Ponzi Schemes, Clawbacks, and the Claim of Right Doctrine

Editor: Alan Wong, CPA

Gains & Losses

Ponzi schemes have been around for a long time, but they have come to the forefront in recent years. Many such schemes were able to continue undetected during good economic times. The economic collapse helped to expose many of them. Unable to keep up with investors’ demands for withdrawals, perpetrators’ schemes collapsed around them.

Much has been written on the tax consequences of losing money in a Ponzi scheme, and the IRS issued specific guidance on how to deal with losses in those cases. Rev. Proc. 2009-20 and Rev. Rul. 2009-9 outline what tax benefits are available to victims of a “specified fraudulent arrangement,” i.e., a Ponzi scheme.

But as time went on and lawsuits were filed, many people who had lost money were told by a bankruptcy trustee that they were “net winners” and were required to pay back past withdrawals to be redistributed to the larger pool of victims. These “clawbacks” arose for many reasons but could affect any investor even if he or she had nothing more to do with the scheme than investing in it.

This item uses an example of an investor in a Ponzi scheme subject to a clawback. The investor’s initial investment in 1995 was $10 million. Over the years his account realized significant returns, and from 1995 to 2008 his account grew to $25 million. For simplicity it is assumed that there were no unrealized gains in the account, so the taxpayer had paid tax in prior years on all appreciation, whether in the form of interest, dividends, or capital gains. The taxpayer properly reported all income shown on the account’s Forms 1099 issued over the years.

In late 2008, he withdrew the $15 million accumulated profits because of concerns about the economic conditions at the time. Later that year, it was discovered that the person he had been investing with was running a Ponzi scheme. The remaining $10 million in the account was lost, but because he had made the $15 million withdrawal just before the scheme was uncovered, he was forced to repay that amount to the trustee for the Ponzi-scheme operator’s bankruptcy estate. The repayment occurred in early 2009.

Rev. Rul. 2009-9 states that an amount lost from criminal fraud or embezzlement in a transaction entered into for profit is deductible under Sec. 165(c)(2) as an itemized deduction that is not subject to the personal loss limits in Sec. 165(h) or the limits on itemized deductions in Secs. 67 and 68. The amount of the theft loss in this transaction is the amount invested less amounts withdrawn, reduced by reimbursements or recoveries and reduced by claims for which there is a reasonable prospect of recovery. Where an amount is reported to the investor as income prior to discovery of the arrangement and the investor includes that amount in gross income and reinvests this amount in the arrangement, the amount of the theft loss is increased by the purportedly reinvested amount. The revenue ruling goes on to say that a theft loss in a transaction entered into for profit does not qualify for the computation of tax provided by Sec. 1341, nor does it qualify for the application of Secs. 1311–1314 to adjust the tax liability in years that are otherwise barred by the statute of limitation of Sec. 6511 on filing a claim for refund.

The taxpayer in this case would be entitled to a theft-loss deduction for the $10 million principal that was lost, subject to the rules laid out in Rev. Rul. 2009-9 and Rev. Proc. 2009-20. But what about the $15 million in previously taxed income that was clawed back? Generally, the amount clawed back is also available for a deduction in the year paid. The problem in many cases is that the deduction for amounts previously included in income either benefits the taxpayer at a much lower tax rate than originally paid, or, worse, the taxpayer may never fully recoup the benefits of the loss because of greatly reduced current and future income. If the clawback amount represents substantially all of the taxpayer’s assets, then he will probably never have sufficient income to absorb the losses unless he has significant earned income. Rev. Rul. 2009-9 does allow for a carryback under Sec. 172(b)(1)(H) of net operating losses created by a Ponzi theft loss for up to five years for 2008 and 2009 net operating losses (for other loss years, a two-year carryback), but this will likely not be sufficient to absorb the entire loss. This is where the Sec. 1341 claim of right doctrine comes into play and, in many cases, can provide a much greater benefit to the taxpayer.

Claim of Right

Sec. 1341(a) states that if (1) an item was included in gross income for a prior tax year (or years) because it appeared that the taxpayer had an unrestricted right to such item; (2) a deduction is allowable for the tax year because it was established after the close of that prior tax year (or years) that the taxpayer did not have an unrestricted right to such income or portion of such items; and (3) the amount of the deduction exceeds $3,000, then the tax imposed for the tax year is the lesser of: (1) the tax for the tax year computed with the deduction, or (2) an amount equal to the tax for the tax year computed without the deduction, minus the decrease in tax for the prior tax year (or years) that would result solely from the exclusion of the item (or portion thereof) from gross income for the prior tax year (or years).

