IRS CCA 200451030, 2004 WL 2915913 (IRS CCA) Internal Revenue Service (I.R.S.) Chief Counsel Advisory Issue: December 17, 2004 September 30, 2004 Section 165 — Deductions For Losses 165.00-00 Deductions For Losses 165.18-00 Other Section 166 — Bad Debts 166.00-00 Bad Debts Section 61 — Gross Income v. Not Gross Income 61.00-00 Gross Income v. Not Gross Income 61.02-00 Return of Capital v. Income CC:ITA:B01:SMDwyer / AMIrving POSTF-164294-03 To: Associate Area Counsel (Small Business/Self Employed)
CC:SB:3:FTL Attention: Ladd Brown From: Chief, Branch 1 Office of the Associate Chief Counsel
(Income Tax & Accounting) CC:ITA:1 Subject: This Chief Counsel Advice responds to your request for assistance
dated December 23, 2003. This advice may not be used or cited as precedent. While we agree with the conclusions reached in your memorandum,
our analysis differs to some extent. Accordingly, we submit the following
discussion for your consideration. LEGEND A = Year 1 = Year 2 = Year 3 = ISSUES (1) Whether investors in a Ponzi scheme that takes the form of
debt investments are entitled to amend their returns for an open year to
reverse interest income received and reported. (2) Whether middle tier investors are entitled
to amend their returns for an open year to reverse commissions received and
reported. (3) Whether investors may claim a theft loss under § 165
for amounts received and reported as income, but reinvested in the scheme. CONCLUSIONS (1) Payments received by investors as interest are generally
includible in income in the year or years they were actually or constructively
received. As a return on an investment, these payments were income whether or
not they technically constituted interest on a bona fide loan. Retroactive
recharacterization of such payments as a return of capital under an
open transaction theory, once the fraud was discovered, is
not warranted; the appropriate form of cost recovery in such a situation is
generally a bad debt or theft loss deduction. Assuming the deduction arises
from theft, and if a net operating loss is created in the year the loss is
sustained, an investor would be entitled to a three-year carryback of the loss
under § 172. (2) Commission income earned by middle-tier
investors is ordinary income for services performed, taxable as such in the
year or years received. (3) It is possible that some of the loans were expected to be
repaid; in such a case, an investor would take a nonbusiness bad debt deduction
under § 166 for unpaid principal, including reinvested interest, in
the year of worthlessness. Generally, however, investors would be entitled to a
theft loss deduction under § 165(c)(3) for funds invested or
reinvested and lost. However, no bad debt or loss deduction is allowable so
long as there is a reasonable prospect of recovery, through the bankruptcy
proceeding or otherwise. In addition, deductions under either § 166 or
§ 165 can be disallowed for participants who were aware of the
fraudulent or illegal nature of the scheme, under the frustration of
public policy doctrine. FACTS Generally, As business began as a legitimate business
buying and reselling surplus sundry items. However, after several unprofitable
deals, A began soliciting loans from investors, promising a return of 5% in six
weeks. After some period, the promoters business had disintegrated
into a Ponzi scheme. A was no longer dealing in sundries, but rather directed
his efforts toward soliciting new investors. Payments to investors were made
with funds obtained from newer investors. Some investors, described as middle-tier
investors, received commissions for soliciting new investors, as well as
interest payments. It is unclear whether these middle-tier investors were aware
of the fraudulent nature of the scheme. In Year 3 the scheme collapsed after As bank contacted
the FBI with respect to the volume of cash moving through As account;
the account was seized and A was forced into bankruptcy. The bankruptcy trustee
has collected funds that will be distributed to investors, but the amount of
the recovery is uncertain. Many investors have filed refund claims for open years on the
ground that the payments they received were not interest but a return of
principal, excludable from income. Investors have also taken theft loss
deductions in Years 1, 2, and 3. For purposes of this discussion, we assume what seems likely on
the facts, which is that As operation of the scheme, at least in
later years, constituted theft, as that term is interpreted for purposes of
§ 165(c)(3) and 165(e). LAW AND ANALYSIS (1) Were the interest payments received by investors income in the
year received? Section 61 of the Internal Revenue Code states that, except as
otherwise provided, gross income means all income from whatever source derived.
This definition covers any items that represent undeniable accessions
to wealth, clearly realized, and over which the taxpayers have complete
dominion. Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955). An item of income is includable in the gross income of a cash
basis taxpayer in the tax year when it is actually or constructively received.
