Another Victim of the Ponzi Schemers: The IRS

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James Leynse / Corbis

The Internal Revenue Service is bracing for a deluge of amended tax returns from tens of thousands of victims caught up in the recent wave of multibillion-dollar Ponzi schemes and other frauds, most notably the sensational swindle perpetrated by Bernie Madoff and R. Allen Stanford's $8 billion certificates-of-deposit scam.

Rough IRS numbers on Madoff's theft alone could total from $7 billion to $10 billion in refunds due to victims, according to accountant tallies. But don't feel too bad for the IRS. Over the past 20 or more years, it has been collecting taxes on income that never actually existed. Last year the IRS sent out 106 million refund checks totaling $254 billion, so Ponzi victims will hardly empty the refund cookie jar. (See pictures of Madoff's demise.)

The IRS is always the first go-to place for financial-fraud survivors trying to recoup lost money. But with the April 15 tax clock ticking, figuring out what to do about recovery, both from taxes and from the Securities Investor Protection Corp. (SPIC), has become a mind-boggling maze for accountants and their Ponzi-victim clients. At a hearing yesterday, Madoff pleaded guilty to his decades-long crime, was handcuffed and ordered to jail. Sentencing is scheduled for June, but he could potentially be sentenced to 150 years on 11 counts. (Read "The Madoff Hearing: A Guilty Plea, but No Catharsis.")

There's no unanimity about what to do in regard to Ponzi and other fraud recovery when it comes to taxes. Ponzi survivors are getting a litany of mixed signals from bulletins, tax-adviser reports, panel discussions and the Web. And to make matters worse, many of those trying to get their tax returns in quickly are being slow-danced by their former feeder-fund managers, who, under advisement, have been slow in sending out amended statements, or K-1s; they have until Oct. 15, the final deadline for 2008 filings. (See a TIME video from outside the courthouse.)

"I think we're going to see the IRS come out with guidelines very shortly," said Neil Tipograph, tax partner at New York City–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 an 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, a "claim of rights credit," is most beneficial, he said. It allows victims to claim a credit on their 2008 tax return for all taxes paid on Ponzi income going back to the first investment year. The catch, according to Tipograph, is that "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. (See 25 people to blame for the financial crisis.)

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 said, since there's a rolling three-year time limit. One can, however, file a "protective refund claim" form, a kind of placeholder that keeps the 2005 return open.

Of course, no one knows what the IRS will do, but Bob Goldstein, a senior consultant at Marks Paneth & Shron LLP in New York City, says he was assured by the IRS that "guidance would be forthcoming" — by April 15, one hopes. He suggests a simple approach for both the victims and the IRS. "If the [IRS] were to allow the victim to deduct his or her tax basis, less the SIPC recovery and less a small reserve for other recoveries, as a theft loss on the victim's 2008 tax return, the taxpayer could quantify the loss quickly and file for the appropriate refunds," Goldstein says. "The benefit for the IRS is the consistency of the claims filed, which will make the administration of this deluge of claims easier."

Goldstein says he has spoken with IRS officials, and they know the complexity of the issues before them. "The people there are sensitive to the victims and to the urgency," he adds.

But Congress is scratching its collective head.

Late last month, two Senators and three Congressmen sent a two-page, single-spaced letter with 10 questions to the IRS asking for direction in resolving a series of important questions regarding Madoff and Ponzis, such as whether there will be special extensions for victims. The letter also suggested setting up a special "Madoff unit" to process claims. (Read more about Ponzi schemes.)

So far, no comment from the IRS.

See pictures of the demise of Bernie Madoff.

See a TIME video from outside the courthouse.