CHICAGO (June 29, 2009) — Victims of Madoff and other recent Ponzi schemes are searching to find meaningful tax relief in a complex legal framework that leaves many questions yet to be answered. On June 23, McDermott Will & Emery LLP sponsored a webinar to help victims and their advisors understand the complex tax issues that must be carefully considered.
Andrea S. Kramer and Thomas P. Ward, tax partners in the Firm's Chicago office, cautioned that Ponzi scheme losses present very difficult tax issues. Moreover, taxes already paid on fictitious gains (phantom income) are not easily recovered. Kramer explained that the IRS issued Revenue Ruling 2009-9 (the Ruling) and Revenue Procedure 2009-20 (the Safe Harbor) in March 2009 to provide guidance to Ponzi scheme victims. Unfortunately, the fact pattern in the Ruling is relatively straight-forward while in reality most taxpayer cases will be far more complex.
The optional Safe Harbor offered to qualifying Ponzi scheme victims is intended to allow a victim to avoid the compliance burdens and difficult factual determinations involved in determining whether and when a theft loss has occurred for tax purposes. However, electing recovery under the optional Safe Harbor is not a simple choice, noted Kramer. The Safe Harbor is only available to certain "qualified investors" to deduct certain "qualified losses" from a "specified fraudulent arrangement."
Taxpayers who invest in partnerships or feeder funds that, in turn, invest in Ponzi schemes cannot rely on either the Safe Harbor or the Ruling, explained Ward. These victims did not participate directly in the fraudulent schemes and were not defrauded directly by the promoters. Rather, the partnerships or feeder funds in which they invested should pursue their own recovery and should pass through theft losses, where available, to their partners.
Tax deferred investments (including pre-tax contributions to employer-sponsored retirement plans and traditional IRAs) are not generally eligible for theft deductions because the owners or employees generally have a zero tax basis in the accounts. Deductions are possible for IRAs (traditional or Roth) in very limited circumstances.
Although private foundations are exempt from income taxes, Ponzi schemes pose serious risks for these institutions. Foundations are subject to excise taxes under Code § 4944 if their investments jeopardize their charitable purposes. An investment jeopardizes a charitable purpose if the foundation managers have failed to exercise "ordinary business care and prudence" in providing for the financial needs of the business to carry-out its exempt purpose(s). Assuming a fraudulent investment scheme jeopardizes a charitable purpose, an initial 10 percent penalty tax of the amount invested during the tax year in question might be imposed upon the foundation. An initial 10 percent penalty (capped at $10,000 per investment) might also be applied on any foundation manager who agreed to the investment, knowing it would jeopardize the foundation's tax exempt purpose. An additional 25 percent penalty could also be imposed on those private foundations that do not attempt to recover their funds. Officers, directors, and trustees can also face an additional 5 percent penalty tax, capped at $20,000 per investment, if they refused to remove the offending investment from the foundation's portfolio in order to restore the foundation's investment portfolio to harmony with the foundation's exempt purposes.
Kramer and Ward noted that many questions will be raised in applying the Ruling and Safe Harbor. They urged investors and their advisors to proceed cautiously.
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