One of last month’s guidances was a revenue ruling that clarifies the income tax law governing the treatment of losses in such Ponzi-type investment schemes (Rev. Rul. 2009-9). The second was a revenue procedure that provides a safe-harbor method of computing and reporting the losses (Rev. Proc. 2009-20).Allowing the use of the theft deduction is a great leniency for the victims of the fraud. (Should we say "casualties," Daphne?)
Under Internal Revenue Code Section 165, these theft losses are not capital losses subject to the limits of being offset by capital gains plus $3,000 per year of ordinary income, when the loss exceeds capital gains from investments. Further, these losses are not subject to the “personal casualty and theft losses,” which are treated as an itemized deduction subject to a reduction of 10 percent of adjusted gross income over the $100 reduction that applies to many casualty and theft loss deductions.
The theft loss is deductible in the year the fraud is discovered, except to the extent there is a claim with a reasonable prospect of recovery. The theft loss includes the investor’s unrecovered investment, including income reported in prior years. It can create a net operating loss for the taxpayer which can be carried back and forward to generate a refund of taxes paid in other taxable years.
The leniency itself is Talmudic and the subsequent issues raised are even more Talmudic, namely, what about the downstream investors? Are they permitted to use the leniency as well? Does investor intention or knowledge play any role in all of this?
How will the losses from these investments, which were ultimately made in a Ponzi schemer’s program, be treated? The investors did not directly or knowingly invest in the Ponzi scheme.I never dreamed that pondering the intricacies of the tax law could be so rewarding to a Talmudist.
Three investment/hedge funds operated by J. Ezra Merkin, Ascot Partners, Ariel Fund and Gabriel Capital, were paid $470 million in fees and performance bonuses from clients. They are parties to a complaint filed by New York Attorney General Andrew Cuomo alleging civil fraud regarding $2.4 billion from these funds that was invested with Mr. Madoff, purportedly without clients being aware of where their money was being invested...
If the taxpayer-investor had no knowledge that the fund in which he or she invested had reinvested in a Ponzi-scheme and did not know it was a Ponzi scheme when losses flowed through to their investment fund, but subsequently were informed — either because their fund revealed this information to them, or the civil or criminal lawsuit against the Ponzi schemer revealed that among its investors was the fund that the subject taxpayer-investor had placed his/her funds — will the taxpayer-ionvestor be entitled to theft loss treatment, in effect, as an indirect, unknowing investor in the Ponzi scheme?
And will the Internal Revenue Service be willing to permit a Ponzi-type scheme theft loss to indirect investors of these funds, whether or not they knew with whom their funds were ultimately invested (and lost)? Will a criminal action be a mandatory element of the facts in order to take the theft loss for income tax purposes?
We envision that the extent of these losses and the topics that arise as a result may go far beyond the anticipated scope of the announced revenue ruling and revenue procedure in the Internal Revenue Service’s guidance.