Tax treatment of loss in Ponzi schemes
Commissioner Douglas Shulman of the Internal Revenue Service recently testified before a senate finance committee. Commissioner Shulman gave testimony concerning the tax treatment of Ponzi schemes and also how the IRS is dealing with off-shore tax avoidance schemes.
There probably aren’t too many people in Rockford who are involved in off-shore tax avoidance schemes. West Michigan, in the past, however, has had a few Ponzi schemes, with the latest being the infamous Pupler Distributing debacle, and there may be one or two out there that we don’t know about yet. These schemes just seem to come out of nowhere.
The IRS recently published Revenue Ruling 2009-09 and Revenue Procedure 2009-20 that clarify the tax treatment of losses in Ponzi schemes, the computation of the loss, and when the loss is deemed to have occurred. These two publications are meant to help taxpayers take advantage of the tax laws in these very difficult situations.
Revenue Ruling 2009-09 states that investors in Ponzi schemes may treat their losses as theft losses. In the past, the IRS has repeatedly ruled that these types of losses are deductible as investment losses. Investment losses are limited to $3,000 per year of capital loss in excess of capital gains. Theft losses are totally deductible in one year. This is a great ruling in favor of the taxpayers.
Revenue Ruling 2009-09 clarifies that Ponzi scheme losses are not subject to the 10 percent of Adjusted Gross Income reduction nor the automatic $100 per incident reduction. The loss is still deductible as an itemized deduction, but the normal reductions in the loss do not apply. This is another great ruling in favor of the taxpayers.
The Revenue Ruling further states that the loss is deductible when the Ponzi loss is discovered. The loss must be reduced by any amount that the taxpayers may have a reasonable chance of recovering through any and all means, such as SIPC insurance or partial recoveries from the courts.
Revenue Ruling 2009-09 further states that taxpayers are allowed a theft loss deduction for the net amount the taxpayers have invested. In addition to the invested amounts, taxpayers will be allowed a loss for any investment income the taxpayers reported on their previous year’s tax returns that was credited to their account. Quite often, this investment income was really fictitious in nature, especially if the taxpayers did not take any distributions.
In Ponzi schemes, the investors are usually credited with higher than normal returns, perhaps even exorbitant returns, to keep the investors from withdrawing their funds. Since 1099s are issued for these returns as interest and dividends earned, the taxpayers must report and pay tax on the amounts on the 1099s. This is true even though the amounts are just made-up figures by the promoter of the scheme. This is another great ruling in favor of the taxpayers.
Revenue Ruling 2009-09 states that the Ponzi scheme loss can create a federal Net Operating Loss (NOL). NOLs can be carried over to future years or carried back to past years. The election to carry back or carry over must be made at the time of filing the return for the year of the loss. For example, a scheme is discovered in 2009. The NOL is calculated and claimed on the 2009 return. When filing that return, the taxpayer makes an election to carry back the NOL to his previous years or elects to carry it forward to future years. This feature allows taxpayers to maximize their own tax savings based on their personal tax situation.
Revenue Procedure 2009-20 provides taxpayers guidance in determining when a theft loss actually occurs. These Ponzi scheme investigations often take place over more than one year. Does the loss actually occur when the promoter is put into jail, when the media breaks the news, or when the assets of the promoter are frozen? The IRS says the loss can be taken when the promoter is charged with committing fraud, embezzlement or a similar crime meeting the definition of theft; when the promoter becomes the subject of a criminal complaint alleging the commission of fraud, embezzlement or a similar crime; when a trustee is appointed to freeze the assets of the promoter; or when the promoter admits guilt of any of the above crimes. If any of these situations apply, the IRS will allow a deemed theft loss to have occurred.
Finally, Revenue Procedure 2009-20 defines the amount a taxpayer is allowed to claim as a theft loss in the year of the loss. Taxpayers are allowed to claim 95 percent of their invested amounts less any amounts expected to be recovered through SIPC insurance or private insurance.
Revenue Ruling 2009-09 and Revenue Procedure 2009-20 are both valuable publications to taxpayers who find themselves in the middle of a Ponzi scheme. The IRS has definitely given some helpful tax treatment to these taxpayers. This is Jerry Coon signing off.
Jerry Coon is an Enrolled Agent. He owns
Action Tax Service on Northland Drive NE, Rockford.
His e-mail address is email@example.com.