Ponzi schemes, clawbacks, and the claim of right doctrine.

• Author: Aponte, Stephen E.

Ponzi schemes have been around for a long time, but they have come to the forefront in recent years. Many such schemes were able to continue undetected during good economic times. The economic collapse helped to expose many of them. Unable to keep up with investors' demands for withdrawals, perpetrators' schemes collapsed around them.

Much has been written on the tax consequences of losing money in a Ponzi scheme, and the IRS issued specific guidance on how to deal with losses in those cases. Rev. Proc. 2009-20 and Rev. Rul. 2009-9 outline what tax benefits are available to victims of a "specified fraudulent arrangement," i.e., a Ponzi scheme.

But as time went on and lawsuits were filed, many people who had lost money were told by a bankruptcy trustee that they were "net winners" and were required to pay back past withdrawals to be redistributed to the larger pool of victims. These" clawbacks" arose for many reasons but could affect any investor even if he or she had nothing more to do with the scheme than investing in it.

This item uses an example of an investor in a Ponzi scheme subject to a claw-back. The investor's initial investment in 1995 was $10 million. Over the years his account realized significant returns, and from 1995 to 2008 his account grew to $25 million. For simplicity it is assumed that there were no unrealized gains in the account, so the taxpayer had paid tax in prior years on all appreciation, whether in the form of interest, dividends, or capital gains. The taxpayer properly reported all income shown on the account's Forms 1099 issued over the years.

In late 2008, he withdrew the $15 million accumulated profits because of concerns about the economic conditions at the time. Later that year, it was discovered that the person he had been investing with was running a Ponzi scheme. The remaining $10 million in the account was lost, but because he had made the $15 million withdrawal just before the scheme was uncovered, he was forced to repay that amount to the trustee for the Ponzi-scheme operator's bankruptcy estate. The repayment occurred in early 2009.

Rev. Rul. 2009-9 states that an amount lost from criminal fraud or embezzlement in a transaction entered into for profit is deductible under Sec. 165(c)(2) as an itemized deduction that is not subject to the personal loss limits in Sec. 165(h) or the limits on itemized deductions in Secs. 67 and 68. The amount of the theft loss in this transaction is the amount invested...