The Tax Impact of Ponzi Scheme Investments

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Jason B. Freeman

Jason B. Freeman

Managing Member


Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

The Tax Impact of Ponzi Scheme Investments

Victims of Ponzi schemes run by fraudulent investment brokers may not realize for several years that the brokers are fraudulently reporting earned income. In a typical Ponzi scheme, the broker represents to the investor that these dividends are being reinvested. Thus, victims are likely to report such income (e.g., interest) as gross income when filing taxes. When the scheme inevitably collapses, and the victims are left with nothing from their investments, the Internal Revenue Code provides multiple ways for them to receive deductions for the loss sustained in the fraudulent scheme, and to recapture some of the taxes they paid on “phantom income”[1]—that is, taxes on money that they never made in the first place.


When a defrauded investor in a Ponzi scheme discovers the fraud, she can claim the loss of her investments as theft loss under IRC § 165(e) as long as there is no reasonable prospect of recovery.[2] Whether a reasonable prospect of recovery exists is a factual inquiry dependent on all the relevant facts and circumstances.[3] Courts have held that victims have a reasonable prospect of recovery when they have bona fide claims for recoupment against third parties, and there is a substantial likelihood that such claims will be decided in favor of the victims.[4] As described by Revenue Ruling 2009-9, the amount of theft loss that the victim can claim is (1) any amount invested in the fraudulent enterprise, less amounts withdrawn, and (2) phantom income.[5]

Due to the highly factual and uncertain nature of determining theft losses, the IRS issued Revenue Procedure 2009-20 to provide a safe harbor for defrauded investors.[6] Under this safe harbor, the IRS will not question the facts of theft losses claimed by qualified investors.[7] Victims can calculate the amount of theft loss under this provision by multiplying the amount of the investment by 95% (if the victim is not going to seek recovery from a third party) or 75% (if the victim is going to seek recovery from a third party), then subtracting from this product actual recovery or anticipated insurance recovery.[8] Taxpayers that elect to seek recovery under the safe harbor can claim theft loss even when they have a reasonable prospect of recovery.

Clawbacks on Ponzi Scheme Income

IRC § 1341 applies in situations where a taxpayer includes an item in gross income that the taxpayer thought she had an unrestricted right to, but finds out later to that she had no such right.[9] An example of this scenario would be a taxpayer whose profits in a Ponzi scheme are clawed back to be distributed to other victims of the scheme. The taxpayer, thinking she has a right to the profit, withdraws it and reports that amount as income to pay taxes on it, despite the fact that she is later forced to forfeit that amount once the scheme collapses.

Taxpayers in this situation may be entitled to a deduction or credit for this amount in the year that they pay it back.[10]When the amount of this deduction exceeds $3,000, which it usually does in a Ponzi scheme scenario, the deduction allowed is the lower of (1) the tax for the clawback year computed with such deduction, or (2) the difference between the tax on the clawback year without this deduction, and the decrease in tax for the year the clawed-back income was originally reported that results from the exclusion of the Ponzi scheme income from gross income.[11] In other words, the taxpayer can either deduct the clawback payment from her income in the year the clawback is repaid, or she can claim a credit in the clawback year in an amount equal to the total tax in the clawback year (with the clawed-back amount included as income) minus the difference between what the taxpayer actually paid in taxes when she originally reported the Ponzi scheme income and what she would have paid in taxes had she never reported the Ponzi scheme income. This ensures that taxpayers get some recovery for clawbacks since they cannot claim them as theft-loss.[12]


Section 1341:

(a) General rule 


(1) an item was included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such item;
(2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and
(3) the amount of such deduction exceeds $3,000,
then the tax imposed by this chapter for the taxable year shall be the lesser of the following:
(4) the tax for the taxable year computed with such deduction; or

(5) an amount equal to—

(A) the tax for the taxable year computed without such deduction, minus
(B) the decrease in tax under this chapter (or the corresponding provisions of prior revenue laws) for the prior taxable year (or years) which would result solely from the exclusion of such item (or portion thereof) from gross income for such prior taxable year (or years).
For purposes of paragraph (5)(B), the corresponding provisions of the Internal Revenue Code of 1939 shall be chapter 1 of such code (other than subchapter E, relating to self-employment income) and subchapter E of chapter 2 of such code.

