Implications of Ponzi scheme "investments"

By williamwagner

Tax Facts | National Underwriter Company


Investors in a Ponzi scheme may be required to repay their profits. Such an investor would not be able to offset the required repayment with income tax paid on the profits or other expenses. However, the investor may be able to obtain a tax refund for some of the income tax paid on the profits that must be repaid, and the investor may also be able to claim an income tax loss on the investment.

By now, almost everyone has probably heard of Bernard Madoff and how his reportedly $50 billion investment firm was allegedly a Ponzi scheme. Essentially, in a Ponzi scheme, earlier "investors" are paid from "investments" of later "investors." Madoff's investors are reported to have included charities, hedge funds, municipalities, universities and well-known public figures. Today, those investors may be lucky if their investments are worth pennies on the dollar. Ponzi schemes generally prove the saying: "If it sounds too good to be true, it probably is."

Under the Uniform Fraudulent Transfer Act (UFTA), investors in a Ponzi scheme can be required to pay back all of their gains so that all investors may be treated on a more equal basis. However, because of a netting process and a statute of limitations, later investors are likely to recover less of their investments than earlier investors.

Under UFTA, if the investor in a Ponzi scheme received more money back than he or she invested (i.e., a positive net amount), the investor is liable. However, the investor is permitted to retain payments up to the amount invested; only profit must be disgorged.

Also, a statute of limitations limits the amount of profits that must be disgorged. For example, there is generally a four-year statute of limitations in California. However, an action for actual fraud can extend the statute of limitations to one year after the fraudulent transfer or obligation was, or could reasonably have been, discovered by the claimant. For purposes of the statute of limitations, the netting rule applies: there is no way to trace whether certain payments were return of principal or profit. A court may also impose, at its discretion, prejudgment interest on a fraudulent transfer from the date each transfer was made.

The investor who is required to repay profits under UFTA is not permitted to offset the profits with income tax paid on the profits or other expenses incurred in conjunction with the investment. The Supreme Court recently denied certiorari in the Ninth Circuit case of Donell v. Kowell, which denied such an offset. It should be noted that even though the investor in Donell v. Kowell was required to repay some profits plus interest, that investor still made a profit. The court noted that most of the scheme's investors will likely receive only pennies on the dollar from their initial investment.

Investors in a Ponzi scheme who have paid income taxes on profits that they are required to repay should file amended income tax returns requesting a refund of overpaid tax for those tax years that are still open. A claim for a refund for overpayment of tax must generally be made by the later of three years from the time the income tax return was filed or two years from the time the tax was paid. A seven-year limitation may be available in conjunction with bad debts or worthless securities.

A deduction may be available for losses sustained during a year, and a deduction is available for losses incurred in a transaction entered into for profit and for theft losses. Yet, it is unlikely that losses from a Ponzi scheme will be characterized as losses resulting from a worthless security.

Donell v. Kowell, 533 F3d 762 (9th Cir. 2008), cert. den

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