Ponzi Schemes And The Theft Loss Deduction

• Published date: 31 January 2022
• Subject Matter: Tax, Criminal Law, Income Tax, White Collar Crime, Anti-Corruption & Fraud
• Law Firm: Freeman Law
• Author: Mr TL Fahring

Every few months or so seem to bring new revelations of a Ponzi scheme gone bust.¹ 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 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...