Ponzi Scheme Losses
Important – Read FIirst
Although casualty and theft losses not attributable to a federally declared disaster are not deductible for personal use property in tax years 2018 through 2025, that suspension does not apply to losses on income-producing property, such as losses from Ponzi-type investment schemes (2021 Pub 547, Page 5). Form 4684 instructions indicate to complete the form’s Section C to compute a theft loss deduction for a Ponzi-Type Investment Scheme using the procedures in Revenue Procedure 2009-20. Generally, Ponzi scheme investment losses will result in the Schedule A itemized deduction on line 15.
Revenue Procedure 2009-20 provides an optional safe harbor treatment for taxpayers that experienced losses in certain investment arrangements discovered to be criminally fraudulent. The revenue procedure also describes how the IRS will treat a return that claims a deduction for such a loss and does not use the safe harbor treatment described in the revenue procedure:
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These returns are subject to examination by the service.
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A taxpayer who claims a theft loss deduction without following the safe harbor treatment must (1) establish that the loss was from theft and that the theft was discovered in the year the deduction is claimed, (2) have sufficient documentation to establish the amount of the claimed loss, and (3) be able to prove that no claim for reimbursement for any part of the loss exists for which there is a reasonable prospect of recovery in the tax year of the claimed loss.
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Additional requirements apply if the taxpayer files or amends a return to exclude previously reported investment income that was not actually or constructively received.
Phantom Income
IRS has provided guidance (Program Manager Technical Advice 2013-003) to persons who do not or cannot use the safe harbor procedures provided in Rev Proc 2009-20 and who have “phantom income.” This guidance pertains to:
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Re-characterizing prior withdrawals as a return of capital - While taxpayers generally bear the burden to prove the legitimacy of amounts included in income, amounts that a taxpayer included in income on a return filed in a closed year should be includible in the taxpayer's basis not only for purposes of computing the amount of a theft loss deduction under Code Sec. 165 , but also for purposes of re-characterizing income in open years under Code Sec. 61, and that this treatment applies whether or not the closed-year income was genuine, fictitious, or a combination of both.
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Treating phantom income as constructively received - In addressing the question as to whether the IRS may assert the doctrine of constructive receipt to claim that a taxpayer has income from a fraudulent investment scheme that can't be recharacterized, the IRS considered the theory that the taxpayer could have withdrawn the taxpayer's entire investment in the scheme. IRS cited cases on both sides of the issue and then concluded, "Under this case law and given the factual nature of the issue, [IRS] has some discretion to determine when to assert the doctrine of constructive receipt in the recompilation of Ponzi income."
Safe Harbor
Under the safe harbor provisions of Rev Proc 2009-20 if a qualified investor follows the procedures prescribed, the IRS will not challenge the following treatment by the qualified investor of a qualified loss:
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The loss is deducted as a theft loss;
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The taxable year in which the theft was discovered within the meaning of § 165(e) is the discovery year described in section 4.04 of the revenue procedure; and
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The amount of the deduction is the amount specified in section 5.02 (“Amount to be Deducted” below) of the revenue procedure.
Amount to be Deducted
The amount specified in section 5.02 is calculated as follows:
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Multiply the amount of the qualified investment by:
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95 percent, for a qualified investor that does not pursue any potential third-party recovery; or
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75 percent, for a qualified investor that is pursuing or intends to pursue any potential thirdparty recovery; and
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Subtract from this product the sum of any actual recovery and any potential insurance/SIPC recovery., The amount of the deduction calculated under this section 5.02 method is not further reduced by potential direct recovery or potential third-party recovery.
Future Recoveries
The qualified investor may have income or an additional deduction in a year subsequent to the discovery year, depending on the actual amount of the loss that is eventually recovered. See § 1.165-1(d); Rev. Rul. 2009-9.
Statement - By Executing the Statement Provided in Section C of Form 4684 the Taxpayer Agrees
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Not to deduct in the discovery year any amount of the theft loss in excess of the deduction permitted by section 5 of Rev. Proc 2009-20;
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Not to file returns or amended returns to exclude or recharacterize income reported with respect to the investment arrangement in taxable years preceding the discovery year;
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Not to apply the alternative computation in § 1341 with respect to the theft loss deduction allowed by Rev. Proc 2009-20; and
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Not to apply the doctrine of equitable recoupment or the mitigation provisions in §§ 1311-1314 with respect to income from the investment arrangement that was reported in taxable years that are otherwise barred by the period of limitations on filing a claim for refund under § 6511.
Definitions
The following definitions apply solely for purposes of Revenue Procedure 2009-20.
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Specified Fraudulent Arrangement - A specified fraudulent arrangement is an arrangement in which a party (the lead figure) receives cash or property from investors; purports to earn income for the investors; reports income amounts to the investors that are partially or wholly fictitious; makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and appropriates some or all of the investors' cash or property., For example, the fraudulent investment arrangement described in Rev. Rul. 2009-9 is a specified fraudulent arrangement.
