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Another View: Ponzi Schemes Raise Tax Questions

Date: Tuesday, April 14, 2009
Author: Dealbook.NYTimes.com

Joseph D. Ament of law firm Much Shelist Denenberg Ament and Rubenstein in Chicago suggests that recent tax guidance for victims of Ponzi schemes leaves many questions unanswered. Mr. Ament is also a professor of taxation and accounting at Roosevelt University’s Walter E. Heller College of Business Administration.

On March 17, 2009, Douglas Shulman, the commissioner of internal revenue, testified before the United States Senate Finance Committee and presented tax issues related to Ponzi schemes. He announced published guidance in two instances to assist taxpayers who are victims of losses from these types of fraudulent investments.

Although Bernard L. Madoff’s name was not specifically mentioned, direct investors in Mr. Madoff’s vast fraud are obviously beneficiaries of the Internal Revenue Service ruling, which permits ordinary loss deductions (with some limitations) that are substantially more beneficial than losses generally applicable to investors, as described below.

We believe many questions will arise as to what types of losses will qualify for the benefits of the revenue ruling and the revenue procedure that have been published as Internal Revenue Service guidance.

One of last month’s guidances was a revenue ruling that clarifies the income tax law governing the treatment of losses in such Ponzi-type investment schemes (Rev. Rul. 2009-9). The second was a revenue procedure that provides a safe-harbor method of computing and reporting the losses (Rev. Proc. 2009-20).

Under Internal Revenue Code Section 165, these theft losses are not capital losses subject to the limits of being offset by capital gains plus $3,000 per year of ordinary income, when the loss exceeds capital gains from investments. Further, these losses are not subject to the “personal casualty and theft losses,” which are treated as an itemized deduction subject to a reduction of 10 percent of adjusted gross income over the $100 reduction that applies to many casualty and theft loss deductions.

The theft loss is deductible in the year the fraud is discovered, except to the extent there is a claim with a reasonable prospect of recovery. The theft loss includes the investor’s unrecovered investment, including income reported in prior years. It can create a net operating loss for the taxpayer which can be carried back and forward to generate a refund of taxes paid in other taxable years.

Since Mr. Madoff’s arrest late last year, many other alleged Ponzi-type schemes have surfaced or been further revealed, such as those involving R. Allen Stanford, Edward T. Stein and George D. Hudgins, for example.

But will victims of other Ponzi-scheme promoters also qualify for the new rules?

What about investors in funds that invested significantly (perhaps totally) with Mr. Madoff or other schemers, but in situations where the taxpayer (and investor) was not aware that the fund in which he or she invested had, in turn, re-invested with Mr. Madoff or other Ponzi schemers? There are many funds-of-funds that invested with Mr. Madoff or other schemers, in which their investors had no information whatsoever how their funds were being invested.

How will the losses from these investments, which were ultimately made in a Ponzi schemer’s program, be treated? The investors did not directly or knowingly invest in the Ponzi scheme.

Three investment/hedge funds operated by J. Ezra Merkin, Ascot Partners, Ariel Fund and Gabriel Capital, were paid $470 million in fees and performance bonuses from clients. They are parties to a complaint filed by New York Attorney General Andrew Cuomo alleging civil fraud regarding $2.4 billion from these funds that was invested with Mr. Madoff, purportedly without clients being aware of where their money was being invested.

Civil actions have been filed against other investment advisers and funds that similarly received compensation from Mr. Madoff and others for funneling their funds into what was later found to be a Ponzi scheme.

Similarly, Fairfield Greenwich Group, a fund of funds co-founded by Walter Noel, had invested over $7 billion of its clients’ money with Mr. Madoff. How will their investors be treated under the theft loss rules?

And the questions continue: Will the promoters of these funds inform their investors that they have been victims of a Ponzi scheme? If not, how will their investors know?

If the taxpayer-investor had no knowledge that the fund in which he or she invested had reinvested in a Ponzi-scheme and did not know it was a Ponzi scheme when losses flowed through to their investment fund, but subsequently were informed — either because their fund revealed this information to them, or the civil or criminal lawsuit against the Ponzi schemer revealed that among its investors was the fund that the subject taxpayer-investor had placed his/her funds — will the taxpayer-ionvestor be entitled to theft loss treatment, in effect, as an indirect, unknowing investor in the Ponzi scheme?

And will the Internal Revenue Service be willing to permit a Ponzi-type scheme theft loss to indirect investors of these funds, whether or not they knew with whom their funds were ultimately invested (and lost)? Will a criminal action be a mandatory element of the facts in order to take the theft loss for income tax purposes?

We envision that the extent of these losses and the topics that arise as a result may go far beyond the anticipated scope of the announced revenue ruling and revenue procedure in the Internal Revenue Service’s guidance.