Additional Relief Provided for Ponzi Scheme Victims

By Marcia Richards Suelzer, Toolkit Staff Writer

In 2009, following a number of high-profile Ponzi schemes and other investment scams, the IRS issued rules that determined when the victim could claim a casualty loss deduction for the year in which the lead figure was charged with embezzlement, fraud or a similar crime under either federal or state law. Now the IRS has expanded the relief to include certain civil actions filed when the lead figure has died.

Tip. The IRS has never specifically identified any particular schemes to which the guidance applies -- although it is clear that a major impetus for the rules was the Madoff scam. Thus, the rules can apply to anyone who is swindled by an individual promoting a Ponzi scheme that meets the test for a "specified fraudulent arrangement."

The IRS defines this as an arrangement in which:

1. one or more lead figures receives cash or property from investors;
2. purports to earn income for the investors;
3. reports income amounts to the investors that are partially or wholly fictitious;
4. makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and
5. appropriates some or all of the investors' cash or property.

By allowing the deduction in the year in which the loss was discovered, the IRS made a significant departure from the strict rules governing theft losses. Under the standard rules, if you have a reasonable prospect of recovering a portion of the losses, you can't claim a deduction until the amount of your recovery is resolved. Clearly, in the case of a far-reaching scheme, any recovery can take years to obtain. Under the 2009 guidance, you can deduct 95 percent of your losses, if you do not pursue any potential third-party recovery. However, if you are pursuing a potential third-party recovery action, then the amount of the deduction is limited to 75 percent.

Think Ahead. Limiting the deduction to 75 percent can benefit the taxpayer in the event there is a recovery of a portion of the losses. Under the tax benefit rule, you have income to the extent you benefited from a tax break (such as a casualty loss deduction.) This provision provides a cushion for some of the tax benefit impact.

Claiming a deduction under these rules is optional. If you have a strong indication that you will recover all or a substantial portion of the money you lost, then you may want to use the regular loss recovery rules.

Under the 2009 guidance, it was necessary that the lead figure in the scheme be charged with a crime: This requirement meant the rules could not apply if the lead figure died. Now, the IRS has modified the rules to address this situation by expanding the definition of a "qualified investment loss" to include situations where:

• the federal or a state government files a civil action against the lead figure (or an associated entity) that alleges all the elements of a specified fraudulent arrangement conducted by the lead figure;
• the lead figure's death precludes criminal charges against that figure, and
• assets of the arrangement must be frozen or be placed under a receiver's jurisdiction.

If these requirements are met, then the loss can be deducted in the year the civil action is filed.