Ponzi meets the Internal Revenue Code

Since 2009, I have served as a bankruptcy trustee for the estate of Kevin Carney, a Ponzi fraudster. Carney stole over $10 million from close to 200 people, most of whom were people of modest means.

The victims of this Ponzi scheme have received a lot of help from the Internal Revenue Service. Not only did the IRS subordinate its claim in the estate, but thanks to a favorable revenue procedure, victims will be able to treat most of their Ponzi scheme losses as losses owing to casualty or theft.

The Carney estate recovered close to $2 million. However, the IRS had filed a claim for over $600,000 representing the income tax on account of Carney’s ill-gotten gains. It seemed wrong to me that income tax against the fraudster should receive a priority pursuant to Section 507(a)(8) of the Bankruptcy Code at the expense of the investors.

The Bankruptcy Code did not provide an answer. Nothing in § 510(c) of the Bankruptcy Code suggested that the IRS’s claim would be subordinated to the victims of a Ponzi scheme. Although there is no specific revenue ruling or statute directly on this point, the IRS agreed to substantially subordinate its claim to the general unsecured claims of creditors who were victims of the Ponzi scheme.

The IRS has also issued Revenue Procedure 2009-20-IRB-2009-14 addressing treatment of Ponzi scheme losses as theft losses in the tax year that the taxpayer discovers the loss.[1] Under this procedure, the IRS affords a 95 percent safe harbor under which qualified investors can treat a loss as a theft loss for investors who don’t pursue a third-party recovery, or by 75 percent for those investors who do pursue a third-party recovery. Any loss ultimately recovered is treated as income in the subsequent year.

Revenue Ruling 2009-9 addresses and answers many questions related to theft loss deductions in Ponzi schemes:

1. Losses from a Ponzi scheme will be considered theft losses, not capital losses;
2. Theft losses are not subject to personal loss limits of §165(h) of the Internal Revenue Code;
3. Theft losses are deductible in the year discovered; 
4. The loss is the amount of the investment theft loss less the amount recovered;
5. The theft loss includes “phantom income” reported by the Ponzi scheme to the investor if it was reported as income in prior years;
6. Ponzi scheme losses could create a net operating loss for business taxpayers; and
7. The taxpayer is not entitled to the benefits of § 1341 of the Internal Revenue Code for Ponzi scheme losses.

Conclusion

Ponzi scheme losses are devastating to the victims. The Internal Revenue Code, however, allows for significant mitigation of these losses by allowing treatment of them as theft losses. Moreover, under certain circumstances, the IRS will subordinate its tax claim to legitimate claims of Ponzi scheme victims.[2]