Henry invests $50,000 in an entity called Forward Investments on January 20, 2019. 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 percent of the amount Forward earns each month from his investment plus 10 percent 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 2019, Henry receives quarterly statements of earnings on his investment in Forward. As of December 31, 2019, the statements indicate that Henry has earned $9,600. In January 2020, Henry hears a rumor that Forward Investments is not a legitimate investment broker. On January 26, 2020, 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 2020.

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.