Theft Loss Deduction for Losses from Fraudulent or Ponzi Schemes, 05-01-2009

We at MH are always on the lookout for possible scams which may defraud our clients. Always be wary of investment schemes that seem too good to be true – they probably are. If you do happen to fall prey to one of these plots, the good news is that the IRS provides for problems like this. Continue reading to understand your options on your tax returns…

The recent downturn in the economy has exposed a number of fraudulent financial schemes in the United States. The most notable of these was perpetuated by Bernie Madoff in New York City. Responding to this and several other of these schemes, the IRS has recently issued two separate Revenue Rulings to give guidance to US taxpayers on how to account for these losses for income tax purposes.

The reason this has recently come to light is inherent in the nature of these arrangements. When a ‘Ponzi’ or other type of fraudulent scheme is being perpetuated, it is reliant upon new money coming into the deal from new investors. Fraudulent returns are paid with new money to the deal rather than with actual earnings. Therefore, when the economy slows and the flow of money is diminished, it exposes the shortcomings of the investment in question. Because many of these schemes have come to light due to the current state of our economy, the IRS has issued guidance so that taxpayers and their representatives can deal with the losses correctly.

A theft loss is deductible in the year it is discovered, provided that it is not covered by a claim for reimbursement or the taxpayer has no reasonable belief that a recovery will be made. The amount of a theft loss deduction includes the original amount invested, less any withdrawals received. The amount deductible also includes any fictitious income that was reported to the investor in the years prior to the discovery of the theft. Therefore, it is necessary for an affected investor to review their prior tax returns to see if they paid tax on ‘phantom’ income that can be added to their current year loss.

The new Revenue Rulings are taxpayer favorable and make it clear how to deal with fraudulent scheme losses. The IRS has provided a safe harbor for taxpayers to enable them to deduct losses from fraudulent investment schemes as theft losses. The requirements necessary to rely on these new safe harbor rules are as follows:

  • The loss must be from a “specified fraudulent arrangement” which generally is a Ponzi scheme that takes cash or other assets from investors, purports to earn income for investors, reports fictitious income, and/or makes any payments from funds contributed by other investors and not from bona fide earnings and appropriates investors’ cash or other assets.
  • The loss must be a “qualified loss” resulting from a specified fraudulent arrangement of which the “lead figure” in charge of the scheme was charged (or admitted guilt) under state or federal law with committing fraud, embezzlement, or other similar crime, that, if proven, would meet the definition of theft under Internal Revenue Code Section 165.
  • The taxpayer must be a “qualified investor” in that he or she must be generally qualified to deduct theft losses under Section 165, did not have knowledge that the arrangement was fraudulent before it was publicly disclosed, and invested cash or other assets in the arrangement.

If all of the above requirements are met, then the taxpayer may take a deduction for 95% of the theft loss incurred on their tax return in the year the fraud was detected. This deduction falls to 75% if the investor is suing a third party with hopes of some recovery of investment. For a tax payer to take the loss on their tax return, a detailed statement is required by the IRS. The contents of this statement are detailed out in the IRS guidance; your tax advisor should be consulted to ensure this is properly prepared. This statement must be signed by the taxpayer.