head of household. Florida protects compensation for personal services or labor whether denominated as wages, salary, commission or bonus. The first $500 a week of such earnings are absolutely exempt from attachment or garnishment and anything above that amount will not be subject to attachment or garnishment unless such person has agreed otherwise in writing. Wages may be protected for six months after receipt.
• Disability insurance and disability insurance proceeds. Florida exempts disability payments from creditors, including lump sum proceeds resulting from settlement of a claim against a disability carrier.
• Pension plans and IRA’s. These are generally protected, but bankruptcy courts have found that pensions will not be protected from creditors in the event of inappropriate compliance with tax or labor laws. Among common defects that may cause this qualification are a failure to cover all employees requiring such coverage, inappropriate investments and loans, and prohibited transactions.
• Alimony rights. These rights are a protected asset.
• Unemployment compensation benefit rights. As defined by Florida law, these rights are exempt from all claims and creditors.

Keep in mind that these are cursory explanations of several asset protection strategies. Business owners should realize that their assets are always at risk, so it’s worth considering these plans with a professional as a way to protect what you’ve built personally and through your business.

Originally Published: May 31, 2002 in South Florida Business Journal

By Richard S. Lehman & Associates Attorneys at Law

The general principles discussed herein are not intended to be legal or tax advice and taxpayers should consult with their individual legal, accounting and tax advisors.

PRE-IMMIGRATION TAX PLANNING

What Can Be Accomplished Prior to Residency Status

South Florida continues to be a destination for legal aliens hoping to invest; do business and live in the United States. Very often immigrating residents are unfamiliar with the tax laws of the United States that they will face upon obtaining their resident status. Often this lack of knowledge can be costly with immigrants paying unnecessary taxes and burdening themselves with liabilities.

The following is a checklist of issues that may be helpful to avoid these tax problems. The checklist does not consider the effect of a tax treaty that may apply to an immigrant.

I. Status for Tax Purposes

- Resident for Income Tax Purposes

a. Green Card

b. Substantial Presence Test

c. Voluntary Election

- Resident for Estate and Gift Tax Purposes

a. Country of Domicile

II. Taxation Pattern

- Resident - Subject to Taxation

a. Income Taxation - Worldwide Income

b. Estate Taxation - Worldwide Assets

c. Gift Taxation - Worldwide Assets

- Non Resident Alien - Subject to Taxation

a. Income Taxation - United States Source Income, Limited type of Foreign Source Income

b. Estate Tax - United States Situs Assets Only

c. Gift Tax - Real and Tangible Personal Property with a United States Situs

- Situs of Assets

a. Real Property in the U.S. - U.S. Situs

b. Tangible Personal Property - Located in the U.S . - U.S. Situs

1. - Cash - Needs Special Consideration

2. - Exceptions for visiting art work

c. Intangible Personal Property - Dependent upon the type of intangible property

III. Pre-Immigration Planning - Income Tax and Gain

- Objective - Minimize United States Gains and Income Tax

a. Key Strategy is to accelerate gains prior to residency so that gains earned while one was a non resident alien are not subject to U.S. tax after residency is obtained. Some examples of acceleration of gain are:

b. Traded securities with unrealized gain may be sold before residency and repurchased with a new cost basis

c. Illiquid assets with unrealized gain may be sold to related parties or third parties and gain realized. Careful planning must be undertaken if one sells and repurchases illiquid assets; especially with related parties.

d. Income expected to be paid after residency should be accelerated where possible and paid prior to residency.

Some examples of acceleration of income are:

1. - Exercise stock options
2. - Accelerate taxable distributionsfrom deferred compensation plans
3. - Accelerate gains on Notes held from installment sales

IV. Pre Immigration Planning - Estate and Gift Tax

- Objective-Minimize United States Estate Tax

a. Key strategy is to minimize assets in one’s estate before obtaining residency status; and where possible to retain some degree of control over assets;

b. Planned gifts to third parties should be made prior to residency;

c. Planned gifts of United States Situs Property

1. - Tangible Property - Physical Change of Situs to a Foreign Situs Before Gift is made;

2. - Real Estate - Contribution to foreign corporation and gift of stock in foreign corporation.

d. Transfers in Trust for Beneficiaries

V. EXCEPTIONAL CIRCUMSTANCES AND SPECIAL TAX BENEFITS

- Students

a. A foreign student who has obtained the proper immigration status will be exempt from being treated as a U.S. resident for U.S. tax purposes even if he or she is here for a substantial time period that would ordinarily result in the student being taxed as a U.S. resident.

b. This student visa not only permits the student to study in the United States and pay taxes only on income from U.S. sources not worldwide income. The visa also permits the student’s direct relatives to accompany the student to the United States and receive the same tax benefits.

c. Assume the student, a Columbian woman aged 40, is married to an extremely successful Columbian businessman who accompanies her with their two children to the U.S. His annual income is $1.0 Million and is earned from the banking business in Columbia. He earns no U.S. income. Under those circumstances, for U.S. income tax purposes, this businessman is exempt from U.S. tax on his worldwide income while living full-time in the U.S. for less than five calendar years.

- Treaty Benefits

Aliens that are governed by a tax treaty can generally spend more time in the U.S. than an alien not covered by a treaty before being considered a resident alien for tax purposes.