Interesting tax question

Ernie, see IRC Sec. 1341.

Katie in San Diego

Katie wrote in news: snipped-for-privacy@d19g2000prm.googlegroups.com:

I thought it was an intersting question, and if I was really interested I might consult IRC. Howver, I am just curious for the short answer, if there is any such thing. Kowell might have been an early "non-victim" of the Ponzi scheme, but should his "winnings" impinge on recovery of losses by the real losers?

Then, IMHO, Grasso is not entitled to his gross (pun intended) payoff.

Not a lawyer.

$32,000 divided by 6000 equals $5.03 per person before administrative costs and attorney fees. Which means the other 6000 receive zip point you-know-what. So the effect upon the Bankruptcy estate is minimal while the effect upon the innocent victims may be devastating.

In 2001, I researched a similar situation for some innocent victims. My suggestion was that they sue the financial advisor who got them to invest in the Ponzi scheme. They did and they got an out-of-court settlement of 34 cents on the dollar.

The UFTA has failed to consider the substantial negative effect this process has upon innocent victims. The Courts should be looking at the intermediary promoters for full recovery for all innocent victims.

IMRHO (with R like in Rarely), the IRC does not handle this very efficiently. The victims most likely have a theft loss which is a Schedule A deduction subject to a 10% of AGI floor. This means many retirees who do not file a Schedule A get shafted.

Since Kowell treated his gains as capital gains, he should have a capital loss for both the $32,000 and his legal fees - probably subject to $3,000 per year.

Perhaps Kowell could argue that because there was fraud involved, his returns for 1997 through 2001 are now open. That would be a great leap of faith.

If Kowell appeared before the Bankruptcy Court pro se, he deserves to be chided for being ignorant.

The best legal adage I know is "Appearing pro se is like walking into a Lions at lunch time without a whip, a gun, and a chair".

Dick

Perfect cite, Katie.

I recall the one time I thought Katie was wrong. After a thorough search of the IRC, Regs, etc. it turned out she was correct.

Dick

It is probably much more than that. Mr. Kowell was only 1 of 800 who made a profit. The opinion didn't indicate how much was recovered from the other 799 victims that also had to give back their "profits" to the bankruptcy receiver.

Unfortunately the only real winners will be the lawyers who get that

5.03 per person.

Let's hope there will be an appeal of the blatantly unfair 9th liberal circuit court decision. there's GOT to be some constitutional issue in this case.

ChEAr$, Harlan Lunsford, EA n LA

It is unfair to some, but more fair to others. All of the "investors" were similarly defrauded, so why should some benefit and others not? Bankruptcy law requires any creditor who gets a "preference" (not what happened in this case) to give back anything received from the debtor, so it can be equally shared with all similarly situated creditors.

In this case the situation is similar. I don't necessarily agree with the legal analysis - it's a little to simple minded. But it is a rational interpretation of the Fraudulent Conveyance laws. And apparently the 9th Circuit is not the only Court of Appeals that thinks so.

Stu

Ernie Klein wrote: ...

If all made as much as Mr K it would still be only 12.5 cents on the dollar before fees, expenses, etc., ... Not likely anybody but the lawyers will get anything significant I'd think unless there were some really large sums recovered. But even if so, one would assume they would be so because the initial investment was much larger and any settlement be allocated based on that investment.

Well, I HAVE been wrong from time to time, and I might be wrong here. But I think the answer is that Kowell received the gains under a claim of right (i.e., based on what was known at the time, he had the right to the money) and Sec. 1341 applies. His tax liability for the year in which he was forced to repay the gains is the lesser of (a) the tax computed with a deduction for the amount repaid or (b) the tax for the repayment year calculated without the deduction, minus the reduction in tax for the year(s) of receipt of the income that would have resulted if that income had not been received.

So yes, I think Kowell does get a deduction for the amount he repaid, or an adjustment to his current year tax liability. Also, I don't think the deduction is a capital loss; I think it's ordinary. The (b) calculation takes care of the difference between capital and ordinary.

Katie in San Diego

Yeah, I think that was the time you agreed with me. ;-)

Stu

Katie:

... YUP! :-) But you always graciously come back and correct the record.

... NOPE! :-)

Think about what could happen if the "gain" had been less than $3000. You are probably not surprised that I am annoyed by the treatment for amounts less $3000.

Do you have any insight into why the Code requires different treatment depending on whether the repayment by the taxpayer is more or less than $3000?

Cheers,

WDK

Let me see if I understand this (and ask a hypothetical question):

10 years ago, someone had "income" of, say, $50,000, which he shouldn't have. This year, he has to return it.

So he does the following calculations:

1) Redo his income tax return for 10 years ago without the $50,000, and see how much less tax he paid. Take that as a tax credit this year. 2) Take a deduction of $50,000 this year. (What sort of deduction? Subject to limitations based on income?)

He does whichever of those is better for him.

Now, suppose he had $50,000 of deferred investment interest expense going in to 1998. The bogus income wiped that out, but didn't actually add to his tax bill. So calculation (1) is $0. However, if he hadn't used it up, he'd have had a lower tax bill the following year (when he had more investment income to deduct it against). Does that matter?

