A Ponzi scheme is a monetary scam in which a promoter offers investors exceptionally high or substantial returns on investment. Gullible investors give their money to the conspirator and initially receive the promised high returns. This, in turn, attracts new investors, which gives the planner even more money. However, the planner never makes investments or profits. Instead, it pays returns to investors with its own money or is paid for by subsequent investors. Sooner or later, Ponzi schemes fail when new investors do not have enough money to pay all the profits promised to previous investors.
Ponzi schemes are named after Charles Ponzi, an Italian immigrant who ran a notorious investment scam involving returned postage coupons in the 1920s. However, these schemes have been around for a long time. By far, the most famous was that of stockbroker Bernard Madoff, which was later discovered in 2008 and ended up costing thousands of investors an estimated $65 billion in losses. However, much smaller Ponzi schemes still continue. Like the Madoff scheme, which has been running for over 20 years, they often go on long before they are discovered.
In response to the terrible losses suffered by Madoff victims, the IRS has enacted special tax rules that make it easier for Ponzi victims to deduct their losses from their taxes. These deductions do not offset all the losses you suffer from Ponzi schemes, but they do help.
Under IRS rules, an investor in a Ponzi scheme is entitled to claim their losses as theft losses rather than a principal investment loss. This is advantageous for investors, as the capital loss deduction on investments is normally capped at a maximum of $3,000 annually. There is no limit to theft losses. In addition, losses resulting from investment theft are not subject to the limitations applicable to losses resulting from accidents and personal theft. The loss can be deducted as an itemized deduction. You are not subject to the 10% adjusted gross income deduction or the $100 deduction that applies to many personal accident and theft deductions. A deduction for theft that creates a net operating loss for the taxpayer can be carried forward for three years and for 20 years. This allows the victim to obtain reimbursement of taxes already paid in previous years.
The loss due to theft is deductible in the year the fraud is discovered unless the investor has a claim against the Ponzi scheme with a reasonable prospect of recovery. The IRS says specifying the year of discovery and applying the "reasonable prospect of recovery" test to any specific theft is information-intensive and can be contentious.
To help victims of the Ponzi scheme, the IRS has created a special "safe haven rule" under which it will automatically accept Ponzi theft losses. Under this rule, the IRS will treat the loss as resulting from theft if:
The fraudster is charged under federal or state law with fraud, embezzlement, or a similar offense; or
The prosecutor was the subject of a state or federal criminal complaint relating to the commission of such a crime, and
There was evidence of the prosecutor's admission of guilt, or a trustee was appointed to freeze the assets of the prosecutor's scheme.
The value of the loss for theft includes the investor's unrecovered investment, including deferred income from previous years. Investors who are defrauded can generally claim a deduction for theft not only for the net amount invested but also for so-called "fictitious income," which the schemer has credited to the investor's account and which the investor has declared as income on the tax return years before the discovery of the scheme.
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