Use the IRS Safe-Harbor Tax Relief for Ponzi Scheme Losses
The Ponzi scheme is an investment fraud where the schemer uses invested money to create fake investment returns. According to an article at CNBC.com, authorities uncovered 60 alleged Ponzi schemes last year involving a total of $3.25 billion in investor funds—the highest amount since around the time of the Great Recession. The Great Recession (2007-2009) revealed the famous Bernie Madoff Ponzi scheme and led both lawmakers and the IRS to create helpful actions for taxpayers, such as the safe harbor described in this article. Thank goodness.
And here’s more good news: the Tax Cuts and Jobs Act (TCJA), which crushed most theft losses for tax years 2018-2025, allowed the IRS tax-favored Ponzi scheme loss deduction rules to remain in place. You might think it ridiculous that the IRS has to issue a safe harbor for deducting a theft loss from a Ponzi scheme. After all, you lose real money here. What could complicate the tax deduction?
As you will learn in this article, claiming a deduction for any theft loss requires the establishment of highly factual proof that often cannot be accomplished by taxpayers in the year they are supposed to claim the deduction. The IRS safe harbor overcomes these difficulties and helps ensure your tax deduction.
This article gives you the nuts and bolts of what you need to do taxwise when you suffer a Ponzi scheme theft loss. It explains the following:
The IRS threats, including possible audits, to your Ponzi scheme theft-loss deduction if you decide not to use the IRS safe harbor
What the safe harbor does for you
The safe-harbor steps to calculating the Ponzi scheme theft-loss deduction
How you claim the deduction on your tax return, and why tax law grants you a deduction for a Ponzi scheme loss but not for the theft of jewelry from your home
What you give to the government when you make use of the safe harbor
What happens in subsequent years if your safe-harbor loss is more or less than your actual loss
How you might qualify for the net operating loss (NOL) carryback and carryforward deductions when your Ponzi scheme loss exceeds your current-year income
When you may want to avoid the safe harbor
How to plan your investment life so as to avoid the Ponzi scheme altogether
The IRS Threats
In Revenue Procedure 2009-20, the IRS stated that you can choose not to use its Ponzi scheme tax relief safe harbor, but then you face the general rules for deducting a theft loss. Under the general theft rules, you need to establish
that the loss was from theft;
that you claimed the theft-loss deduction in the year you discovered the theft (this is often problematic);
the dollar amount of the theft, through sufficient documentation; and
that no claim for reimbursement of any portion of the loss exists for which there is a reasonable prospect of recovery in the taxable year you claim the theft-loss deduction.
Then, just in case this does not intimidate you enough, the IRS added this audit threat as a warning to taxpayers who don’t use the Rev. Proc. 2009-20 safe harbor:
Returns claiming theft-loss deductions from fraudulent investment arrangements are subject to examination by the IRS. That threat of an IRS audit gets your attention, doesn’t it?
What the Safe Harbor Does for the Taxpayer
The IRS will not challenge a Ponzi scheme victim who uses the IRS tax relief safe harbor as to the following treatments of the loss:
The Ponzi scheme loss is deductible as a theft loss.
The loss is deductible in the year of discovery, which (under this tax relief safe harbor) is the year a lead figure in the Ponzi scheme is
charged by indictment with the commission of fraud, embezzlement, or a similar crime;
the subject of a state or federal criminal complaint and either (a) admits guilt, or (b) has his, her, or its assets frozen by a court-appointed receiver or trustee; or
the subject of the fraudulent arrangement but (due to his or her death) faces no charge by indictment, information, or criminal complaint (this condition also requires either that a receiver or trustee was appointed with respect to the arrangement or that assets of the arrangement were frozen).
The loss amount is computed using the safe-harbor formula, which allows either 95 percent or 75percent of the loss in the year the Ponzi scheme victim files the safe harbor, as explained below.
The tax relief safe harbor truly simplifies the Ponzi scheme theft-loss deduction for the victim. The IRS frequently disagrees with theft-loss deductions. The rules for deduction and the different interpretations of the facts generate a good number of conflicts and enough litigation to make this safe harbor appealing.
Establishing the Safe-Harbor Ponzi Scheme Loss in Your Tax Return
To use the safe harbor, you need to comply with its requirements. These include required statements and declarations you make under penalties of perjury on IRS Form 4684, where you
name the Ponzi scheme perpetrator;
state that you have written documentation that supports the amounts you are claiming for deduction;
declare Ponzi scheme victim status as a qualified defrauded investor; and
abide by other terms of the declaration.
When calculating your Ponzi scheme safe-harbor loss on IRS Form 4684, you can deduct 95 percent if you are not seeking any third-party recovery. If you pursue or intend to pursue any recovery from third parties (i.e., parties other than the perpetrators), then your deduction is limited to 75 percent of the loss under the safe harbor.
You are not being cheated by the 95 percent or 75 percent limits here. For example, when using the 75 percent safe harbor, you are getting your deduction in advance of when you would get it otherwise. Furthermore, as you will see below, if you recover more or less in subsequent years, you adjust your gain or loss to match the actual amounts.
