November 8, 2018 2:04 am

Ponzi Scheme Safe Harbor not for Pump-and-Dump Scheme

Following the widespread losses of investments with Bernard Madoff, the IRS issued a safe harbor (Rev. Proc. 2009-20) to enable investors to take losses even though some recovery was possible. One couple tried to use this safe harbor for their investment losses sustained through a pump-and-dump scheme. However, the Court of Federal Claims concluded that the safe harbor was inapplicable to this type of investment loss (Charles P. Adkins, Fed. Cl., 10/26/18).

A Ponzi scheme is one in which fictitious earnings are reported to investors who receive payments from other investor’s accounts…until no new investors can be found and the scheme collapses. In contrast, a pump-and-dump scheme is merely manipulation of stock prices by stockbrokers to line their pockets (the brokers get investors to buy stock they own and sell at the inflated prices), leaving investors with losses. Here investors receive earnings drawn from their own accounts…until the money runs out.

In the recent case, a couple invested with a particular brokerage firm. Their account was valued at $3.6 million in February 2000, but was only $9,849 as of December 31, 2001. They tried to deduct the loss on their 2004 return, the year that the firm’s principals were indicted on criminal charges. The question was whether this was the correct year for the loss, meaning the year in which there is no longer any reasonable prospect of recovery. The court concluded that in 2004 there remained three ways in which they could still recovery money (e.g., arbitration against the firm and three principals, a claim against another person in the firm, and criminal restitution).

The court refused to look to the Ponzi scheme safe harbor for direction in pinning down the year of the loss. That safe harbor allows a loss to be claimed in the year one or more of the lead figures of the fraud is charged by an indictment. But the safe harbor is inapplicable to the couple’s situation because the IRS didn’t include pump-and-dump schemes in the safe harbor language.

Note: While a theft loss related to personal-use property cannot be claimed in 2018 through 2025 unless the result of a federally-declared disaster, a theft loss of investment property continues to be deductible as an itemized deduction (“other” itemized deduction on Schedule A, Form 1040).

Tax Glossary

Deferred compensation

A portion of earnings withheld by an employer or put into a retirement plan for distribution to the employee at a later date. If certain legal requirements are met, the deferred amount is not taxable until actually paid, for example, after retirement.

More terms