No Deduction for Unpaid Service Fees Related to Ponzi Scheme

By Sally P. Schreiber, J.D.

The Tax Court upheld the IRS’s denial of a loss deduction of $730,786 for services the taxpayer had provided to a company that was part of a Ponzi scheme (Haff, T.C. Memo. 2015-138).

In 2005, the taxpayer, Henry Haff, began to invest through his wholly owned limited liability company in another company, GSH Development LLC, that was formed to develop housing in Illinois. The other member of GSH was Grant Street LLC, which was owned directly or indirectly by WexTrust Capital LLC. Haff invested $1 million initially and then an additional $337,960 between 2005 and 2010. He also claimed that he provided $730,786 in services to GSH.

In 2008, the SEC filed a complaint in federal court against the owners of WexTrust, claiming it was a Ponzi scheme. A receiver appointed by the court determined that the development project GSH had undertaken was not economically feasible and halted it.

Haff claimed a bad debt expense deduction of $2,068,476 for 2009, which included the $1,337,960 investment in GSH and the $730,786 GSH owed him for his services in development, sales, marketing, and construction. Haff had never included the amount he claimed was owed him as fees for his services in income. The IRS allowed the $1,337,960 deduction, but recharacterized it as a theft loss (this was not an issue at trial). It disallowed the $730,786 deduction.

As the Tax Court explained, under Sec. 165, the amount of a theft loss is limited to the taken property’s adjusted basis. Basis does not include the value of services performed unless and until the value of those services has been subjected to tax.

Although Haff had not included the fees for his services in income, he argued that Rev. Proc. 2009-20, which provides a safe harbor for Ponzi-scheme losses (and was issued in response to the Bernie Madoff Ponzi scheme that was revealed in 2008), allows a deduction for amounts not previously included in income. But the Tax Court disagreed with this interpretation, explaining that the procedure allowed a deduction to the extent of a taxpayer’s qualified investment. According to the revenue procedure, a qualified investment could include net income from a specified fraudulent arrangement, but only if the taxpayer included it in income for federal tax purposes.

Because Haff had not included the fees owed to him by GSH in income for tax purposes, the Tax Court found the fees did not constitute basis in his investment in GSH for purposes of Sec. 165 or Rev. Proc. 2009-20.  Consequently, the court denied the $730,786 theft loss deduction for the fees and upheld the IRS’s deficiency determination.

Sally P. Schreiber ( is a Tax Adviser senior editor.

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