Home      Login

Abstract: 

In 2008 it came to light that a number of high-profile investment managers, most notably Bernard L. Madoff Investment Securities LLC (BMIS), had defrauded investors by engaging in so-called “pyramid” or “Ponzi” schemes in which no actual investments were acquired with investor funds and new contributions to the fund were used to make distributions and redemption payments to existing investors. After the extent of the BMIS fraud became known, defrauded investors began seeking tax advice on the amount and timing of any loss deductions for which they might be eligible. Tax advisors soon discovered, as one commentator noted, “a poorly marked path of confusing and contradictory authorities.” This article examines a range of issues for which clear, authoritative guidance was lacking, including whether a Ponzi scheme loss is a theft loss or capital loss under Section 165; if treated as a theft loss, whether the allowable loss is limited under Section 165(h) to the amount exceeding 10 percent of the taxpayer’s adjusted gross income; the amount and timing of the loss if there exists a prospect for at least some recovery; whether “phantom income” reported in closed and/or open years can be added to basis for theft loss purposes or, alternatively, whether one may file amended returns to eliminate “phantom income” for open years; whether such a loss can create or increase a net operating loss under Section 172 and, if so, what the applicable carryback period is; whether Section 1341, generally associated with the restoration of amounts previously included in income under a claim of right, applies in computing the tax in the year the loss deduction is allowed; and whether a taxpayer could benefit from the mitigation provisions of Sections 1311-1314 to adjust its tax liability in otherwise closed years.

Keywords: Securities fraud; IRS Section 165 losses; tax liability on phantom income; Section 172 NOL losses.

Affiliations:  1: Drinker Biddle & Reath LLP; 2: Roberts & Holland LLP; 3: Drinker Biddle & Reath LLP.