Taxpayers not using the safe harbor for determining the amount and timing of a loss from a Ponzi scheme under Rev. Proc. 2009-20 may file claims for refund and amend returns for years open within the statute of limitation to eliminate “phantom,” or fictitious income, the IRS stated in a program manager technical assistance memorandum (PMTA 2013-003). Income may be considered phantom whether it was only constructively received or, if paid, if it was not actually earned as the promoter of the scheme falsely represented but was instead paid from the capital funds of the taxpayer or other investors to perpetuate and conceal the scheme.
In a series of questions and answers and three taxpayer scenarios, the memo states that taxpayers who do not use the safe harbor may either:
- Deduct as a theft loss under Sec. 165(c)(2) their investment in the Ponzi scheme, including amounts previously included in income, less cash withdrawn. As with all theft losses, the deduction is taken in the year the theft is discovered or, if there is a reasonable prospect of recovery, when one no longer exists; or
- Amend returns for open years under Sec. 61 to remove constructively received phantom income. Withdrawals of cash previously reported as income in an open year may be treated as a nontaxable return of capital. If the taxpayer did not withdraw those amounts and reported the income as being constructively received, then the taxpayer would treat the phantom income as never having been received. The taxpayer must establish the amount of income that was fictitious in the open years.
If the taxpayer chooses to amend prior returns to eliminate phantom income under the second option and establishes the amount of income that was fictitious, then withdrawals of the taxpayer’s investment, or basis, in the scheme in an open year may be treated as a nontaxable return of capital. For this purpose, the basis in the scheme is the sum of prior cash investments, plus amounts previously reported as income, less prior cash withdrawals.
If the taxpayer deducts the investment as a theft loss under the first option, while a reasonable prospect of recovery may postpone a theft loss deduction, it does not prevent amending prior open-year returns to eliminate phantom income, the memo noted.
Under the safe harbor of Rev. Proc. 2009-20, qualified investors in a Ponzi scheme may elect to deduct 75% of their loss in the tax year of discovery as a theft-loss even if the investor is pursuing a third-party recovery, or 95% of the amount if the investor is not. For more, see “Tax Matters: Ponzi Guidance Welcomed,” JofA, June 2009, page 74, and “Ponzi-Scheme Losses: Indirect Investor and State Tax Issues,” JofA, Feb. 2011, page 46. Taxpayers using the safe harbor also may not file or amend returns excluding or recharacterizing income reported with respect to the Ponzi scheme.
PMTA Memo. 2013-003
By Paul Bonner, a JofA senior editor.