Thus, Sec. 1341 allows the taxpayer to compute his tax liability from earlier years, excluding the income reported but eventually paid back. The difference between the tax actually paid in those earlier years and the recomputed tax reduces the tax due in the current year. Sec. 1341(b) states that if the resulting decrease in tax exceeds the tax imposed for the current year, the excess is considered to be a payment of tax on the last day prescribed by law for the payment of tax for the year and is refunded or credited in the same manner as if it were an overpayment for that tax year.

In the example in this item, the taxpayer very likely would receive a greater benefit if he could take advantage of Sec. 1341. He would be able to recoup taxes paid from 1995 to 2008 on income reported from the account related to the Ponzi scheme that was subsequently clawed back, taxes that were likely paid at a much higher marginal rate than in 2010 and beyond. (Note: The increased tax rates scheduled to take effect on Jan. 1, 2013, could change this analysis in future years.)

In the example above, the taxpayer meets the first requirement of Sec. 1341(a) because he previously included an item in gross income that he appeared to have had an unrestricted right to. The amount paid back represented items of interest, dividends, and capital gains that were previously included in income. Since the taxpayer had no knowledge of the Ponzi scheme and was not involved with it in any way other than by being a victim, it certainly appeared at the time the income was received that he had an unrestricted right to it.

The taxpayer also meets the second requirement, that a deduction is allowed for the tax year in which the item is repaid because it is established that the taxpayer did not have an unrestricted right to the item. The substance of the transaction is that the money was lost in a Ponzi scheme. The fact that there was a clawback payment and the money was not lost directly should not limit the taxpayer’s ability to take a theft-loss deduction. The form of the transaction was not of the taxpayer’s choosing. The second part of this requirement is whether the taxpayer had an unrestricted right to the income. Because the taxpayer was forced, likely by court order, to repay the money and did not do it voluntarily, it is reasonable to say that he did not have an unrestricted right to the income.

Interplay of Sec. 1341 and Ponzi-Scheme Guidance

Since it is established that the taxpayer meets the requirements of Sec. 1341 with regard to the amount clawed back, the remaining question is whether the safe-harbor procedures under Rev. Proc. 2009-20 and Rev. Rul. 2009-9 preclude the taxpayer from taking advantage of it.

Rev. Proc. 2009-20, Section 6.02(3), requires the taxpayer to agree to not apply the alternative computation in Sec. 1341 with respect to the theft-loss deduction allowed by this revenue procedure. But using the safe-harbor provisions for the direct loss of the principal amount should not hamper the taxpayer’s ability to use Sec. 1341 for the indirect loss related to the repayment of income.

Rev. Rul. 2009-9 states that Sec. 1341 does not apply because the deduction does not arise from an obligation to restore income. While that may be true for the amount of the initial investment lost, certainly the clawback was an obligation to restore income. Therefore, in cases where there is a clawback, this section of the revenue ruling should not apply to those amounts.

In the example above, the end result for the taxpayer would be a theft loss on his 2008 return for the principal invested of $10 million (subject to the safe-harbor provisions of Rev. Proc. 2009-20). This would likely cause the taxpayer to have a net operating loss, which could be carried back for three or more years (Sec. 172). He could also use the provisions of Sec. 1341 to recompute his tax for 1995–2008 without inclusion of income from the Ponzi scheme. The difference in tax as a result of that recomputation for each year could be claimed as a payment of tax on his 2009 tax return.

However, many states do not allow itemized deductions. Taking the entire $25 million as a deduction would provide no benefit in those states. Using Sec. 1341, however, could provide a benefit if the taxpayer’s state uses similar rules.

The issues surrounding Ponzi-scheme losses are complex, and every case is different. All factors should be considered before taking any positions and filing returns. Practitioners should be ready to support their positions, since the IRS is likely to review any such claims.

EditorNotes

Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or awong@hrrllp.com.

Unless otherwise noted, contributors are members of or associated with DFK International/USA.