January 2015

The current tax season brings some small consolation to victims of Ponzi schemes and certain other financial fraud, with the Internal Revenue Service (“IRS”) allowing duped investors to obtain partial relief in the form of a theft loss tax deduction.  Internal Revenue Code (“IRC”) 165(a) provides that a theft loss incurred in a transaction entered into for profit and sustained during the taxable year is deductible to the extent it is not compensated by insurance or otherwise recovered.

For federal income tax purposes, “theft” covers “any criminal appropriation of another’s property to the use of the taker, including theft by swindling, false pretenses and any other form of guile.”  In order to qualify as a theft loss, the taxpayer must demonstrate that the act was done with criminal intent, but does not require a conviction.  The IRS describes that a Ponzi scheme fits this definition because the perpetrator specifically intended to, and did, deprive the investor of money by criminal acts.  Revenue Ruling 2009-9 addresses the tax treatment of losses from criminally fraudulent investment arrangements that take the form of Ponzi schemes.  In contrast, a loss sustained on an open market stock investment, even if the loss is attributable to fraudulent activities of the corporation’s officers or directors, is a capital loss.  The IRS describes that this is because the officers or directors did not have the specific intent to deprive the shareholder of money or property.

The allowable theft loss deduction is the basis of the property (i.e. the amount of money) that was lost, less any reimbursement or other compensation received or reasonably expected.  Often in fraudulent investment schemes a court-appointed trustee or receiver is assigned to recover assets derived from the scheme, including clawback actions for amounts paid to net winners (investors who profited from the scheme by receiving payments in excess of their investment, albeit generally without knowledge of the fraud) and distribute the proceeds to victims as a full or partial recovery of their theft losses. The calculation of the loss therefore includes:

  1. The original amount invested
  2. Any subsequent investments
  3. Any amount reported as gross income in prior years and reinvested (not withdrawn)
  4. Less any amounts actually withdrawn
  5. Less any reasonably certain prospects of recovery

The above amount is deductible in the taxable year the theft was discovered.  To the extent that a larger than originally reported recovery is obtained (or reasonably expected) in a later year, the incremental amount is included in gross income in that later year under the tax benefit rule, but only to the extent the earlier deduction reduced income tax.  If instead a smaller than originally expected recovery is obtained/later reasonably expected, an additional deduction is available in that year.  The taxpayer may not amend a prior year’s income tax return to match the ultimate recovery.  However, a theft loss in a transaction entered into for profit may create or increase a net operating loss that can be carried back up to 3 years (with different options available to eligible small businesses) and forward up to 20 years.

The above is not a complete discussion of all circumstances that may affect your tax position and one should consult a tax professional for advice on your specific situation.  Of course, it is certainly better to avoiding investing in a Ponzi scheme altogether than to later obtain a theft loss deduction for tax purposes.  This related article includes information on how to avoid a Ponzi scheme.

Fulcrum Inquiry performs fraud audits, and other financial investigations. Our experience includes assisting with asset recoveries and related accountings when financial frauds have occurred.