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The “Safe Harbor” needs to be studied carefully

It is important to remember that the IRS is not in business to give back money.

The “Safe Harbor” (Rev. Proc. 2009-20) needs to be studied carefully, because it could be extremely expensive from a tax standpoint. It might be a safe harbor — but the tax cost to dock your boat in this harbor could be very high.

To provide a very simplistic example, assume that there are $30 billion of Ponzi scheme losses that would be able to receive theft loss tax benefits. Assume that this Ponzi scheme Income or amounts of principal, when taxed, were in the highest tax brackets. Therefore, again, to keep it simple, assume the average tax bracket is 35% for the Ponzi Income included in Income by taxpayers in prior years. Taxes collected $10.5 billion (35% x $30 billion).

For reasons like this, many Ponzi scheme victims may choose not to avail themselves of the safe harbor of Rev. Proc. 2009-20. This is especially so because the legal guidance offered by Rev. Rul. 2009-9 is so helpful.

For many taxpayers, the “tax rights” that must be waived to take advantage of the “tax benefits” of the safe harbor could be very expensive and unnecessary. Many taxpayers will find that the tax benefits available by relying on the revenue ruling and other law are preferable alternatives to the benefits of the safe harbor.

Before Rev. Rul. 2009-9 was issued, there was a good deal of case law interpreting various aspects of the theft loss deduction. The cases relied on were at times 40 to 50 years old, and many reflect the absence of the type of forensic accounting that can be accomplished today. For this reason and others, although there was a great deal of case law interpreting the statutes and regulations, there remained a great deal of confusion about where certain lines were drawn.

The IRS has done an extremely good job of clarifying that confusion by way of Rev. Rul. 2009-9. These clarifications are very helpful, whether or not one chooses to be covered by the “safe harbor.” There are certain benefits to using the safe harbor, but most of the tax benefits granted by the safe harbor are no different from the tax benefits that the taxpayer would receive under the law as interpreted by Rev. Rul. 2009-9. However, to achieve these benefits, the safe harbor requires that the taxpayer must waive valuable potential tax rights.

Finally, the IRS is using a not-so-subtle form of administrative coercion to force the use of the safe harbor by announcing that those who do not choose the safe harbor may be subject to stricter standards of proof and increased audit potential.

Therefore, it is imperative that Ponzi scheme victims meet with their accountants and financial advisors that have the knowledge and facilities to compare the economic effect of the use of the safe harbor to that of reliance on the law in each individual situation.

Read Richard Lehman’s full Report No. 3: The Safe Harbor. This Report gives an example of how the safe harbor provision could be costly for some Ponzi scheme victims.

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