Federal Income Tax Relief for Investors in Ponzi Schemes

The criminal fraud charges brought against Bernard Madoff have been the focus of headlines around the world. Indicted for allegedly operating a securities business in which he paid certain investors purported returns on investments with the principal received from other investors (a 'Ponzi' scheme), Madoff's activities have resulted in his investors losing an estimated $50 billion dollars. Investors may have lost not only the supposed return on their investment in Madoff's funds (which a trustee may 'claw back' if it is considered another investor's principal), but also the principal they invested in the funds. This unfortunate event raises a number of tax issues.

The US tax implications of a Ponzi scheme are complex and each investor's situation is unique. Therefore, the comments provided herein are not tax advice but rather illustrative of the tax issues that may arise. Each investor should immediately consult with an experienced tax professional since certain actions that an investor should take may be very time sensitive. The material contained in this Client Alert is only a general review of the subjects covered and does not constitute legal advice. No legal or business decision should be based on its contents.

The following describes some of the tax issues that an investor in a Ponzi scheme may face. To illustrate, consider the following hypothetical taxpayer, Investor A, who in 1998 acquired an ownership interest in a fund (the 'Fund') for $1 million which has never been returned. Each year, Investor A believed (based on his Form K-1) that he was allocated $120,000 of the Fund's income. He paid annual income taxes of $42,000 on such income. In 2008, Investor A discovers that the income purportedly allocated to him did not exist, and his initial investment of $1 million has been used to pay other investors.

Theft Loss Deduction

• It is uncertain as to whether and when Investor A will receive any recovery from the Fund, but it may be possible to generate some cash relatively quickly from tax refunds or savings from a tax deduction for the theft loss.
  
  
• Generally , Investor A should consider claiming a theft loss on his 2008 tax return for at least the amount of his $1 million investment. Although the IRS may assert that the loss should be taken in a later year, even the IRS advises a taxpayer to claim a loss at the earliest possible time. However, if Investor A has an interest in the Fund only indirectly through an individual retirement account, or IRA, he may not be able to claim a theft loss.
  
  
• If the deductible theft loss exceeds Investor A's income in 2008, the excess loss generally may be carried back up to three years and forward up to twenty years. Investors should confirm deadlines for filing amended tax returns for prior years.
  
  
• The entire amount of the deductible theft loss incurred by an individual or a non-corporate entity generally is limited to the amount of the loss that exceeds the sum of 10% of the taxpayer's adjusted gross income for the year plus $100. If Investor A is a partnership, each individual or non-corporate partner would be required to apply the limits to his share of the partnership losses as well as his personal losses.
  
  
• Investors who have made substantial estimated tax payments or had tax withheld from wages or bonuses should consider filing their tax returns for 2008 as soon as possible. Filing the returns electronically may allow the taxpayers to receive the refunds as early as January or February of 2009. Taxpayers who generally make their final estimated state tax payment before the end of the year to accelerate their federal deduction for state tax payments may wish to consider whether or not to make the payment if they believe the loss is sufficiently large.

Filing a Refund Claim for Tax Paid on Allocated Phantom Income

• Investor A should consider filing a refund claim with respect to the taxes paid on the phantom income for the tax years three years from the time the tax return was filed. However, the IRS may assert that no refund is allowed if, for example, in prior years an investor has received a payment on the investment or has decided to reinvest a check made available to him by the Fund.