In the wake of the unravelling of uber-Ponzi schemer Bernard Madoff’s scam, the IRS has announced new guidance on how it will handle the tax consequences of being a victim of a Ponzi scheme — whether Madoff’s or any one else’s.

Yesterday, March 17th, IRS Commissioner Doug Shulman described the agency’s position in testimony before the Senate Finance Committee:

• The investor is entitled to a theft loss, which is not a capital loss. In other words, a theft loss from a Ponzi-type investment scheme is not subject to the normal limits on losses from investments, which typically limit the loss deduction to $3,000 per year when it exceeds capital gains from investments.

• The revenue ruling clarifies that “investment” theft losses are not subject to limitations that are applicable to “personal” casualty and theft losses. The loss is deductible as an itemized deduction, but is not subject to the 10 percent of AGI reduction or the $100 reduction that applies to many casualty and theft loss deductions

• The theft loss is deductible in the year the fraud is discovered, except to the extent there is a claim with a reasonable prospect of recovery. Determining the year of discovery and applying the “reasonable prospect of recovery” test to any particular theft is highly fact-intensive and can be the source of controversy. The revenue procedure accompanying this revenue ruling provides a safe-harbor approach that the IRS will accept for reporting Ponzi-type theft losses.

• The amount of the theft loss includes the investor’s unrecovered investment – including income as reported in past years. The ruling concludes that the investor generally can claim a theft loss deduction not only for the net amount invested, but also for the so-called “fictitious income” that the promoter of the scheme credited to the investor’s account and on which the investor reported as income on his or her tax returns for years prior to discovery of the theft.

Some taxpayers have argued that they should be permitted to amend tax returns for years prior to the discovery of the theft to exclude the phantom income and receive a refund of tax in those years. The revenue ruling does not address this argument, and the safe-harbor revenue procedure is conditioned on taxpayers not amending prior year returns.

• A theft loss deduction that creates a net operating loss for the taxpayer can be carried back and forward according to the timeframes prescribed by law to generate a refund of taxes paid in other taxable years.
  

In the wake of master swindler and former NASDAQ chairman, Bernard Madoff’s $65-billion dollar, multi-decade, worldwide Ponzi scheme, it might seem like scams are popping up everywhere one looks..

In this context, in January, 2009, a U.S. Justice Department announcement reports that Ponzi-schemer-or-collaborator Shirley G. Graybill, 72, of North Haven, Conn., was sentenced to two years of probation — the first four months of which she must spend in home confinement. She had pleaded guilty in June, 2005 to one count of making and subscribing to a false 2002 tax return.

What happened between the June 2005 guilty plea and the three-and-a-half-year later sentencing announcement?

According to court records, the Triple Diamond Foundation was an entity created by Graybill and her husband, Dale L. Graybill, purportedly to fund cancer research, but which did not have tax-exempt status from the IRS. The Graybills controlled the Triple Diamond Foundation and its bank account. And apparently, they were quite adept at using that bank account.

During the 2002 tax year, the Graybills transferred about $350,000 from the Triple Diamond Foundation account, used those funds as income, but failed to pay federal taxes amounting to almost $93,300.

The Justice Department also reports that on October 13, 2003, Graybill filed a tax return with the IRS in which she failed to claim her actual taxable income, “when in fact she knew it to be approximately $316,519.79.”

Does anyone else find government-style reporting uniquely interesting in its departures from common sense? The Justice Department is reporting that schemer Graybill knew her taxable income was “approximately $316,519.79.”

“Approximately”?

When was the last time anyone you know has come up with a nice round number like “approximately” $316,519.79?

I know: approximately 4.7 people did roughly that just about 3.24 weeks ago.

Returning to the Graybills: they also must pay $93,293 to the Internal Revenue Service. In addition, Dale Graybill was sentenced to 48 months in prison following his conviction on one count of mail fraud stemming from his operation of a multimillion-dollar Ponzi scheme in which he solicited investments for fictitious investment programs.

Dale Graybill was also ordered to pay his victims restitution exceeding $10.6 Million dollars. And these consequences do not include what they will also owe in Connecticut state income tax.

So, leaving aside the unique style-book that the government uses, not only was the conduct of the Graybills illegal, for which they are now subject to the consequences (“the weed of crime bares bitter fruit” said The Shadow), but it also is double-plus-ungood.