Author: Leon Clinton

The Ponzi scheme is an investment fraud where the schemer uses invested money to create fake investment returns. 

According to an article at CNBC.com, authorities uncovered 60 alleged Ponzi schemes last year involving a total of $3.25 billion in investor funds—the highest amount since around the time of the Great Recession.

The Great Recession (2007–2009) revealed the famous Bernie Madoff Ponzi scheme and led both lawmakers and the IRS to create helpful actions for taxpayers, such as the safe harbor described in this article. Thank goodness.

And here’s more good news: the Tax Cuts and Jobs Act (TCJA), which crushed most theft losses for tax years 2018–2025, allowed the IRS tax-favored Ponzi scheme loss deduction rules to remain in place.

What the Safe Harbor Does for the Taxpayer

The IRS will not challenge a Ponzi scheme victim who uses the IRS tax relief safe harbor as to the following treatments of the loss:

1. The Ponzi scheme loss is deductible as a theft loss.
2. The loss is deductible in the year of discovery, which (under this tax relief safe harbor) is the year a lead figure in the Ponzi scheme is
   • charged by indictment with the commission of fraud, embezzlement, or a similar crime; 
   • the subject of a state or federal criminal complaint and either (a) admits guilt or (b) has his, her, or its assets frozen by a court-appointed receiver or trustee; or
   • the subject of the fraudulent arrangement but (due to his or her death) faces no charge by indictment, information, or criminal complaint (this condition also requires either that a receiver or trustee was appointed with respect to the arrangement or that assets of the arrangement were frozen).
3. The loss amount is computed using the safe-harbor formula, which allows either 95 percent or 75 percent of the loss in the year the Ponzi scheme victim files the safe harbor, as explained below.

The tax relief safe harbor truly simplifies the Ponzi scheme theft-loss deduction for the victim. 

The IRS frequently disagrees with theft-loss deductions. The rules for deduction and the different interpretations of the facts generate a good number of conflicts and enough litigation to make this safe harbor appealing.

How Individuals and Businesses Claim the Ponzi Scheme Loss Deduction

Say a thief breaks into your home and steals $100,000 worth of your belongings. Your personal theft-loss deduction is zero if the loss is not attributable to a federally declared disaster. That’s the way it is under the TCJA rules for 2018–2025.

But the individual who mistakenly invested in a Ponzi scheme did so for the purpose of making a profit. Tax law treats this theft differently from the theft that occurs when someone breaks into your home and steals your jewelry.

Because of the profit motive, the Ponzi scheme theft is fully deductible as an itemized deduction. Note the “fully” deductible part. The loss is not a capital loss that’s limited to the $3,000 ceiling. It’s a fully deductible theft loss—and as you see below, it can produce an NOL.

The business treatment of the Ponzi scheme loss produces a full deduction as well, albeit as a business casualty loss.

Subsequent Years

Once you make the safe-harbor calculation and deduct the 95 percent or 75 percent, you may collect a different amount in a subsequent year. That’s no problem. If you receive additional income, you report that additional income in the year of recovery under the tax benefit rule (to the extent that you received a benefit from the earlier deduction).

Should the amount of your loss increase because you collect less than the amount of the claim that you established as a reasonable prospect of recovery, you deduct the additional loss in the year that you can identify that additional loss with reasonable certainty.

Ponzi Scheme Loss Carryback as an NOL

The individual taxpayer who becomes a theft-loss victim may treat his or her theft loss as a loss from a sole proprietorship for purposes of computing the NOL deduction.

Planning note. If you qualify for a 2020 Ponzi scheme loss deduction and that deduction produces an NOL, you carry that loss to your 2015 tax year—or you can elect to forgo the carryback and instead carry the loss forward.

If you have had the misfortune of investing in a Ponzi scheme, please call me so that we can get on top of this early on.

• By Leon Clinton
• January 3, 2021

College is expensive. Data for the 2019–2020 academic year indicates that the average cost of tuition, fees, room, and board was $30,500. Tax law has provisions to help you cover the costs, including Coverdell, Section 529 savings, and Section 529 tuition plans. 

Contribute to a Coverdell Education Savings Account

You can contribute up to $2,000 per year to the child’s CESA. If you have several children, you can set up a CESA for each of them. 

Contributions are non-deductible, but earnings are allowed to accumulate free of any federal income tax. You can then take tax-free withdrawals to pay for the account beneficiary’s post-secondary tuition, fees, books, supplies, and room and board.

Maybe not for you. Your right to contribute is phased out between modified adjusted gross income (MAGI) of $95,000 and $110,000 if you are unmarried, or between $190,000 and $220,000 if you are a married joint-filer.