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Qualified Loss - A qualified loss is a loss resulting from a specified fraudulent arrangement in which, as a result of the conduct that caused the loss:
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The lead figure (or one of the lead figures, if more than one) was charged by indictment or information (not withdrawn or dismissed) under state or federal law with the commission of fraud, embezzlement or a similar crime that, if proven, would meet the definition of theft for purposes of § 165 of the Internal Revenue Code and § 1.165-8(d) of the Income Tax Regulations, under the law of the jurisdiction in which the theft occurred; or
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The lead figure was the subject of a state or federal criminal complaint (not withdrawn or dismissed) alleging the commission of a crime described in section 4.02(1) of Revenue Procedure 2009-20, and either –
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The complaint alleged an admission by the lead figure, or the execution of an affidavit by that person admitting the crime; or
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A receiver or trustee was appointed with respect to the arrangement or assets of the arrangement were frozen.
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In Rev. Proc. 2011-58 the IRS has broadened this definition in two ways:
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By including schemes in which a civil complaint is brought against the lead figure (or an associate entity involved in the fraudulent arrangement) by a state or federal authority that has not been withdrawn, and
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By making an exception for the non-withdrawal requirement for indictments or complaints withdrawn due to the lead figure’s death.
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Qualified Investor - A qualified investor means a United States person, as defined in § 7701(a)(30) --
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That generally qualifies to deduct theft losses under § 165 and § 1.165-8;
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That did not have actual knowledge of the fraudulent nature of the investment arrangement prior to it becoming known to the general public;
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With respect to which the specified fraudulent arrangement is not a tax shelter, as defined in § 6662(d)(2)(C)(ii); and
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That transferred cash or property to a specified fraudulent arrangement. A qualified investor does not include a person that invested solely in a fund or other entity (separate from the investor for federal income tax purposes) that invested in the specified fraudulent arrangement. However, the fund or entity itself may be a qualified investor within the scope of this revenue procedure.
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Discovery Year - A qualified investor’s discovery year is the taxable year of the investor in which the indictment, information, or complaint described in section 4.02 of the revenue procedure is filed. Rev. Proc. 2011-58 expanded this definition to include arrangements involving a civil complaint.
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Responsible Group - Responsible group means, for any specified fraudulent arrangement, one or more of the following:
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The individual or individuals (including the lead figure) who conducted the specified fraudulent arrangement;
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Any investment vehicle or other entity that conducted the specified fraudulent arrangement, and employees, officers or directors of that entity or entities;
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A liquidation, receivership, bankruptcy or similar estate established with respect to individuals or entities who conducted the specified fraudulent arrangement, in order to recover assets for the benefit of investors and creditors; or
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Parties that are subject to claims brought by a trustee, receiver, or other fiduciary on behalf of the liquidation, receivership, bankruptcy or similar estate described in section 4.05(3) of the revenue procedure.
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Qualified Investment -
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Qualified investment means the excess, if any, of --
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The sum of --
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The total amount of cash, or the basis of property, that the qualified investor invested in the arrangement in all years; plus
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The total amount of net income with respect to the specified fraudulent arrangement that, consistent with information received from the specified fraudulent arrangement, the qualified investor included in income for federal tax purposes for all taxable years prior to the discovery year, including taxable years for which a refund is barred by the statute of limitations; over
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The total amount of cash or property that the qualified investor withdrew in all years from the specified fraudulent arrangement (whether designated as income or principal).
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Qualified investment does not include any of the following:
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Amounts borrowed from the responsible group and invested in the specified fraudulent arrangement, to the extent the borrowed amounts were not repaid at the time the theft was discovered;
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Amounts such as fees that were paid to the responsible group and deducted for federal income tax purposes;
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Amounts reported to the qualified investor as taxable income that were not included in gross income on the investor's federal income tax returns; or
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Cash or property that the qualified investor invested in a fund or other entity (separate from the qualified investor for federal income tax purposes) that invested in a specified fraudulent arrangement.
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Actual Recovery - Actual recovery means any amount a qualified investor actually receives in the discovery year from any source as reimbursement or recovery for the qualified loss.
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Potential Insurance/SIPC Recovery - Potential insurance/SIPC recovery means the sum of the amounts of all actual or potential claims for reimbursement for a qualified loss that, as of the last day of the discovery year, are attributable to:
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Insurance policies in the name of the qualified investor;
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Contractual arrangements other than insurance that guaranteed or otherwise protected against loss of the qualified investment; or
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Amounts payable from the Securities Investor Protection Corporation (SIPC), as advances for customer claims under 15 U.S.C. § 78fff-3(a) (the Securities Investor Protection Act of 1970), or by a similar entity under a similar provision.
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Potential Direct Recovery - Potential direct recovery means the amount of all actual or potential claims for recovery for a qualified loss, as of the last day of the discovery year, against the responsible group.
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Potential Third-Party Recovery - Potential third-party recovery means the amount of all actual or potential claims for recovery for a qualified loss, as of the last day of the discovery year, that are not described in section 4.08 or 4.09 of this revenue procedure.