Interesting tax question

Ernie Klein · 2008-07-02T02:37:12+00:00

An opinion by the Ninth Circuit Court of Appeals was issued today (Donell v. Kowell). Mr. Kowell was an early, innocent investor in what turned out to be a Ponzi scheme. Because Kowell was an early investor, he was one of 800 that actually made a profit from his investment, the other 6000 investors either lost some or all of their investment. The time period was between 1997 and 2001. California law (The Uniform Fraudulent Transfer Act (³UFTA²)) provides that Kowell (and the other 800 who made a profit) must return the profit, about $32,000 in Kowell's case (only the profit - he can keep his original investment) that he received to the bankruptcy receiver, to be distributed to those other 6000 who lost their investments. Mr. Kowell was arguing that he was also an innocent victim of the Ponzi scheme and should not have to pay back the money that he received and spent years ago, AND [here comes the tax question] paid all Federal and State taxes on the investment income.Kowell lost the appeal and the court said "Ponzi schemes leave no true winners once the scheme collapses?even the winners were defrauded, because their returns were illusory. Those who receive gains from innocent participation in the scheme may be required to disgorge those amounts, long after the money has been spent."Since Kowell's return was "illusory" as the court said, but he paid capital gains tax between 1997 and 2001 as if it was real and now he has to give it back, can he now declare it a capital loss (even though it was never a "real" capital gain in the first place)?

Jul 02, 2008 24 Replies

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Katie 18 years ago

Note that the Sec. 1341 deduction in the year of restoration, if it is a miscellaneous itemized deduction, is not subject to the 2% AGI floor. That's something I learned from our discussion with Dieter, that I didn't know before. So thanks to Dieter for that.

Katie in San Diego

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KEBSCHULLW 18 years ago

To All:

Looks like we've finally got this figured out!

But what we cannot forget is that if the amount that has to be repaid is $3000 or less and has to be reported as a deduction subject to the 2% AGI floor, the taxpayer can still be whacked even when the

2% AGI floor does not reduce the deduction. Why? Because $3000 of income can produce more than $6000 of taxable income because the $3000 is included in the AGI phase-out calculations that are part of almost 30 provisions in the Tax Code related to deductions, exemptions, exclusions, credits, etc. Thus the taxpayer can pay tax on more than $6000 on the $3000 of income that has to be repaid and get a $3000 deduction or if the deduction is phased-out by the 2% AGI floor he/she may get zippo benefit when the $3000 is repaid.

So at the 25 percent tax rate, the taxpayer can get whacked for $1500 in taxes with "illusory income". Do we have a great Congress or what?

And compare that with the instructions that IRS has derived from section 56(b)(1)(D). See line 7 on Form 6251 and consider what happens when the refund is from a year when the regular tax was paid. Deduction for the tax overpayment and then exclusion of the refund from AMTI.

Cheers,

WDK

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Arthur Kamlet 18 years ago

Are we entering the third and final year of the phase-out of the phase-out? Meaning no more phase-outs?

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KEBSCHULLW 18 years ago

What 'chu talking bout, Art? Anything other than the phase-out of the exemption phase-out? Phase-out up to 85 percent of the Social Security benefit exclusion and the phase-out of medical and miscellaneous expense deductions due to the thresholds can more than double the taxable income attributable to income at the margin.

Cheers,

WDK

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KEBSCHULLW 18 years ago

... and the phase-out of the phase-out (down) of total itemized deductions.

Cheers,

WDK

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