Section § 1.451-1(a) of the Income Tax Regulations. Income is
constructively received in the tax year in which it is credited to the
taxpayers account, set apart for him, or otherwise made available so
that he may draw upon it at any time. Treas. Reg. § 1.451-2(a). When
the payor lacks funds to make the payment, there can be no constructive
receipt. Fraudulent pyramid or Ponzi schemes may take a
variety of forms. Generally the perpetrators promise the victims a significant
return on capital, as interest, dividends, capital gains, sales proceeds,
rentals, royalties, etc. In all cases the perpetrators intent is to
swindle the investors—funding payments of income
using money invested by current and new investors—though many
investors will receive some return, and some investors may make an overall
profit from the scheme. The present scheme took the form of short term
loans issued at interest rates in excess of 43% annually. Open transaction doctrine in general You state that a number of investors have filed amended returns
for open years, recharacterizing the taxable interest they reported in those
years as, in hindsight, a nontaxable return of principal. Presumably, the
justification for this treatment is the open transaction
doctrine. The open transaction doctrine occasionally applies to
permit an investor to recover capital prior to recognizing gain, where the
receipt of deferred payments is speculative or contingent. The Supreme Court
established the open transaction doctrine in Burnet v. Logan, 283 U.S. 404 (1931). In
Logan, the taxpayer owned stock in a corporation which, along with several
other corporations, held a leasehold interest in a mine. The taxpayer sold the
stock for cash plus a royalty of 60 cents per ton on all ore apportioned to the
corporation. There was no provision for a maximum or minimum tonnage. The contractual
promise to pay the royalty was held to be too contingent and speculative to
have any ascertainable value, and as a result, the transaction could not be
regarded as closed. The open transaction doctrine is sparingly applied. It originated
and has most often been invoked in the context of sales of property and, even
within that context, has only been applied in rare and extraordinary
circumstances. See Treas. Reg. § 1.1001-1(a); McShain v.
Commissioner, 71 T.C. 998, 1004 (1979); Estate of Wiggins v. Commissioner, 72
T.C. 701, 708 (1979); Estate of Meade v. Commissioner, 489 F.2d 161, 163 (5th
Cir.), cert. denied, 419 U.S. 882 (1974). In a line of older cases, the open transaction doctrine has also
been applied to the treatment of discount income on a loan, on the ground that
the instrument was speculative. See Underhill v. Commissioner, 45 T.C. 489, 495
(1966) (stated interest reportable as income, but discount income not
reportable as interest until entire investment recovered); see also Liftin
v. Commissioner, 36 T.C. 909 (1961); Phillips v. Frank, 295 F.2d 629, 633-
34 (9th Cir. 1961). With respect to notes issued in a fraudulent scheme, two cases
have applied a version of open transaction treatment. In Greenberg v.
Commissioner, T.C. Memo. 1996-281, the judge, citing Burnet v. Logan, permitted interest
payments received by a passive investor in a Ponzi scheme to be treated as a
recovery of principal. There was sufficient evidence to determine the amount of
funds paid and received by the taxpayers. The opinion states that the payments
the taxpayers received were not interest because they were not compensation for
the use or forbearance of money. Instead, the payments were made to conceal the
fraudulent misappropriation of the taxpayers investment. And in Taylor
v. United States, 81 AFTR 2d 98-1683, 98-1 USTC ¶ 50,354 (E.D. Tenn.
1998), an individual fraudulently claimed to be investing funds on behalf of a
partnership; the court held that the partnership did not realize income in the
year prior to the year the fraud was discovered, since the partnership did not
receive more than it invested in that year. [FN1] In contrast, most courts have been reluctant to apply the open
transaction doctrine in this context. In Parrish v. Commissioner, 168 F.3d 1098 (10th
Cir. 1999), affg T.C. Memo 1997-474, for example, the court found
that payments of interest, dividends, and finders fees were taxable as current
income. The court distinguished the rather unique Greenberg opinion, finding that
the taxpayer had not established that the open transaction doctrine or, if
different, the rationale of Greenberg, applied. Similarly, in Premji v.
