Favorable Tax Consequences - Ponzi Schemes And The Clawback

Most of us are familiar with the concept of the Ponzi Scheme. An investment built on phony profits that crashes and burns, financially devastating many.

What is less familiar is the fact that an investor in a Ponzi Scheme cannot only lose all of their investment. Investors in Ponzi Schemes can also be forced to pay back additional moneys earned from the Ponzi Scheme years before it exploded. This is what is known as a clawback.

As the baby boomers age, the fear grows that they will outlive their remaining financial resources. After an internet bust, a real estate bust, a Wall Street giveaway, a worldwide recession and banks now borrowing money at less than one percent while the boomers are paying 25% on their credit cards, the boomers are now prime targets for Ponzi Schemes. Multi-billion dollar Ponzi Scheme failures are announced with regularity and the list will grow.

With the entire group of baby boomers seeking alternative investments to make sure they are secure, financial frauds, especially Ponzi Schemes will surely grow as the baby boomers reach their peak. Over 70 million people will be looking for the same high rates that will not exist. The term “clawback” will become more familiar as those Ponzi Schemes self destruct.

The definition of a Ponzi Scheme is provided by the I.R.S. and the legal principles governing such a scheme are found at Rev. Proc. 2009-20 at Section 4.01 and Rev. Rul. 2009-9. The I.R.S. calls a Ponzi Scheme a Specified Fraudulent Arrangement.

Specified fraudulent arrangement. A specified fraudulent arrangement is an arrangement in which a party (the lead figure) receives cash or property from investors; (ii) purports to earn income for the investors; (iii) reports income amounts to the investors that are partially or wholly fictitious; (iv) makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and (v) appropriates some or all of the investors’ cash or property.

A Ponzi Scheme will by its very nature reward certain innocent investors to prove the scheme works; and ultimately crash on those investors that left their funds in the scheme to keep earning the large returns or new investors who came in just before the crash. Certain investors will receive their principal and outsized profits while some lose it all.

Once the Ponzi Scheme crashes, there are insufficient funds to meet the obligations and a Trustee is appointed for the Estate of the perpetrators of the Ponzi Scheme. The Trustee is in fact the continuing entity of the perpetrators. However, this Trustee has very broad powers to recoup funds for the general estate so that the Trustee can provide equity among the investors who all have been in the same investment but some have lost while others have won. This is the clawback.

Clawback is a term used to describe the power that a trustee has to regain assets of a debtor that should have been available as part of the bankruptcy estate, but were removed or hidden from the Trustee by the debtor by means of preferential or fraudulent transfers.

The Bankruptcy Code authorizes the trustee to reach back 2 years to recover fraudulent conveyances. There are two general types of fraudulent conveyances (a) a transfer made with actual intent to hinder, delay or defraud creditors (i.e. an actual fraudulent transfer) and (b) a transfer made for less than reasonably equivalent value or fair consideration by an entity that is insolvent or under capitalized (i.e. a constructive fraudulent transfer).

The Trustee has varying powers in this situation to recoup funds. Without explaining these laws in detail, suffice it to say, the Trustee may recoup profits earned by an innocent investor in a Ponzi Scheme. The Statutes governing this case are very much like strict liability where the innocent investor, (the “Taxpayer”), does not need any wrong intention to be liable. There is liability imposed on the innocent Taxpayer because the Ponzi Scheme perpetrator and not the defrauded Taxpayer ran a Ponzi Scheme. Nevertheless, the Taxpayer was paid from the scheme and can be liable for the return of profits and principal.

As an example, assume Mr. Jones invested $1.0 Million in a Ponzi Scheme and earned $1,500,000 in securities income. The income was distributed to Mr. Jones and Mr. Jones paid tax on the income. The balance of the income was spent by Mr. Jones. Assume the Ponzi Scheme collapses with Mr. Jones holding a balance in his account of $1.0 Million that is lost. Since Mr. Jones’ cash out exceeded his cash in, he may be forced to repay certain income to the Trustee, in spite of his $1.0 Million loss of principal.

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