Taxing Ponzi Victims

It’s bad enough that the victims of Bernard Madoff and Earl Jones have lost their money, but now they have a tax mess spanning many years. Fortunately, there are tax rules in place to alleviate some of the pain.

To illustrate the potential tax unfairness, consider a hypothetical investor Ian who invested $200,000 with a charismatic guy who turned out to be running a Ponzi scheme. For 10 years, Ian received a cheque for $1000 every month along with a statement showing his savings rising steadily. Ian’s last statement before the Ponzi scheme was uncovered showed a balance of $300,000.

Each of the last 10 years Ian has been paying taxes on the $12,000 interest at his marginal tax rate. If the tax man treats Ian’s $300,000 as suddenly going to zero, then Ian will have a net capital loss of $200,000. Unfortunately, Ian doesn’t have other investments with capital gains, and so he can’t make much use of this large capital loss.

In reality, though, Ian’s money didn’t evaporate suddenly. The Ponzi operator actually returned some of Ian’s money to him each month and stole the rest a little at a time. One way to look at Ian’s investment is that he put in $200,000 and had $1000 of it returned to him each month for 120 months.

Taking this view, Ian shouldn’t have paid any tax on the $1000 per month, and he should be left with an $80,000 capital loss. In most cases the tax rules will permit Ian to re-file his income taxes for some number of previous years to reflect this reality.

The U.S. has the concept of a “theft loss” that permits victims to offset any type of income against the loss. Canadian tax authorities can choose to make similar allowances for victims. This is a complex part of tax law and victims would be wise to consult experts to maximize the amount of past taxes on phantom income that can be recovered.