Commissioner, T.C. Memo 1996-304, affd without published opinion,
139 F.3d 912 (10th Cir. 1998), the taxpayer received interest payments from an
investment in a Ponzi scheme. Checks for the loan principal were also made
available but the taxpayer chose to reinvest them. The taxpayer argued that an
interest payment on one of the notes was not required to be included in income,
under the open transaction doctrine. The Tax Court concluded that the payment
was income in the year received, and not a recovery of principal, since the
taxpayer could not establish that the recovery of the principal amount was
sufficiently uncertain. See also Wright v. Commissioner, T.C. Memo. 1989-557,
affd, 931 F.2d 61 (9th Cir. 1991); Murphy v. Commissioner, T.C. Memo. 1980-218,
affd per curiam, 661 F.2d 299 (4th Cir. 1981). In the present case, we conclude that amounts, if any, recovered
with respect to an instrument after discovery of the fraud (that is, after the
point at which, we assume, a typical investor would be aware that recovery of
his or her principal was uncertain) are properly treated as a return of
capital—not includable in income, in whole or in part, but instead
reducing basis otherwise recoverable through a bad debt or loss deduction. For
several reasons, however, we do not believe the open transaction doctrine
applies for prior years. This conclusion holds true whether or not a given obligation was,
in fact, bona fide indebtedness, respected as such for federal income tax
purposes— although the reasoning behind the conclusion differs to
some extent. Bona fide debt A bona fide debt is a debt that arises from a debtor-creditor
relationship based upon a valid and enforceable obligation to pay a fixed or
determinable sum of money. § 1.166-1(c). Generally, whether a
transaction for federal income tax purposes constitutes a bona fide loan is a
factual question, and the courts have identified several factors to be used in
the determination. However, a distinguishing characteristic of a loan is the
knowledge of each party to the transaction that there is a loan, and the
intention of each party that the money advanced be repaid. Commissioner v.
Makransky, 321 F.2d 598, 600 (3d Cir. 1963), affg 36 T.C. 446
(1961); Moore v. United States, 412 F.2d 974, 978 (5th Cir. 1969); Litton Business
Systems, Inc. v. Commissioner, 61 T.C. 367, 377 (1973), acq., 1974-2 C.B.
3; Leaf v. Commissioner, 33 T.C. 1093, 1096 (1960), affd per curiam 295
F.2d 503 (6th Cir. 1961). Courts have looked at whether there was an express or
implied consensual recognition of the obligation to repay, and whether each
party viewed the transaction as a loan. Collins v. Commissioner, 3 F.3d 625, 631 (2d
Cir. 1993), affg T.C. Memo. 1992-478. The determination is made at
the inception of the transaction. On this basis, swindlers or embezzlers, who receive loan
proceeds but do not recognize a consensual obligation to repay them,
must include the proceeds in income, and cannot take a deduction under
§ 163 for payments that are not, in fact, interest (although they may
be entitled to a § 162 deduction for such payments, as an ordinary and
necessary expense of the fraudulent enterprise). See Collins; United States v.
Rosenthal, 470 F.2d 837, 842 (2d Cir. 1972); United States v. Rochelle, 384 F.2d 748 (5th
Cir. 1967); Smith v. Commissioner, T.C. Memo. 1995-402. [FN2] Although we have found no authority directly on point, presumably
if an instrument is not true debt for the borrower, it is
not true debt for the lender either. In the present case, we cannot reach blanket conclusions with
respect to whether the purported loans were bona fide indebtedness. The fact
that a business degenerates over time into a pyramid scheme does not rule out
the possibility that some of its obligations were bona fide debts, and you may
conclude that certain of the obligations in question were intended to be repaid
and otherwise met the requirements for treatment as
indebtedness under the Code. Accordingly, we will analyze
both possibilities. Application of open transaction doctrine For those obligations that you conclude did constitute bona fide
debt, we see no justification for retroactive recharacterization of interest,
actually or constructively received, as a return of principal. Under Reg.
§ 1.446-2(e), a payment on a debt instrument is generally treated as a
payment of interest to the extent of any accrued and unpaid interest. This
includes original issue discount and any other amounts treated as interest,
whether stated or unstated. § 1.446-2(a). [FN3] The treatment of
market discount and contingent debt in such older cases as Underhill and Liftin
has largely been superseded by subsequent developments in the law and it is
questionable what, if any, precedential value they now have. See
§§ 1276-78; § 1.1275-4; D. Garlock, Federal Income
Taxation of Debt Instruments § 6.03[D][3] (4th Edition 2003). The fact
that a lender on a bona fide debt obligation ultimately fails to recover all or
part of the loan principal may result in a deduction under § 166; it
does not, however, justify retroactive recharacterization of payments properly
included in income in prior years. [FN4] As to those transactions that you conclude did not constitute bona
fide debt, even though a payment is not technically interest it is still a
return on investment, taxable as such, and application of the open transaction
doctrine is inappropriate. See Parrish; Premji. As noted above, the open transaction doctrine—an
exception to the general rule that each tax year stands on its own, see Burnet
v. Sanford & Brooks, 282
U.S. 359 (1931)—is only applied in rare and extraordinary
circumstances, and even then primarily in the context in which Burnet v.
