Tax Treatment of "Ponzi" Scheme Losses

"Ponzi" schemes are fraudulent investment arrangements in which the party perpetrating the fraud receives cash or property from investors, purports to earn income for the investors, and reports to the investors income amounts that are wholly or partially fictitious. Payments, if any, of purported income or principal to investors are made from cash or property that other investors invested in the fraudulent arrangement.  The party perpetrating the fraud criminally appropriates some or all of the investors' cash or property.

The IRS has issued guidance addressing the tax treatment of losses due to criminally fraudulent investment arrangements in the form of "Ponzi" schemes.  The guidance provides that investors in such schemes will be entitled to claim a theft loss under the casualty loss rules, rather than a capital loss, because the perpetrators of such fraudulent schemes actually deprive investors of money by criminal acts.  In addition, since the loss is from a transaction entered into for profit, it is neither subject to the $100 ($500 for 2008) nor the 10% of gross income (AGI) personal loss limitations. 

The theft loss is deductible in the year it is discovered, provided that it is not covered by a claim for reimbursement, or other recovery as to which the investor has a reasonable prospect of recovery.  The amount of the theft loss deduction includes the amount invested in the scheme, less any amounts withdrawn, reimbursements, and claims as to which there is a reasonable prospect of recovery.  The deductible amount also includes any fictitious income that was reported to the investor in years prior to the discovery of the theft that was included in the investor's gross income, and reinvested in the scheme.

To the extent an investor's theft loss deduction exceeds the investor’s income for the year, a net operating loss (NOL) is created which allows the investor to carry that loss back up to three years and forward up to twenty years until used up.  Under a special rule for 2008, an eligible small business with a 2008 NOL can elect a 3-, 4-, or 5-year NOL carryback.

The IRS has provided a safe harbor for taxpayers to enable them to deduct losses from fraudulent investment schemes as theft losses.  The new procedure also provides guidance for taxpayers choosing not to use the safe harbor, but who plan to deduct investment fraud losses under the theft loss provisions of Code Sec. 165.  The procedure applies to investment fraud losses discovered in tax years after 2007.
 
The IRS procedure and rules related to claiming losses from fraudulent investments is somewhat complicated and includes certain qualifications and disclosure requirements.  Keep in mind that fraud must be involved, not just losses from investments.  If you or someone close to you has been a victim of a “Ponzi” scheme or, for that matter, any other type of investment fraud, please call this office for additional information about the available tax options.

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