Rev Proc 2008 50: Ponzi Scheme Theft Loss Deduction

Revenue Procedure 2009-20 offers a safe harbor for taxpayers who have suffered losses in “specified fraudulent arrangements,” more commonly known as Ponzi schemes. This guidance provides a simplified and predictable method for victims to claim a theft loss deduction, removing some of the evidentiary burdens associated with proving a theft loss for tax purposes.

This relief allows an investor to claim a substantial portion of their loss without the difficult process of demonstrating the exact nature and timing of the theft. Instead of waiting for legal proceedings to conclude, the revenue procedure allows the loss to be claimed in the year the fraud is discovered, providing more immediate tax relief and ensuring consistency.

While the Tax Cuts and Jobs Act of 2017 suspended the deduction for most personal casualty and theft losses through 2025, this limitation does not apply to Ponzi scheme losses. Because these are considered losses from an income-producing activity or a transaction entered into for profit, the safe harbor deduction remains available to eligible taxpayers.

Qualifying for the Safe Harbor

To use the safe harbor method, an individual must be a “qualified investor,” which is a person who transferred cash or property to a specified fraudulent arrangement. This includes individuals who invested directly or through a third party, provided their funds were ultimately transferred to the scheme with an expectation of profit.

The investment must be in a “specified fraudulent arrangement,” which refers to a scheme where a lead figure has been formally charged by indictment or criminal complaint with a crime like fraud or embezzlement. The legal action must allege that the lead figure’s actions caused the investors’ losses, which provides the trigger for the safe harbor’s availability.

Several other conditions must also be met. The investor must have been unaware of the fraudulent nature of the arrangement before it became public knowledge to ensure only unwitting victims can use this relief. Furthermore, the arrangement cannot be a tax shelter as defined by the tax code.

The investor must also agree not to deduct the loss outside of the safe harbor provisions. By choosing this method, the taxpayer accepts the specific calculation and timing rules, and the safe harbor becomes the exclusive means of deduction once elected.

Calculating the Theft Loss Deduction

The calculation of the deductible loss under the safe harbor is a multi-step process. The starting point is to determine the initial investment basis by summing all the cash or the fair market value of property that the qualified investor contributed to the fraudulent arrangement.

The calculation also involves accounting for “phantom income.” This is income reported to the investor on tax forms, such as Form 1099-DIV or Form 1099-INT, but was never actually received. Because the investor likely paid taxes on this phantom income, the IRS allows these reported amounts to be added to the investment basis. This step ensures the loss reflects not just the principal lost but also the taxes paid on non-existent earnings.

From this augmented basis, the next step is to subtract any amounts the investor received from the arrangement, including all withdrawals or distributions. Any actual or potential reimbursements from other sources, such as the Securities Investor Protection Corporation (SIPC) or insurance policies, must also be subtracted.

Once the net loss is calculated, a percentage is applied to determine the final deductible amount. An investor who does not intend to pursue recovery from third parties can deduct 95% of their calculated loss. If an investor is pursuing or intends to pursue such a third-party claim, the deduction is limited to 75% of the loss.

For example, assume an investor put $200,000 into a scheme, was issued tax forms showing $50,000 in phantom income, and withdrew $25,000. Their net loss calculation would be ($200,000 + $50,000) – $25,000 = $225,000. If this investor does not plan to sue any third parties, they can claim a theft loss deduction of $213,750 (95% of $225,000). If they do intend to pursue recovery, their deduction would be $168,750 (75% of $225,000).

How to Claim the Deduction

The deduction must be claimed in the “discovery year,” which is the taxable year in which the lead figure of the fraudulent arrangement is formally charged by indictment, information, or criminal complaint. The loss cannot be claimed in the year the investor realized they were a victim, but only in the year of the official legal action.

To claim the deduction, taxpayers must use Form 4684, Casualties and Thefts. The IRS has a specific section on this form, Section C, “Theft Loss Deduction for Ponzi-Type Investment Scheme,” for taxpayers using the safe harbor.

The calculated loss from Section C is then entered in Section B of the form, which is for losses from income-producing property. Completing Section C replaces the need to create and attach a separate statement detailing the loss.

Post-Filing Rules and Considerations

If an investor receives any money in a subsequent year related to the theft loss, this amount is treated as a recovery. Such recoveries, whether from a bankruptcy proceeding or a settlement, must be included in the investor’s gross income for the year they are received. This is governed by the tax benefit rule, which requires income inclusion for a recovery of an amount that produced a tax deduction in a prior year.

A significant theft loss can result in a Net Operating Loss (NOL), which occurs when a taxpayer’s deductions for a year exceed their income. A theft loss from a Ponzi scheme is treated as a business loss for calculating an NOL. This allows an individual’s loss to create or increase an NOL, which can be carried to other tax years to offset income and reduce tax liability.

The rules also address investors whose recovery intentions change. An investor who initially claimed the 75% deduction because they were pursuing recovery from a third party might later decide to abandon that effort. In that year, they are permitted to claim an additional deduction for the remaining 20% of the loss, which is claimed on that year’s tax return.