Logan was decided, the sale of property. Generally, taxpayers are held to the form of
their transactions, and cannot recharacterize them with the benefit of
hindsight; this reasoning would apply, in particular, to
middle-tier investors and others who benefited from a
pyramid scheme, especially if they were aware of the nature of the scheme. See
Parrish; Premji. [FN5] Apart from the Greenberg opinion, a memorandum
decision of the Tax Court, the Taylor case, which is ambiguous on this point, and
dicta in other opinions, we have found no authority for applying the open
transaction doctrine when payments on an instrument are denominated as a return
on investment and the recipient either receives the funds, or is in
constructive receipt but chooses to reinvest them. Finally, in these situations
it seems that the Code establishes a method whereby investors can recover their
cost—through either a bad debt or loss deduction. Arguably, it is
inconsistent with this statutory scheme (and perhaps unfair to those investors
who received no return on their investment) for investors to avoid the
restrictions of §§ 165 and 166 through the retroactive
recharacterization of prior receipts, in advance of the year a debt becomes
worthless or a theft loss is discovered, and when there may still be a
reasonable prospect of recovery that would further postpone cost recovery. We recognize that this treatment may appear unfair, especially as
applied to lower-tier investors who were unaware of the
true nature of the pyramid scheme at the time of the income payments, and
especially if the amounts were only constructively received and reinvested. We
note that whether constructive receipt applies is a factual determination, and
you may conclude that amounts were not properly reported as income because,
with respect to a particular loan, the promoter was not in
fact willing and able to pay. [FN6] See the discussion of constructive receipt
in Premji. However, if a payment of income was, in fact, actually or
constructively received, prior to the discovery of the fraud, we conclude that
an investor may not recharacterize it retroactively as a return of capital
under the open transaction doctrine. The remedy, in such a case, is a bad debt
or theft loss deduction. Note that, as discussed below, the Code does
contemplate the reduction of income received in years prior to the year a theft
loss is sustained in certain circumstances, through the application of the net
operating loss provision, § 172. (1) Were commissions earned by middle-tier
investors income in the year received? Section 61(a)(1) states that gross income includes compensation
for services, including fees, commissions, fringe benefits, and similar items. With respect to commissions earned by
middle-tier investors as a result of their enrolling new
investors in the scheme, there is no question of return-of-capital or open
transaction treatment. It seems clear that these amounts represented
compensation for services, includible in income when actually or constructively
received, regardless of whether the taxpayer was aware of the fraudulent nature
of the scheme. (2) May investors claim a theft loss under § 165 for
amounts received and reported as income, but reinvested in the scheme? Bad debt or theft loss Section 166(d) allows a noncorporate taxpayer a short-term capital
loss deduction for any nonbusiness debt that becomes worthless within the tax
year. Section 165(a) allows a deduction for any uncompensated loss
sustained during the tax year. Section 166, not § 165, governs the deduction of
worthless debts, Spring City Foundry Co. v. Commissioner, 292 U.S. 182 (1933), Rev.
Rul. 69-458, 1969-2 C.B. 33, and this is true even if worthlessness was
indirectly caused by fraud or theft. Rev. Rul 77-383, 1977-2 C.B. 66. However,
a loss that is the direct result of fraud or theft is deductible under
§ 165, even though the transaction takes the form of a borrowing. Rev.