(b) Special rules

(1) If the decrease in tax ascertained under subsection (a)(5)(B) exceeds the tax imposed by this chapter for the taxable year (computed without the deduction) such excess shall be considered to be a payment of tax on the last day prescribed by law for the payment of tax for the taxable year, and shall be refunded or credited in the same manner as if it were an overpayment for such taxable year.
(2) Subsection (a) does not apply to any deduction allowable with respect to an item which was included in gross income by reason of the sale or other disposition of stock in trade of the taxpayer (or other property of a kind which would properly have been included in the inventory of the taxpayer if on hand at the close of the prior taxable year) or property held by the taxpayer primarily for sale to customers in the ordinary course of his trade or business. This paragraph shall not apply if the deduction arises out of refunds or repayments with respect to rates made by a regulated public utility (as defined in section 7701(a)(33) without regard to the limitation contained in the last two sentences thereof) if such refunds or repayments are required to be made by the Government, political subdivision, agency, or instrumentality referred to in such section, or by an order of a court, or are made in settlement of litigation or under threat or imminence of litigation.
(3) If the tax imposed by this chapter for the taxable year is the amount determined under subsection (a)(5), then the deduction referred to in subsection (a)(2) shall not be taken into account for any purpose of this subtitle other than this section.

(4) For purposes of determining whether paragraph (4) or paragraph (5) of subsection (a) applies—

(A) in any case where the deduction referred to in paragraph (4) of subsection (a) results in a net operating loss, such loss shall, for purposes of computing the tax for the taxable year under such paragraph (4), be carried back to the same extent and in the same manner as is provided under section 172; and
(B) in any case where the exclusion referred to in paragraph (5)(B) of subsection (a) results in a net operating loss or capital loss for the prior taxable year (or years), such loss shall, for purposes of computing the decrease in tax for the prior taxable year (or years) under such paragraph (5) (B), be carried back and carried over to the same extent and in the same manner as is provided under section 172 or section 1212, except that no carryover beyond the taxable year shall be taken into account.

(5) For purposes of this chapter, the net operating loss described in paragraph (4)(A) of this subsection, or the net operating loss or capital loss described in paragraph (4)(B) of this subsection, as the case may be, shall (after the application of paragraph (4) or (5)(B) of subsection (a) for the taxable year) be taken into account under section 172 or 1212 for taxable years after the taxable year to the same extent and in the same manner as—

(A) a net operating loss sustained for the taxable year, if paragraph (4) of subsection (a) applied, or
(B) a net operating loss or capital loss sustained for the prior taxable year (or years), if paragraph (5)(B) of subsection (a) applied.


[2] Kaplan v. United States, 2007 U.S. Dist. LEXIS 59684, at *14-15 (M.D. Fla. Aug. 15, 2007) (citing 26 C.F.R. § 1.165-1(b)); see IRS Rev. Rul. 2009-9, 2009 I.R.B (April 6, 2009), at 3-4 [hereinafter “Revenue Ruling”].

[3] Revenue Ruling at 7.

[4] Vincentini v. Comm’r of Internal Revenue, 2011 U.S. App. LEXIS 14349 (6th Cir. July 12, 2011).

[5] See Beacon Assocs. Mgmt. Corp. v. Beacon Assocs. LLC I, 725 F. Supp. 2d 451, 462 (S.D.N.Y. 2010); Revenue Ruling at 8.

[6] Rev. Proc. 2009-20, 2009-1 C.B. 749 (I.R.S. March 17, 2009) at 2.

[7] Id. at 7-8.

[8] Id. at 8.

[9] See IRC § 1341(a)(1); Revenue Ruling at 10.

[10] See id. at § 1341(a)(2).

[11] Id. at § 1341(a)(3)-(5); Revenue Ruling at 11.

[12] Revenue Ruling at 13.



White Collar Defense Attorneys

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