Question

Henry invests $50,000 in an entity called Forward Investments on January 20, 2018. Under the terms of the investment agreement, the $50,000 is considered a loan that Forward will use to invest in derivative contracts. Henry is to receive 2% of the amount Forward earns each month from his investment plus 10% simple interest on funds left invested for a full year. Henry can withdraw part or all of his investment at any time on 10 days' notice to Forward.
During 2018, Henry receives quarterly statements of earnings on his investment in Forward. As of December 31, 2018, the statements indicate that Henry has earned $9,600. In January 2019, Henry hears a rumor that Forward Investments is not a legitimate investment broker. On January 26, 2019, Henry withdraws his investment, receiving $60,050 (the $50,000 original investment plus $10,050 in earnings). In late February, he learns that Forward Investments is a pyramid scheme through which early investors were paid earnings out of capital contributions by later investors. The U.S. Securities and Exchange Commission files suit against Forward in March 2019.
Henry wants to know the taxability of the amounts he received from Forward. He thinks that he never really earned any income from his investment because he was paid out of later investors' capital contributions. Write Henry a letter explaining the income tax effects of the payments he received from Forward Investments.

In a memo

Please include these headings:

• Facts
• Issues
• Conclusions
• Reasoning

Answer 1

Write Henry a letter explaining the income tax effects of the payments he received from Forward Investments.

Answer:-

Under Sec. 61, all income received is taxable unless specifically excluded. The fact that the $10,050 in earnings that Henry received is paid from other investor's contributions does not negate the increase in wealth he receives from his investment. The only question to be resolved is when to recognize the income. In Wright v. Comm., 931 F.2d 61 (9th Cir., 1991), the taxpayer contended that income from an illegal Ponzi scheme is not recognized until it is actually received, overriding the constructive receipt of the income as it is credited to their account. The 9th Circuit affirmed the decision of the Tax Court, which held that because the taxpayers are not the embezzlers, the proposition that illegally obtained income is not taxable until the year of actual receipt did not apply to them. The court found that because the taxpayer has an unrestricted right to the income when it is credited to his account, the income is taxable at that time. Applying Wright to Henry's situation, the $9,600 of earnings in 2018 is available for him to withdraw at any time. Therefore, he is in constructive receipt of the $9,600 and must include it in his 2018 income. The remaining $450 of income is taxable when it is received in 2019.