Rul. 77-215, 1977-1 C.B. 51; Rev. Rul. 71-381, 1971-2 C.B. 126. As discussed above, whether a purported debt instrument is
respected as such for tax purposes depends primarily on whether the parties
recognized it as a binding obligation, and you may conclude that some of the
loan obligations issued in this scheme should be treated as bona fide debt. If
so, then with respect to those instruments the investor would be entitled to a
bad debt deduction under § 166 if it became worthless. As a
nonbusiness bad debt, it would be a short-term capital loss, under §
166(d). With respect to those instruments that were not bona fide debt
(and assuming you conclude that the scheme met the definition of
theft for purposes of § 165), investors are
entitled to a theft loss deduction under § 165. Frustration of public policy With respect to certain investors who are found to have been
active and knowing participants in the scheme, there may be a ground for
disallowing a bad debt or theft loss deduction altogether. The Supreme Court has held that a deduction is not allowable where
to do so would severely and immediately frustrate a sharply defined national or
state governmental declaration of policy. See Commissioner v. Tellier, 383 U.S. 687 (1966); Tank
Truck Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958). While
this doctrine has been superseded by specific legislation for purposes of
§§ 162 and 212, it still applies in the context of other Code
provisions, such as § 165. See Rev. Rul. 77-126, 1977-1 C.B. 47; Wood
v. Commissioner, 863 F.2d 417, 420-22 (5th Cir. 1989). If a taxpayers activities in connection with a claimed
theft loss are contrary to public policy, that may be grounds for denying a
theft loss deduction. See Richey v. Commissioner, 33 T.C. 272 (1959); Mazzei
v. Commissioner, 61 T.C. 497 (1974). In Lincoln v. Commissioner, T.C. Memo. 1985-300,
the taxpayer was swindled in connection with his participation in a scheme to
buy stolen money at a discount. The court did not allow a theft loss deduction,
stating that it is as important to the policy of the state and nation
to prevent attempts to buy stolen goods as it is to prevent an actual purchase
[of stolen goods]. The same reasoning could apply to a claimed bad
debt loss under § 166. [FN7] Section 165(c)(2) or 165(c)(3) Section 165(c) limits loss deductions for individuals to business
losses, § 165(c)(1); losses incurred in a transaction entered into for profit,
§ 165(c)(2); and nonbusiness, noninvestment losses that arise from
casualty or theft, § 165(c)(3). Section 165(h) imposes certain limits
on deductions in the last category. Section 165(e) provides that any loss arising from theft is
treated as sustained during the tax year in which the taxpayer discovers the
loss. Since the investors entered into the loan transactions with an
expectation of profit, arguably their losses are deductible under §
165(c)(2), not § 165(c)(3)—although the timing of the loss
would still be governed by § 165(e). See, for example, the
governments apparent concession to this effect in Premji. However, the
official position of the Service is that such a loss is deductible only under
§ 165(c)(3). See Rev. Rul. 71-381. As such, it is subject to the
limitations in § 165(h). Treatment of reinvested amounts The amount of the deduction under both § 165 and
§ 166 is limited to the taxpayers basis.
§§ 165(b), 166(b). In the present case, an investors basis in an
instrument—for purposes of § 165 or § 166, as the
case may be—would include the investors original
investment, less any amounts reported as return of principal, plus amounts
reinvested (including amounts actually or constructively received, reported as
interest income, and reinvested). See the discussion in Premji. Year of deduction A short-term capital loss deduction for a nonbusiness debt is
allowable in the year of total worthlessness. § 166(d)(1)(B);
§ 1.166-5(a)(2). Generally, a loss is sustained in the taxable year in which the
loss occurs as evidenced by a closed and completed transaction and as fixed by
identifiable events. See § 1.165-1(d)(1). Section 165(e) and
§ 1.165-8 of the Income Tax Regulations provide that a loss arising
from a theft shall be treated as sustained during the taxable year in which the
taxpayer discovers the loss. Section 1.165-8(a)(2) provides that if in the year the taxpayer
discovers the loss arising from a theft there exists a claim for reimbursement
with respect to which there is a reasonable prospect of recovery, no portion of
the loss for which reimbursement may be received is sustained, for purposes of
section 165, until the taxable year in which it can be ascertained with
reasonable certainty whether or not such reimbursement will be received. See
also § 1.165-1(d)(3). Therefore, a theft loss deduction will be barred
to the extent that a reasonable prospect of reimbursement exists. If the theft
loss exceeds the claim for recovery, the excess would be deductible in the year
the theft is discovered. Ramsay Scarlett & Co. v. Commissioner, 61 T.C. 795 (1974),
affd, 521 F.2d 786 (4th Cir. 1975). Although the test for worthlessness of a debt, for purposes of
§ 166, is not necessarily identical to the test for when a loss is
sustained, for § 165 purposes, a reasonable prospect of recovering on
a nonbusiness debt will generally postpone a deduction under § 166(d),
since the debt is not totally worthless. See §§ 1.166-2(a),
1.166-5(a)(2); Aston v. Commissioner, 109 T.C. 400, 415-16 (1997); Crown v.
