Ponzi Schemes –

The United States Securities and Exchange Commission (SEC) defines a “Ponzi Scheme” as follows:

The schemes are named after Charles Ponzi, who duped thousands of New England residents into investing in a postage stamp speculation scheme back in the 1920s. At a time when the annual interest rate for bank accounts was five percent, Ponzi promised investors that he could provide a 50% return in just 90 days. Ponzi initially bought a small number of international mail coupons in support of his scheme, but quickly switched to using incoming funds from new investors to pay purported returns to earlier investors.

A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors to create the false appearance that investors are profiting from a legitimate business.

With the rise and fall of many of these high profile schemes in the past decade, some costing billions of dollars, there were a lot of taxpayers left with large losses that they could never recover nor deduct in their lifetimes under traditional capital loss rules.

Legislation and IRS rulings in 2009 changed the treatment of losses falling into this category from a capital loss to a theft loss. (Rev. Rul. 2009-09, Rev. Proc 2009-20, and Rev. Proc. 2011-58) This allows the victim to recoup some of their losses more quickly rather then being limited to the maximum capital loss of $3000 per year.

From 2009-2012 these losses were entered on the on the Form 4684 in Section B like all other investment casualty/theft losses. Starting in tax year 2013 there is a new Safe Harbor Election section of the Form 4684 specifically for Ponzi-type losses, Section C.

The important thing to remember is that if your theft loss meets the definition of a Ponzi Scheme you must treat it as a theft loss as it does not qualify as a capital loss any longer. You have the choice of the Safe Harbor election or non-Safe Harbor, but you must put the loss on the Form 4684. There are some special rules in the Safe Harbor Election when dealing with how to determine if you have a Ponzi-type loss and how to treat it. These rules are listing in Rev. Proc. 2009-20, attached to your material. The basic rules are as follows:

1. The arrangement must be determined to be a “specified fraudulent arrangement” (SFA) as defined above by the SEC.

2. There must be a qualified loss defined as the lead figure in the scheme being charged by indictment under federal or state law with the commission of fraud, embezzlement, or a similar crime. Rev. Proc 2009-20 was supplemented by Rev. Proc. 2011-58 to allow for victims to proceed with a theft loss even if the lead figure was not convicted due to a variety of reasons, the main one being death of the lead figure.

3. The lead figure was the subject of a state or federal criminal complaint alleging one of the above crimes and either the lead figure completes an affidavit admitting the crime or a trustee is appointed over the SFA and it is frozen.

4. The victim must: Be a qualified investor defined as a United States person under §7701(a)(30); generally qualified to deduct theft losses as discussed above under §165; not have knowledge of the fraudulent nature of the investment, the investment was not designed to be a tax shelter as defined under §6662(d)(2)(C)(ii); the person who transferred the cash or property into the SFA. If the victim invested money into a fund or other entity that then invested in the SFA they are not the victim, the other fund or entity may be the actual victim.

5. Discovery year is defined as the year in which the lead figure was placed under indictment, complaint, or trustee as described above or the year of death of the lead figure.

6. The victim must have made a qualified investment in the scheme defined as the excess of the sum of all cash, adjusted property basis, reinvested “earnings” which were reported on prior tax returns over the total amount the victim received back from the specified fraudulent arrangement.

7. Qualified investments do not include any amount borrowed from the SFA that were not repaid at the time the theft was discovered, fees paid to the SFA that were deducted on a prior return, and amounts reported by the SFA as income in a prior year that was not included on a return.

As with all casualty and theft losses the potential or actual hope of recovery or reimbursement has to be factored into the calculations. For the Ponzi-type situation you must deduct any funds you actually recover or remove from the scheme prior to it being frozen and you must also reduce your total loss by 5% for the possibility of direct recovery once litigation is over. If you plan on pursuing the lead figure(s) in a third party recovery attempt you must reduce your loss by 25%. These number are the SEC’s averages for actual recovery in a direct or third party recovery situation.

Example: In 2005 Donald invested $250,000 in Madoff Inc with a Dividend reinvestment plan (DRIP). Over the course of the next 8 years Donald received Form 1099Div showing $50,000 in ordinary dividends which he included on his yearly tax returns. In 2009 he took a cash withdrawal of $30,000. In 2013 Mr. Madoff is arrested and charged with running a Ponzi scheme and all assets are frozen in trust. You prepare Donald’s 2013 tax return and present him with his options as follows:

Safe Harbor                                                                                                           Non-Safe Harbor
$250,000 + $50,000 – $30,000 = $270,000                                                   Same
Investment           DRIP           W/D             Loss
$270,000 X .95 = $256,500 loss no 3rd party                                                 $270,000 section B form 4684
$270,000 X .75 = $202,500 loss w/3rd party

If the taxpayer elects to use the Safe Harbor method they are required to complete Section C, Part 2 of the form 4684 attesting to the following:

1. information known about the lead figure,

2. that they have written documentation of the losses claimed,

3. They are a qualified investor as defined above,

4. That if they use the 95% calculation they are not and do not intend to pursue any third party collections, and

5. they agree to comply with the conditions in Rev. Rul. 2009-20 concerning amended returns for prior years, Sec. 1341 claims, equitable recoupment or mitigation provisions in §§1311-1314.

If the client elects not to use the Safe Harbor method under Rev. Rul. 2009-20 they must fall back to the much higher burden of proof under §165(c) and the loss is reported in Section B of the Form 4684. Depending on the length of time since the investment and the types of documentation the client has available they may not have substantiation for the non-Safe Harbor method.

Lastly, we will review documentation and record reconstruction, tomorrow.

In accordance with Circular 230 Disclosure