How Individuals and Businesses Claim the Ponzi Scheme Loss Deduction
Say a thief breaks into your home and steals $100,000 worth of your belongings. Your personal theft-loss deduction is zero if the loss is not attributable to a federally declared disaster. That’s the way it is under the TCJA rules for 2018-2025. But the individual who mistakenly invested in a Ponzi scheme did so for the purpose of making a profit. Tax law treats this theft differently from the theft that occurs when someone breaks into your home and steals your jewelry. Because of the profit motive, the Ponzi scheme theft is fully deductible as an itemized deduction. Note the “fully” deductible part. The loss is not a capital loss that’s limited to the $3,000 ceiling. It’s a fully deductible theft loss—and as you see below, it can produce an NOL. The business treatment of the Ponzi scheme loss produces a full deduction as well, albeit as a business casualty loss.
What You Give the Government When You Agree to the Safe Harbor Ponzi Scheme Loss Deduction
The IRS would tell you that you are really giving up nothing much when you agree to tax relief using the Ponzi scheme safe harbor. When you claim your Ponzi scheme tax deduction by using the safe harbor, you agree
to deduct, in the year of discovery, only the 95 percent or 75 percent calculated as explained above;
not to file or amend tax returns that exclude or recharacterize income in taxable years that precede the “year of discovery”;
not to claim a Section 1341 tax benefit from this Ponzi scheme loss, using the restoration of an amount under the claim of right doctrine; and
not to apply the doctrine of equitable recoupment or the mitigation provisions of Sections 1311-1314.
In Revenue Ruling 2009-9, the IRS lays out a pretty good case against the claim of right doctrine, the doctrine of equitable recoupment, and the mitigation provisions of Sections 1311-1314.
You would have to expect that if you want to make these claims, the IRS would at a minimum contest them—and would likely push the matter to the courts. That doesn’t mean you couldn’t win; it just means extra time, trouble, and expense.
Once you make the safe-harbor calculation and deduct the 95 percent or 75 percent, you may collect a different amount in a subsequent year. That’s no problem. If you receive additional income, you report that additional income in the year of recovery under the tax benefit rule (to the extent that you received a benefit from the earlier deduction). If the amount of your loss increases because you collect less than the amount of the claim that you established as a reasonable prospect of recovery, you deduct the additional loss in the year that you can identify that additional loss with reasonable certainty.
Ponzi Scheme Loss Carryback as an NOL
The individual taxpayer who becomes a theft-loss victim may treat his or her theft loss as a loss from a sole proprietorship for purposes of computing the NOL deduction.
Planning note. If you qualify for a 2020 Ponzi scheme loss deduction and that deduction produces an NOL, you carry that loss to your 2015 tax year—or you can elect to forgo the carryback and instead carry the loss forward.
When Not to Use the Safe Harbor
You may have a situation where the safe harbor is not the answer. For example, you are not permitted to amend your prior returns when you use the safe harbor. But if the Ponzi schemer paid your investment returns with your invested money, you did not have income from the investment during those years. By eliminating your phantom income in the open years with an amended return, you may come out better than you would by using the safe harbor.
Planning note. The argument that the money you received was really nothing more than a return of your capital is a difficult argument to prove. But with very large losses and good advisors, it is an argument to consider.
How to Avoid the Ponzi Scheme
To avoid the Ponzi scheme, don’t give the perpetrator control of your money.
Hire an Investment Advisor, but Control the Funds Yourself
Another option is to engage an individual to manage your investment portfolio, but not allow your investment advisor to have direct access to the funds.
For example, the Schwab Advisor Network allows investment advisors to create an account at Schwab and make the investments for you, but prevents the investment advisors from touching your money. Thus, you can check your Schwab account at any time and see your money. You can even have this account pay the fees charged by the investment advisor.
Fidelity Investments has a similar type of investor advisor network, as do a number of other independent brokerages.
What You Should Always Do
To avoid getting caught up in a Ponzi scheme, ask questions about your portfolio. Be aware of any money that disappears. That’s no guarantee that you won’t get ripped off, but you can certainly reduce the chances when you become a careful investor.
You can see that the safe harbor offers a nice, clean path to the Ponzi scheme tax deduction. IRS Form 4684makes the deduction clear and easy to apply. Here are three highlights from the good news about the Ponzi scheme deduction:
It creates an ordinary loss deduction (not a capital loss that’s limited to the $3,000 ceiling).
If the Ponzi loss exceeds your 2020 income, you treat it as a sole proprietorship business loss and carry it back five years or elect to carry it forward.
You have a clear path to identifying the year of the loss (unlike with a usual theft loss).
Use of the safe harbor requires you to give up your ability to make different tax-benefit computations. This requires your consideration. But in most cases, being able to claim a current-year deduction for a known amount, without worry of disallowance, makes the safe harbor a good bet.
On the other hand, the Ponzi scheme may have paid your investment returns with what was really your money, in which case you could forgo the safe harbor and amend open years to remove the phantom income. Taking the position that you received not taxable income but rather a return of your investment is not easy, and this path may not be available to you. To get this done right, you need to consult with knowledgeable advisors.
Finally, plan your investment life to avoid the Ponzi scheme altogether by using an investment advisor account at an independent brokerage or by some other means. You won’t want to just turn your money over willy-nilly to another individual for investment.