Commissioner, 77 T.C. 582, 598 (1981). Whether the investors in the present situation had a reasonable
prospect of recovery at a given point in time is a question of fact. However,
substantial amounts were seized before the filing of the Chapter 7 bankruptcy
proceeding, and although these amounts represented only a percentage of the
creditors claims the trustee could reasonably have been expected to
recover additional amounts. We agree that these facts do not lead to an
inference that the losses were deductible, as bad debts or theft losses, in the
year the bankruptcy petition was filed. A deduction may be available under § 165, however, to the
extent the bankruptcy court has limited the amount it will attempt to recover.
A taxpayer may deduct that portion of a loss that is not covered by a claim for
reimbursement as to which there is a reasonable prospect of recovery.
§ 1.165- 5(d)(ii). You have indicated that the bankruptcy court has
reduced the total claim of at least some investors by amounts they previously
received as interest. As discussed above under Issue (1), for tax purposes
those payments are properly treated as income, rather than a return of capital;
as such, the payments would not reduce the taxpayers basis in their
investment. Assuming that they do not have avenues of recovery other than the
bankruptcy proceeding, therefore, investors in this situation would be able to
deduct the excess of their basis over the amount of the bankruptcy claim; this
partial loss deduction would not be postponed by the bankruptcy proceeding.
Note that this treatment would not apply to any obligations that you determine
were bona fide loans, since a deduction is not available under §
166(d) for the partial worthlessness of a nonbusiness debt. Possible net operating loss carryback Investors whose theft losses exceed their income in the year the
losses are sustained may be able to carry back the losses against prior
years income as a net operating loss under § 172. Although
§ 172 is primarily concerned with business operating losses, a loss
arising from casualty or theft is allowable in computing a net operating loss
regardless of whether it arises in a business, investment, or personal context.
§ 172(d)(4)(C). In addition, although a net operating loss can
generally be carried back two years and forward 20 years, the former three-year
carryback has been retained for casualty and theft losses. §
172(b)(1)(F)(ii)(I). CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS *** This writing may contain privileged information. Any unauthorized
disclosure of this writing may undermine our ability to protect the privileged
information. If disclosure is determined to be necessary, please contact this
office for our views. Please call (202) 622-5020 if you have any further questions. FN1. It is unclear from the Taylor opinion whether this issue was
conceded by the government, whose primary argument was that the investment was
made by the partners, not the partnership. FN2. Courts have treated proceeds from fraudulent schemes as
income even though the perpetrator may have had a vague hope of repaying
investors eventually, and even though certain amounts were repaid to facilitate
the scheme. See McSpadden v. Commissioner, 50 T.C. 478 (1968); see also Moore
v. United States, 412 F.2d 974, 978 (5th Cir. 1969); Webb v. Internal Revenue
Service,
823 F. Supp. 29 (D. Mass. 1993), affd, 15 F.3d 203 (1st Cir. 1994). FN3. A similar rule applies if the debt instrument has original
issue discount, see § 1.1275-2(a), although, for purposes of this
memorandum, we assume that the interest in question is not original issue
discount. FN4. Note that this does not mean that all payments necessarily
constituted interest. If a payment on an obligation exceeded the amount of
accrued and unpaid interest on that obligation, the excess would properly have
been treated as a return of principal under § 1.446-2(e). FN5. Arguably, active participants in the scheme should be held to
the form of their transaction even if they became aware of the nature of the
scheme—and aware of the possibility that they might not recover their
investments as the scheme unraveled—before innocent investors did. FN6. Note that the issue of constructive receipt is a threshold
question. If you conclude that an investor did not constructively receive a
payment that was reinvested in the scheme, you do not reach
the income/capital characterization issue. FN7. Loss deductions are often disallowed altogether for taxpayers
who participate in a sham transaction. See, e.g., Viehweg
v. Commissioner, 90 T.C. 1248 (1988); Marine v. Commissioner, 92 T.C. 958 (1989),
affd, 921 F.2d 280 (9th Cir. 1991), cert. denied, 502 U.S. 819
(1991). The rationale is that the taxpayers suffered no economic loss, since
they got what they bargained for: a tax shelter. Marine, 92 T.C. at 978; Rev.
Rul. 70-333, 1970-1 C.B. 38. This rationale does not apply in the present case.
Although the scheme may have been a sham, in that the promoters
misrepresentations masked its substance, it was not a tax shelter and the
investors potential losses are real. This document may not be used or cited as precedent. Section
6110(j)(3) of the Internal Revenue Code. |