Tuesday, March 30, 2010

Bi-Partisan Senate Bill Would Provide Tax Relief to Victims of Ponzi Investment Schemes

By James Hamilton, J.D., LL.M.

Bi-partisan Senate legislation would provide tax relief to investors victimized by securities fraud in Ponzi-scheme types of operations. Since the legislation applies only to qualified fraudulent investment losses discovered in calendar years 2008 or 2009, it essentially assists victims of frauds such as those run by disgraced financiers Bernie Madoff and Alan Stanford. Generally, the measure would extend certain benefits that are already available to larger investors to smaller investors as well. It would allow victims to take a deduction for funds lost from their IRA accounts, allow for accelerated and increased contributions to tax-free retirement accounts to make up for losses, and allow for penalty-free early withdrawals from retirement accounts for investors in dire need of cash.

The Ponzi Victims Tax Bill of Rights, S 3166, was introduced by Senator Charles Schumer and has picked up strong bi-partisan support, including that of Senate Banking Committee Chair Chris Dodd. Senator John Kyl, a key member of the Finance Committee, is a Republican co-sponsor. Other co-sponsors of the legislation who are also members of the Finance Committee are Senators Maria Cantwell, John Kerry, Bill Nelson, and Blanche Lincoln. Senator Schumer is a member of both the Banking and Finance Committees, as is co-sponsor Senator Robert Menendez.

The IRS originally issued rules in March 2009 allowing a direct investor to take a theft loss deduction for their Ponzi scheme losses. The rule said that theft losses could be treated as net operating losses (NOLs), as if the individual investors were small businesses. Direct investors were allowed to carry back their losses for 5 years instead of 3, and carry forward any remaining losses for up to 20 years. A longer carry back is important because it affords by providing refunds for taxes paid in past year.

However, even with the NOL relief afforded to thousands of victims, a number of tax problems remain unaddressed. In order to expand relief available to smaller investors, the Schumer-Kyl legislation would increase the amount victimized investors can carry back on their income taxes; allow victims who lost money within an IRA to recoup some of the losses for the first time by allowing a theft loss for their basis in the account, or half their total losses; raise the limit on tax-free contributions to retirement accounts so investors can replenish losses quicker; and waive penalties for withdrawing from retirement accounts to increase daily cash flow.

The measure would define a qualified fraudulent investment loss based on definitions included in the March 2009 IRS guidance. Thus, the legislation amends Section 165 of the IRC to define a ``qualified fraudulent investment loss’’ as a loss discovered in 2008 or 2009 resulting from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss a person was charged with the commission of fraud, embezzlement, or similar crime which, if proven, would constitute a theft or a person was the subject of a criminal complaint alleging the commission of fraud, embezzlement, or similar crime would constitute a theft and the complaint alleged an admission by such person admitting the crime, or a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.

Essentially providing a workable definition of a Ponzi scheme, amended Code Section 165 would define a ``specified fraudulent arrangement’’ to mean an arrangement in which a person receives cash or property from investors, purports to earn income for the investors, reports income amounts to the investors that are partially or wholly fictitious, makes payments, if any, of purposed income or principal to some investors from amounts that other investors invested in the fraudulent scheme, and appropriates some or all of the investors’ cash or property.

The legislation would allow both direct and indirect investors with qualified fraudulent investment losses to carry back eligible losses to up to 6 prior taxable years, essentially doubling the period that existed prior to March 2009. Thus, under the legislation, the same rules with respect to NOL carry backs of qualified fraudulent investment losses would apply to both direct and indirect investors. For all provisions of S 3166, the amount of any qualified fraudulent investment loss is reduced by any expected recovery through the Securities Investor Protection Corporation or legal action.

Many victims, particularly a number of the smaller investors, held Ponzi-related assets in an IRA. Under current law, no tax relief is available for losses resulting from the theft of assets held in an IRA. Thus, an individual that lost a $250,000 investment in a taxable account as a result of the Ponzi-scheme theft received a deduction for the loss, but an individual that lost a $500,000 investment in an IRA received no relief.

Because taxes have not been paid on the majority of retirement savings, since they are funded with pre-tax money, the amount of the allowable tax loss must be adjusted. Under the bill, victims will be allowed to claim a loss deduction for the qualified fraudulent investment loss in an IRA in an amount equal to the greater of 100 percent of their individual and employer contributions or 50 percent of the IRA theft loss. The maximum loss that may be claimed under this provision is $1.5 million. Under the legislation, the IRA loss deduction may be carried back to up to 6 taxable years and carried forward up to 20 years. For IRAs that contain money rolled over from other retirement accounts, the amount of the rollover is not itself considered to be an employee contribution. Instead, an individual must substantiate the portion of the rollover that is attributable to employee and employer contributions.

For any eligible individual who turned 65 by December 31 of the year that the theft was discovered, the bill would increase the maximum NOL carry back period for qualified fraudulent investment losses to 7 years. Moreover, the legislation would allow a waiver of the 10 percent tax penalty for withdrawals from retirement plans for an individual who is under age 59½ and who suffered a loss related to the Ponzi scheme.

Penalty-free withdrawals would be permitted for up to 10 years from the date of the discovery of the fraud, or until a taxpayer has withdrawn the amount of the loss, whichever comes first. An individual would still be required to pay the income taxes on the withdrawn funds since the measure would simply waive the 10 percent penalty on early withdrawals in these circumstances.

To help restore an individual’s IRA savings in the event of a qualified fraudulent investment loss, the bill would include a special catch-up contribution provision allowing an individual to contribute up to an additional 100 percent of the current contribution limits to any IRA account for a period of up to 10 years. This special catch-up contribution will be available for any individual who owns an IRA that lost at least 50 percent of its value as a result of a qualified fraudulent investment loss. For an individual with multiple IRAs, the bill allows the catch-up contribution for each eligible IRA.

Many victims filed estate or gift tax returns reporting investments in Ponzi-scheme assets, which necessarily overstated the value of these assets. The measure would allow a period of time to file amended estate and gift tax returns to obtain a refund of transfer taxes paid or to adjust the lifetime gift tax or generation skipping transfer tax exemptions to reflect the lower value of the assets transferred. The effect of the bill would be to permit certain estate or gift taxes paid on Ponzi-scheme assets, or lifetime gift tax or generation skipping tax exemptions that have been utilized with respect to Ponzi-scheme assets, to be appropriately refunded or restored.

The bill would also allow an individual to amend returns, as necessary, for reportable gifts made in the year the theft is discovered, and the 6 taxable years prior to the theft discovery. An individual would have up to four taxable years after the discovery of the fraud to amend his or her gift tax returns. Thus, for example, a victim of the Madoff Ponzi scheme would have until December 31, 2012 to file amended gift tax returns for gifts made in tax years beginning January 1, 2002, and subsequent years through the date of discovery of the theft.Finally, for estate taxes, the measure would allow estate tax returns for decedents dying after December 31, 2007 to be amended to account for Ponzi scheme assets. For decedents dying before January 1, 2008, consistent with present law, beneficiaries who inherited assets that became worthless after inheritance as a result of a Ponzi scheme would be able to utilize the NOL treatment and other benefits afforded to all victims.

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