Time magazine published an article today discussing what many tax attorneys and CPAs had already been discussing amongst themselves on internet listservs and at wild and crazy tax attorney/CPA parties for the past few months — the massive amount of tax refunds that are going to be filed for by victims of Bernard Madoff and other Ponzi crooks. Per the article:
“I think we’re going to see the IRS come out with guidelines very shortly,” said Neil Tipograph, tax partner at New York-based, Imowitz Koenig & Co, LLP, an accounting firm specializing in private equity and feeder hedge funds. According to Tipograph and other tax experts, victims involved in Ponzis have four ways to reclaim taxes paid on fraudulent income, the first being a good old-fashioned “Theft Loss” deduction, which allows a person to go back three years and reclaim taxes paid. Currently, no deduction can be made on the original investment, especially if a SIPC claim has been made.
The second is a “Phantom Income Deduction,” which allows you to remove the Ponzi income going back three years, but if you still have a loss you can carry it forward [i.e., apply it as a deduction against future gains] until the full loss is made up.
The third option, “Claim of Rights Credit,” is most beneficial, he says. It allows victims to claim a credit for all taxes paid on Ponzi income going back to the first investment year on their 2008 tax return. The catch, according to Tipograph: “It’s never been tested in regard to Ponzis.” This option is typically used in insider trading cases, when tax monies need to be returned.
The last option is “Mitigation,” which requires the taxpayer to go back and reopen each year’s tax filing, back to the year of the first investment. There are some technical requirements related to this option.
“It’s likely the IRS will just allow for the theft loss,” said Tipograph. “It’s not the best option for taxpayers, but is a reasonable way to handle this.” But if you don’t file by April 15, you can lose out on filing for 2005, Tipograph says, since there’s a rolling three-year time limit.
I was really hoping that the IRS itself would issue guidance on the subject well before April 15, but as the clock ticks, that’s looking more and more unlikely.