Contribute to a Section 529 College Savings Plan

Section 529 college savings plans are state-sponsored arrangements named after the section of our beloved Internal Revenue Code that authorizes very favorable treatment under the federal income and gift tax rules. 

You as the parent of a college-bound child begin by making contributions into a trust fund set up by the state plan that you choose. The money goes into an account designated for the beneficiary whom you specify (your college-bound child). 

You can then make contributions via a lump-sum pay-in or via installment pay-ins stretching over several years. The plan then invests the money using the investment direction option that you select. 

When your child reaches college age, you can take federal-income-tax-free withdrawals to pay eligible college expenses, including room and board under most plans. Plans will generally cover expenses at any accredited college or university in the country (not just schools within the state sponsoring the plan). Community colleges qualify as well.

In essence, a Section 529 college savings plan account is a tax-advantaged way to build up a college fund for your child.

Don’t Confuse Savings Plans with Prepaid Plans

Don’t mix up Section 529 college savings plans with Section 529 prepaid college tuition plans—which we will give only a brief mention here. Both types of plans are properly called “Section 529 plans” because both are authorized by that section of the Internal Revenue Code. Both receive the same favorable federal tax treatment. But that’s where the resemblance ends.

The big distinction is that prepaid tuition plans lock in the cost to attend certain colleges. In other words, the rate of return on a prepaid tuition plan account is promised to match the inflation rate for costs to attend the designated school or schools—nothing more, nothing less. That’s okay if that’s what you really want.

No Kiddie Tax on Section 529 Plan

You don’t have to worry about the kiddie tax if you set up a custodial 529 plan in the child’s name. The 529 plan is an investment plan where the monies remain in the plan. You make contributions with after-tax dollars.

When the child takes the money out of the plan for college, he or she does so tax-free when the funds are used to pay for qualified higher education expenses.

If you want to discuss your college-planning strategies, please call me on my direct line at 408-778-9651.

• By Leon Clinton
• December 31, 2020

If a loved one passes away and you serve as the executor or inherit assets, you need to consider your duties and so some tax planning. 

Filing the Final Form 1040 for Unmarried Decedent

If the decedent was unmarried, an initial step is to file his or her final Form 1040. 

That return covers the period from January 1 through the date of death. The return is due on the standard date: for example, April 15, 2021, for someone who dies in 2020, or October 15, 2021, if you extend the return to that date.

Surviving Spouse May Be Able to Use Joint Return Rates for Two Years Following Deceased Spouse’s Year of Death

The benefits of the married-filing-joint status are extended to a qualified widow or widower for the two tax years following the year of the deceased spouse’s death. 

In general, to be a qualified widow/widower for the year, the surviving spouse must be unmarried as of the end of the year. 

If Decedent Had a Revocable Trust

To avoid probate, many individuals and married couples of means set up revocable trusts to hold valuable assets, including real property and bank and investment accounts. 

These revocable trusts are often called “living trusts” or “family trusts.” For federal income tax purposes, they are properly described as “grantor trusts.” 

As long as the trust remains in revocable status, it is a grantor trust, and its existence is disregarded for federal income tax purposes. Therefore, the grantor or grantors are treated as still personally owning the trust’s assets for federal income tax purposes, and tax returns of the grantor(s) are prepared accordingly. 

Basis Step-Ups for Inherited Assets

If the decedent left appreciated capital gain assets—such as real property and securities held in taxable accounts, the heir(s) can increase the federal income tax basis of those assets to reflect fair market value as of 

• the decedent’s date of death, or 
• the alternate valuation date of six months after the date of death, if the executor of the decedent’s estate chooses to use the alternate valuation date. 

When the inherited asset is sold, the federal capital gains tax applies only to the appreciation (if any) that occurs after the applicable magic date described above. The step-up to fair market value can dramatically lower the tax bill. Good!  

Co-ownership. If the decedent was married and co-owned one or more homes and/or other capital gain assets with the surviving spouse, the tax basis of the ownership interest(s) that belonged to the decedent (usually half) is stepped up.    

Community property. If the decedent was married and co-owned one or more homes and/or other capital gain assets with the surviving spouse as community property in one of the nine community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin), the tax basis of the entire asset—not just the half that belonged to the decedent—is stepped up to fair market value. 

This strange-but-true rule means the surviving spouse can sell capital gain assets that were co-owned as community property and only owe federal capital gains tax on the appreciation (if any) that occurs after the applicable magic date. That means little or no tax may be owed. Good!

If you have questions about any of the above, please don’t hesitate to call me.

• By Leon Clinton
• December 29, 2020