Over the past few years, we have all witnessed the collapse of many large fraudulent investment schemes. Where once the victims of such scams were unsophisticated, often elderly or otherwise easy targets for financial predators, frauds such as those perpetrated by Bernard Madoff, Allen Stanford, Marc Drier and the Bayou Group, to name just a few, counted some of the most successful institutional and private investors, major pension funds, hedge funds and charities among their victims. Once a fraudulent enterprise collapses, it falls to regulators, receivers and bankruptcy trustees to sort out the wreckage and redistribute the remaining assets in an effort to reduce the impact of the crime on the victim pool.
This typically means that “net winners,” those who received back both their principal and a return on their initial investment, referred to as “false profits” or “fictitious profits,” must return their gains for redistribution to “net losers,” those who lost principal. Further, where there are insufficient false profits to compensate net losers, victims may have to disgorge principal to ensure an equitable distribution among the entire victim pool. Like any transaction, be it legitimate or fraudulent, tax issues apply and need to be assessed. This article explores the tax treatment of net winners and losers of Ponzi schemes.
What Is a Ponzi Scheme?
A Ponzi scheme is a fraudulent pyramid-type scheme named after Charles Ponzi (Cunningham v. Brown, 265 U.S. 1 (1924)). In such a scheme, money from new investors is used to pay artificially high returns to earlier investors in order to create an appearance of profitability and attract new investors so as to perpetuate the fraud. Thus, without a constant flow of new investors into the fraud, the Ponzi scheme will collapse because the new money is needed to pay the returns for earlier investors. Some Ponzi schemes are “pure” in nature, and there is no real business underlying the fraud. In a “pure” Ponzi scheme, the perpetrator is merely moving money from new investors to earlier investors. Other Ponzi schemes may involve a legitimate or quasi-legitimate underlying business, which affords the perpetrator a veneer of legitimacy. Ultimately, all Ponzi schemes do collapse, as the geometric expansion of the fraud eventually causes the outflow of funds to exceed receipts from the recruitment of new investors.
Tax Treatment of Disgorgement of Profits by Net Winners
Once a Ponzi scheme is discovered, those who made out best—the net winners—are typically the target of avoidance actions by the bankruptcy trustee or receiver appointed to ensure equitable treatment of all victims. When a net winner is required to disgorge false profits, the amount disgorged is deductible, so long as the net winner had previously reported the false profits (26 U.S.C. § 165(c)(2)). The false profits that are repaid are deductible in the same character (ordinary or capital) as they were treated for purposes of initial tax reporting. It does not appear that amendment of prior year’s returns would be an appropriate way to address disgorgement of false profits unless taxes were paid as phantom income only. See Chief Counsel Advice 200811016 (“Returns may be amended if an amount was reported as income but was not in fact actually or constructively received… However, the open transaction doctrine should not be applied retroactively, and must yield to the general rule that each tax year stands on its own... The proper remedy for taxpayers who have suffered a [theft] loss is a deduction.”) Accordingly, the tax effect to a net winner who must return his or her winnings should be neutral.
Tax Treatment of Loss of Principal by Net Losers
Where a victim loses her principal investment, considerable questions exist as to whether the deduction can be taken under § 165(e) for a theft loss, or has to be treated as a capital investment loss under § 165(c). Further, if the deduction can be taken as a theft loss, do the loss-limitation rules under § 165(h) and limitations applicable to itemized deductions apply? In the wake of the Madoff Ponzi scheme, the IRS issued Rev. Rul. 2009-9 to assist in responding to these questions. Rev. Rul. 2009-1 held, inter alia: (1) a victim who lost her principal investment may take a deduction as a theft loss; (2) the loss is not subject to the loss limitation rules of § 165(h); (3) the deduction may be taken in the year the loss is discovered; and (4) a loss that creates an NOL may be carried back 3 years and forward 20 years. The IRS also explained that amount of the deduction equals the “amounts invested… less amounts withdrawn…and reduced by claims as to which there is a reasonable prospect of recovery” (emphasis added).
While the IRS could have chosen a more straightforward approach by making any deduction taken subject to later recapture if victims recovered some portion of their loss, instead, the IRS provisioned deduction on a prospective recovery adjustment. In this regard, concurrently with the issuance of Rev. Rul. 2009-9, the IRS promulgated Rev. Proc. 2009-20, creating a safe harbor for theft-loss deductions attributable to Ponzi schemes. The safe harbor permits the deductibility of 95 percent of the loss for investors that do not pursue third-party remedies to recover funds lost. If an investor does pursue such remedies, they may only deduct 75 percent. However, if the investor/victim recovers additional funds in the future, that amount is subject to recapture under normal IRS rules (26 C.F.R. § 1.165-1(d)(2)(iii)). Similarly, Rev. Proc. 2009-20 also contains a provision that permits deductibility of future losses. To elect safe-harbor treatment, the taxpayer must attach the required statement to his or her return.
Should a taxpayer not apply for safe harbor treatment under Rev. Proc. 2009-20, the taxpayer is “subject to all of the generally applicable provisions governing the deductibility of losses under §165.” Since the promulgation of Rev. Rul. 2009-9 and Rev. Proc. 2009-20, the issues presented and addressed therein have not been subject to extensive litigation.
Tax Treatment for Disgorgement of Principal
Rev. Rul. 2009-9 does not speak directly to the situation where the victim of a Ponzi scheme is required to actually disgorge principal. This issue has become particularly relevant in connection with the avoidance action filed by the Madoff bankruptcy trustee against the owners of the New York Mets baseball team, wherein the trustee sought to recover not only their profits but also their initial investment. Applying the standards established by Rev. Rul. 2009-9, taxpayers should be entitled to take a theft loss in the year the loss is recognized for the full amount of the disgorgement. Rev. Proc. 2009-20 does not apply to disgorgement of principal.
Conclusion
Depending on whether the victim made or lost money affects their choices concerning tax treatment of any losses they suffered on account of involvement in a Ponzi scheme. While the 2009 IRS guidance provides some assistance to taxpayers, many vexing questions are left open. These matters range from the ministerial, such as when can victims deduct the remaining 5 or 25 percent of their loss under Rev. Proc. 2009-20, to the fascinating, such as how the IRS treats deductions claimed by so-called “feeders,” who solicited their friends and family members into the scam and are forced to disgorge profits or principal. Accordingly, Ponzi scheme victims and their tax professionals must remain alert in what is likely to be a rapidly changing legal landscape.