Ponzi Schemes and the Theft Loss Deduction
Every few months or so seem to bring new revelations of a Ponzi scheme gone bust. In the aftermath, erstwhile investors often struggle to be made whole again. Fortunately, the federal income tax offers options to help, although none are perfect.
Under the federal income tax, individuals currently have two ways to claim a deduction for losses due to Ponzi schemes: 1) follow the general rules for deducting theft losses under I.R.C. § 165 (which can be unduly burdensome), or 2) follow the “safe-harbor” under Revenue Procedure 2009-20 (which sets limitations on the deductible amounts of such losses).
I.RC. § 165, Generally
I.R.C. § 165 generally allows individuals to deduct losses not otherwise compensated for that are sustained during the taxable year in any transaction entered into for profit.[i] See I.R.C. § 165(a), (c)(2). This includes losses due to theft. See Treas. Reg. § 1.165-8(a)(1).
For federal income tax purposes, theft has a “general and broad connotation and includes any criminal appropriation of another’s property . . . .” Evensen v. Comm’r, T.C. Memo 2018-141 (citing Edwards v. Bromberg, 232 F.2d 107, 110 (5th Cir. 1956)). Still, a taxpayer claiming a theft loss deduction must demonstrate that there was a taking of property with criminal intent that was illegal under the law of the jurisdiction in which the taking occurred. See, e.g., Rev. Rul. 72-112. The taxpayer also must establish the amount of the loss, the year in which the taxpayer discovered the loss, and that there is no reasonable prospect of recovery in that year. See Treas. Reg. §§ 1.165-1(d), 1.165-8(a)(2).
Establishing these elements can be difficult. For instance, proving that a taking was illegal within a particular jurisdiction and that it was done with criminal intent often puts the taxpayer in the position of a prosecutor, only without the state’s investigative resources. For Ponzi schemes, especially, establishing when the taxpayer discovered that a theft has occurred can be problematic, since it is the nature such schemes to appear to be a legitimate investment opportunity. It also may be unclear at any given point whether there is a reasonable prospect of recovery. There may even be some question as to which jurisdiction’s law governs whether a taking is theft when the taking involves conduct in more than one state or country. See Giunta v. Comm’r, T.C. Memo 2018-180 (providing as a basis for rejecting a taxpayer’s theft loss deduction that the taxpayer had not proven which jurisdiction’s law would govern the “theft” inquiry).
Revenue Procedure 2009-20
Given the difficulty of establishing a theft loss deduction generally under I.R.C. § 165, the IRS has provided an optional safe-harbor for certain good faith investors claiming a deduction for losses arising from Ponzi-type schemes in which some specified legal action has been taken against the lead figure of the scheme. If a taxpayer meets the requirements of the safe harbor, the IRS will not challenge the taxpayer’s claim of a theft loss deduction in connection with such a scheme.
Revenue Procedure 2009-20, which first announced the safe harbor, speaks in terms of “specified fraudulent arrangements,” “qualified losses,” and “qualified investors.”
According to the Revenue Procedure, a “specified fraudulent arrangement” is “an arrangement in which a party (the lead figure) receives cash or property from investors; purports to earn income for the investors; reports income amounts to the investors that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investors’ cash or property.”
A “qualified loss,” on the other hand, is defined with respect to some legal action that the government has taken with respect to a lead figure. Thus, a “qualified loss” is a loss arising from a specified fraudulent arrangement in which:
- a lead figure was charged by indictment or information under state or federal law with a crime in connection with the arrangement that, if proven, would amount to theft for federal income tax purposes under the law of the jurisdiction in which the theft occurred, and the indictment or complaint has not been withdrawn or dismissed other than because of the lead figure’s death;
- a lead figure was the subject of a state or federal criminal complaint alleging theft, such complaint has not been withdrawn or dismissed other than because of the lead figure’s death, and either: (i) the complaint alleges the lead figure’s admission or execution of an affidavit admitting to the crime, or (ii) a receiver or trustee was appointed with respect to the arrangement, or the assets of the arrangement were frozen; or
- a lead figure, or an associated entity involved in the specified fraudulent arrangement, was the subject of a civil complaint or similar document that a state or the federal government has filed with a court or in an administrative agency enforcement proceeding, and (i) the civil complaint or similar document alleges facts that comprise substantially all of the elements of a specified fraudulent arrangement conducted by the lead figure; (ii) the lead figure’s death prevents an indictment, information, or criminal complaint from being filed against the lead figure; and (iii) a receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.
See id. (as modified by Rev Prov. 2011-58).
A “qualified investor” is a U.S. person that (1) generally qualifies to deduct theft losses, (2) did not have actual knowledge that the investment arrangement was fraudulent before it became publicly known, (3) did not use the specified fraudulent arrangement as a tax shelter, and (4) transferred cash or property to the specified fraudulent arrangement. Id.
Revenue Procedure 2009-20 states that the IRS will not challenge a qualified investor’s theft loss deduction for a qualified loss in the taxable year in which the indictment, information, or complaint against a lead figure was filed, if the amount of the deduction meets certain limitations. Id. In other words, the Revenue Procedure uses the state or federal government’s action in bringing criminal charges against a lead figure as a proxy for the taxpayer’s discovery of the theft.
The amount of theft loss deduction that the IRS will allow under the Revenue Procedure 2009-20 is determined by multiplying the amount of the investor’s qualified investment by 95% (for a qualified that does not pursue potential third-party recovery) or 75% (for a qualified investor that is pursuing or intends to pursue potential third-party recovery), and then subtracting the sum of an any actual recovery and claims for reimbursement for the qualified loss that are attributable to insurance policies, contractual arrangements, or amounts payable from the Securities Investor Protection Corporation. Id. In this context, a “qualified investment” means the total cash or basis of property that the qualified investor invested in the arrangement plus the total net income with respect to the fraudulent arrangement that the qualified investor included as income for federal tax purposes, minus the total amount of cash or property that the qualified investor withdrew from the specified fraudulent arrangement. Id. A qualified investor may have income in a future year depending on the actual amount of the loss that is recovered. Id.
Procedurally, a taxpayer claiming the safe harbor under Revenue Procedure 2009-20 must write “Revenue Procedure 2009-20” at the top of the Form 4684 for the federal tax return for the discovery year and complete and sign a statement that will be attached with the return.
While the safe harbor in Revenue Procedure 2009-20 provides more certainty and mitigates some of the harshness that taxpayers face in claiming a theft loss deduction generally under I.R.C. § 165, it is hardly perfect. Taxpayers left reeling in the aftermath of a Ponzi scheme should consult with tax counsel to figure out possible options for being made as close to whole again as possible.
 As the FBI explains:
“Ponzi” schemes promise high financial returns or dividends not available through traditional investments. Instead of investing the funds of victims, however, the con artist pays “dividends” to initial investors using the funds of subsequent investors. The scheme generally falls apart when the operator flees with all of the proceeds or when a sufficient number of new investors cannot be found to allow the continued payment of “dividends.”