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
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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.
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