Ponzi Scheme Tax Recovery And The Importance Of “Timing” When Claiming Tax Losses

Since the timing of the theft loss deduction is critical to the real economics of the recovery, this phrase is all important. Therefore, before considering tax planning opportunities, on must study the phrase “a reasonable prospect of recovery” in more depth.

The phrase finds its origin in the early internal revenue codes that permitted a theft loss deduction for losses sustained in a taxable year but did not define the word sustained. Therefore, prior to 1954 the law was unsettled as to when a loss was sustained. This caused taxpayers to often lose their tax deduction for a theft loss when the statute of limitations had run on prior years; and it was later found that a loss had been sustained in one of those prior years that was no longer open for change.

The new law in 1954, that still applies today, adopted the principle that generally a theft was sustained in the year of discovery. However, this definition was tempered since it only applies to that portion or all of the theft loss that the taxpayer could identify as not having any reasonable prospect of recovery. Until it was clear that a loss was assured and closed and completed, there would be no deduction. The law attempts to make sure there is no deduction in the year of discovery or any other year unless the loss is assured.

There is no set of fixed rules that clearly define the taxpayer’s reasonable prospect of a recovery, that will result in a limitation of a taxpayer’s theft loss deduction in the year of discovery. We will also look at general principles that have emerged from the court cases and review two cases that could be said to represent the extreme ends of the spectrum of just what is a reasonable prospect of recovery.

One court has defined the reasonable prospect of recovery as follows:

In determining whether a reasonable prospect of recovery existed as of the year of discovery, we start from the premise that petitioner is not required to avoid both the scullion role of the incorrigible optimist and the charbdian character of the estygian pessimist. The standard to be applied is the exercise of sound business judgment based upon as complete information as is reasonably obtainable.

Another court has stated it as:

The reasonableness of a taxpayer’s prospect of recovery is primarily tested objectively, although a court may consider to a limited extent evidence of the taxpayer’s objective contemporaneous assessment of his own prospect of recovery. “[t]he taxpayer’s attitude and conduct are not to be ignored, but to codify them as the decisive factor in every case is to surround the clear language of . .. [the statute] with an atmosphere of unreality and to impose grave obstacles to efficient tax administration.”

In addition to these general statements, the courts in deciding whether there is a prospect for a reasonable recovery have also agreed on several principles that provide further guidance:

(i) In determining the reasonableness of a taxpayer’s belief of loss the courts had to be practical and aware of the individual facts of a case.

(ii) The relevant facts and circumstances are those that are known or reasonably could be known as of the end of the tax year for which the loss deduction is claimed. The only test is foresight, not hindsight.

(iii) Both objective and subjective factors must be examined.

(iv) The taxpayer’s legal rights as of the end of the year of discovery are all important and need to be studied to make a proper decision.

(v) One of the facts and circumstances deserving of consideration is the probability of success on the merits of any claim brought by the taxpayer.

(vi) The filing of a lawsuit may give rise to an inference of a reasonable prospect of recovery. However, the inference is not conclusive nor mandatory. The inquiry should be directed to the probability of recovery as opposed to the mere possibility. A remote possibility of recovery is not enough; there must be a reasonable prospect of recovery at the time the deduction was claimed, not later.

Case Law

Looking at the two cases that also will help define the reasonable prospect of recovery standard, we see two situations in which great efforts were made to seek a recovery of a loss, including extensive litigation. In both cases the courts did a complete analysis of the legal rights of the taxpayers and determined in one line of cases the taxpayer did not have a reasonable prospect of recovery even though the taxpayers never wrote the theft loss off of their corporate financial statements in the year of discovery; had tremendous lobbying efforts on their behalf both individually and through trade groups to recoup their losses from multiple sources; and in the case of one taxpayer (a bank) even had the perpetrators’ money deposited in their bank while the actions seeking recovery were ongoing. Since the victim, a bank had no legal rights to hold the deposited money; the funds were released from the victim bank to the perpetrator of the theft.

This was the situation when the Iranian government expropriated assets of U.S. companies in Iran with the fall of the Shah of Iran and the Iranian Hostage taking. In this case, the I.R.S. argued against permitting a theft loss in the year of discovery.

In spite of several potential areas of recovery, which did in fact later lead to recovery and consideration that was paid for confiscated assets; the court was convinced that no legal rights existed for recovery in the year of discovery. Without legal rights, efforts that may present only a possibility of recovery are not enough to stop the taxpayer from taking the theft loss deduction in the year of discovery.

On the other hand, while in the Iranian expropriation cases the existence of only possible legal rights did not foreclose the deduction, another court took a different view of the presence or absence of legal rights in the year of discovery. In this other court the I.R.S. insisted that a taxpayer must take his theft loss in the year of discovery because of the status of that taxpayer’s legal rights.

Even though a taxpayer won litigation in the lower court awarding him a recovery, the Court found the lower court’s ruling was illogical and that in spite of the ruling allowing a recovery, the taxpayer had no real possibility of a recovery. The Court ruled that this taxpayer had no legal rights to recovery and was therefore forced to take the deduction in the year of discovery. The Court’s independent review of the litigation awarding the recovery was that the lower court’s opinion (which was in fact overruled) was wrong. Therefore, the taxpayer could not even rely on a successful lower court opinion to support his belief in the year of discovery that there would be a recovery.

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Richard S. Lehman is a graduate of Georgetown Law School and obtained his Master’s degree in taxation from New York University. He has served as a law clerk to the Honorable William M. Fay, U.S. Tax Court and as Senior Attorney of the Interpretative Division in the Chief Counsel’s Office of the Internal Revenue Service in Washington D.C., the IRS’s internal law firm.

Mr. Lehman has had extensive experience with all areas of the Internal Revenue code that apply to American taxpayers and nonresident aliens and foreign corporations investing or conducting business in the United States, as well as U.S. citizens and domestic corporations investing abroad.

Mr. Lehman regularly works with law firms, accountants, businesses and individuals struggling to find their way through the complexities of the tax law.

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