If not (and he didn't have much investment income in the ensuing decade), he's just converted $50,000 of deferred (and still deferrable) investment interest expense into an actual $50,000 deduction, right?

Seth

No, none whatever. As far as I can see, Sec. 1341 including the $3,000 limitation goes back to the 1954 Code and who knows how far beyond. Certainly $3,000 was a lot more when this statute was first enacted than it is today, so your objection would have been much more significant then than it is now.

Bear in mind that in general, if a taxpayer repays an amount received in an earlier year under a claim of right, a deduction is allowed in the year of repayment. Sec. 1341 provides an additional benefit in the form of what is in effect a refund of the overpayment of tax in the year the income was received, if that's more than the reduction in current year tax arising from the deduction. So even if the repayment is less than $3,000, a deduction is allowed in the repayment year. You just don't get the (possibly) additional benefit of the (b) calculation.

I did look at the regs and I see that I was wrong about the nature of the deduction in the year of repayment. Reg. Sec. 1.1341-1(c) says that if the income was capital gain, the repayment is treated as capital loss subject to the Sec. 1211 limitation on current year deduction. So, unless the taxpayer has other capital gains in the repayment year, the deduction is limited to $3,000. That makes it perhaps more likely that the (b) calculation will be more advantageous

-- which is the whole point of Sec. 1341.

Katie in San Diego

Suppose the repayment of less than 3k is a repayment of wages, then the deduction is reported on Schedule A as misc deduction subject to the 2% of AGI limit. If the taxpayer does not itemize, then they don't get any benefit from the deduction, which discriminates against lower income taxpayers. And besides, if they do itemize it is subject to the 2% limit, which means that you likely don't get the benefit of the deduction anyway, which discriminates against taxpayers dealing with small amounts of money.

Publication 525, Repayments:

Consider the following scenario for method (b), where you compute your tax on your prior year tax return without the extra income, and take the difference as a credit on line 70. Say in the prior year of 1998 your income was 125k, including the 32k capital gain. You had rental loss of 10k, but as your income was above the 100k, the loss was partially disallowed and you got to deduct only 5k, and 5k got carried over. The following year your rental income was a profit of 8k, but combined with the carried over loss of 5k, the actual profit is 3k. Now you go back and redo your 1998 return without the 32k income. The income is 93k, so the entire loss of 10k is allowed. But this does not sound right as the 10k loss would be deducted in full in 1998, and then part or all of it deducted again in 1999. So I'm guessing that you should not increase your rental loss (meaning still take only 5k of loss as in your original return), or for that matter any item with a carryover component (such as investment interest, charitable contributions, etc).

The original post mentions 32k of long term capital gains in a year probably before 2000, so the tax on it would be 20% of 32k, or $6,400. In addition, the 32k income might have lowered the AMT exemption and thereby increased AMT tax, increased AGI and thereby lowered medical expense deduction and so on, so all in all, the credit would be $6,400 or something in excess of $6,400.

Finally, what about state taxes.

Regarding method (b) of computing the credit, will the same method carry over to the state?

And would method (a) of taking the deduction also carryover to state? Say the person did not live in California when they got the 32k, but they are a California resident now, then I imagine the deduction is not allowed.

That's OK. If the taxpayer is from higher income upbringing, and is pushed into AMT territory, he won't get any benefit from the deduction, which discriminates against higher income tax payers.

Fair & equitable, no?

If they're from higher income upbringing, their normal tax might be more than the AMT tax, so they do get the benefit of the deduction.

The 2% floor on itemized deductions dates back to the 1986 Tax Reform Act. The $3,000 limit on application of Sec. 1341 goes back a lot farther than that -- at least into the 1950s and maybe as far as the

1930s.

The problem with an anomaly or injustice or whatever you want to call it that has small tax effects, like this one, is that no one taxpayer can afford to pursue it, either by a lawsuit or by lobbying for a statutory change.

I think the regs take care of this. See Reg. Sec. 1.1341-1(d). You have to recalculate the tax for all of the prior years that were affected by the inclusion of that income. So you would have to reduce the (b) calculation by the amount of tax benefit you got in subsequent years from any carryovers that resulted from the inclusion of the income.

Many states probably conform to Sec. 1341. A state that, by statute, starts the calculation of taxable income with federal AGI or federal taxable income probably conforms. However, you would have to look at it state by state.

California does have a statute that conforms very closely to Sec. 1341 (CRTC Sec 17049). Also, in California, after 2001 an individual resident takes items into account as if he had been a resident for all relevant years. So the deduction would be allowed, just as a resident is allowed to claim a capital loss carryforward that arose in a nonresident year. Of course the result of the (b) calculation would be zero, unless the taxpayer actually filed a nonresident return and paid a tax in the year the income was reported. Again, you'd have to look at this state by state.

Katie in San Diego

As a deduction, it is ordinary - because it goes on schedule A. As a credit, the character doesn't matter. However, it is a REFUNDABLE credit.

Actually, Dieter, I was wrong about that. The deduction in the restoration year is a capital loss, subject to the Sec. 1211 limitation, if the income was originally capital gain. See Reg. Sec.

1.1341-1(c).

Katie in San Diego