Perhaps the most publicized Ponzi scheme in history was uncovered in 2008. In the Bernard Madoff ("Madoff") Ponzi scheme, funds provided by investors were generally not invested. However, in order to attract additional funds, investors were credited with significant purported earnings on their investments and received annual Form 1099s reporting such purported earnings for tax purposes. Investors then reported income and paid tax based on such fabricated Form 1099s. Investors that demanded and received distributions from Madoff typically did not receive earnings. Instead, they received either their own original investment, or the funds of other investors that invested in the scheme. The Madoff Ponzi scheme collapsed when too many investors demanded distributions of their investment and purported earnings.
Although certainly the most widely-known, the Madoff Ponzi scheme is just one of many such financial schemes that victimize investors. Other Ponzi schemes generally are similar to the Madoff Ponzi scheme, resulting in investors paying taxes on fictitious earnings, based on fabricated Form 1099s they received from the Ponzi scheme promoters.
In response to the Madoff Ponzi scheme, the New Jersey Division of Taxation issued a notice providing that victims of the scheme were limited to claiming a loss in 2008 that could be netted only against gains and income in the category of net gains or income from disposition of property.[1] The amount of the loss in this regard is the amount invested in the Madoff Ponzi scheme plus income reported with regard to such investment less distributions received by the investor. The New Jersey Gross Income Tax generally does not allow a net loss from one category of income to offset income or gains from other categories of income. Further, any excess loss within a category may generally not be carried back or carried forward.[2] As such, pursuant to such notice, Madoff Ponzi scheme victims may not be able to fully deduct their loss, and may in fact pay tax on purported income which they never received. The Division of Taxation also indicated in the notice that purported investment income reported by Madoff Ponzi scheme victims (which they did not actually receive) is considered constructively received, such taxpayers could not amend prior year returns and no refunds are available.[3]
The taxpayers in Dalton v. Director, Division of Taxation filed gross income tax refund claims for their 2005-2007 tax years with regard to purported income earned on their investments with Madoff which was reported on fabricated Form 1099s issued by Madoff. The taxpayers received distributions relating to their Madoff investments. However, such distributions were in the aggregate less than the amount they invested.
The New Jersey Tax Court held that due to the nature of the Madoff Ponzi scheme, the taxpayers could not constructively receive the purported earnings they reported as income on their tax returns because there was never any gain or other income with regard to the funds provided by investors due to the fact that such funds were never invested by Madoff. Therefore, the income reported by the taxpayers did not fall within any category of income subject to tax under the New Jersey Gross Income Tax Act. The Tax Court allowed the refund claims of the taxpayers since they received no economic gain from the income reported on their tax returns and, therefore, they should not be prohibited from recovering tax paid on "phantom income."
The Tax Court did note that if a taxpayer received distributions greater than the amount invested, such excess could conceivably be income derived from crimes or offenses and subject to tax under the New Jersey Gross Income Tax. However, since that issue was not present, the Tax Court did not decide it.
Taxpayers who have invested in Ponzi schemes should consider filing New Jersey tax refund claims for all open years. In general, taxpayers subject to the New Jersey Gross Income Tax Act may make a refund claim within three years from filing a tax return or two years from the time the tax was paid, whichever is later.
[1] The New Jersey Gross Income Tax Act subjects only enumerated categories of income tax.
[2] The New Jersey Gross Income Tax Act was recently amended to allow limited netting between certain categories of business income and limited carryovers of losses with respect to such categories. However, such amendment does not allow netting or carryovers with regard to the category net gains or income from disposition of property.
[3] The Division of Taxation also indicated in the notice that partnerships and S corporations that invested in the Madoff Ponzi scheme must claim losses in 2008. The losses would be netted against other business income during the year in arriving at New Jersey distributable share of partnership income or net pro rata share of S corporation income. This amount would flow through to partners or shareholders who would then include such amount in their returns in the category net distributable share of partnership income or net pro rata share of S corporation income. The New Jersey Tax Court did not address in Dalton v. Director, Division of Taxation whether partnership or S corporation investors would be allowed to amend their returns allowing partners and shareholders in such entities to seek a tax refund. However, the same holding reached by the New Jersey Tax Court in that case should arguably apply in such instances.
