The recent investigation and shutdown of an alleged Ponzi (or pyramid) scheme known as Zeek Rewards made me think about what advice I could give clients who may have gotten stung. My practice is generally limited to corporate and business law issues, not tax matters, but I found this very good article that offers to explain a specific tax deduction that may be available to victims. Be advised: This blog is for your information only, and not intended as legal or tax advice, and should not be relied upon for any purpose without the services of a qualified professional.
Ponzi Scheme Tax Advice, by Robert Wood
Fortunately, when you are defrauded you can usually claim a tax loss. Of course, a loss on your taxes hardly makes you whole. If you’re in a 35% tax bracket, a deductible loss [still] costs you 65%, with the government picking up the rest.
IRS theft loss deductions come in many guises and the IRS has specifically addressed Ponzi schemes. If you’re the victim of a Ponzi scheme there’s some retroactive good news applying to any year after Dec. 31, 2007. Shortly after Madoff’s guilty plea the IRS provided safe harbors for victims of “specified fraudulent arrangements”—IRS speak for Ponzi scheme. These rules were designed to eliminate uncertainty about when you could claim losses and in what amount.
With a Ponzi scheme, records won’t be clear about what is real and what is fake. See Revenue Procedure 2009-20. The filing of criminal charges was a key threshold to this 2009 relief, but the IRS recognized there wouldn’t be criminal charges if the perpetrator was deceased. Thus, Revenue Procedure 2009-20 listed safe harbors for Ponzi scheme victims, to address situations where a lead figure died and foreclosed criminal charges.
Now, in Revenue Procedure 2011-58, the IRS has modified the definition of a “qualified loss” retroactive to 2007. This IRS Revenue Ruling allows investors a theft loss, not a capital loss. A theft loss from a Ponzi scheme is not subject to the normal limits on losses from investments. Those rules normally allow only $3,000 a year beyond capital gains from investments.
You [may] deduct it in the year you discover the fraud unless you have a claim with a reasonable prospect of recovery. Determining the year of discovery and applying the “reasonable prospect of recovery” rule depends on your facts. This IRS Revenue Procedure (2011-58) provides two assumptions taxpayers can use to report losses.
Your theft loss can include your unrecovered investment, including income you reported in past years. Investors generally can claim a theft loss deduction for the net amount invested and even for the “fictitious income” the promoter of the scheme credited to you account—on which you paid tax—before you discovered the fraud.
Some taxpayers argue they should be allowed to amend prior tax returns since the income most Ponzi scheme victims were reporting in the past was fictitious. But the IRS generally disagrees with this approach and doesn’t address it in its Ponzi guidance.