Ponzi Scheme Losses – Don’t forget to take an ordinary loss deduction

By: Robert Schachter, Partner – WithumSmith+Brown, PC

The Madoff Ponzi scheme seems like an eternity ago, but Ponzi scheme losses are still in the headlines today. It is important to note that Revenue Rule 2009-09 and Rev. Proc. 2009-20 & 2011-58 provided safe harbor loss deductions from criminal fraud or embezzlement from transactions entered into for profit. Such losses are deductible as theft losses not capital losses. Ponzi scheme losses not reimbursed by insurance or having a reasonable prospect of recovery may be taken as theft losses not subject to personal loss limitations or limits on itemized deductions. In addition, the theft loss can create or increase a net operating loss.

The Chief Counsel’s Office has recently advised in CCA 201445009 that an Investor was entitled to safe harbor treatment for losses not specifically identified in the previous Revenue Ruling and Revenue Procedures. The facts were similar to other investor thefts with a couple of wrinkles, Rev. Proc. 2009-20 provides an optional safe-harbor provision that a qualified investor does not include a person that invested solely in a fund or other entity that, in turn, invested in the specified fraudulent arrangement, and that the fund or other entity itself may be a qualified investor. This provision potentially negated the ability for the Investor to utilize the benefits of Rev. Proc. 2009-20. In addition, Rev. Proc. 2011-58 recognized deaths of lead Ponzi scheme figures preventing governmental authorities from charging the lead figure did not jeopardize the theft loss deduction.

The Chief Counsel’s office was required to consider whether to bar the Investor’s theft loss deduction because it is a third party and would not be deemed a qualified investor under Rev. Proc. 2009-20 because Investor did not invest the funds directly into the investment itself. Not investing directly in the investment vehicle negated the benefits of the Rev. Proc. 2009-20. The Chief Counsel’s Office determined that the Investor’s advisor was acting as an agent of the Investor and therefore the Investor was deemed to have invested the funds directly into the fraudulent arrangement and has set a precedent that Rev. Proc. 2009-20 was not intended to preclude investors from taking a theft loss deduction that would otherwise qualify as a theft loss deduction.

To learn more, check out the summer issue of Finance That Matters by clicking here.

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