The IRS Provides Clarification for Ponzi Scheme Victims

April 28, 2009

By: Larry Goldsmith, J.D., C.P.A., C.F.F.A.

The recent revelations about the nefarious activities of Bernie Madoff have once again brought the phrase “Ponzi scheme” back into the news. Madoff was convicted of operating a Ponzi scheme that has been called the largest investor fraud ever committed by a single person, bilking thousands of investors of almost $65 billion, leaving many financially destroyed. The sole solace that these unfortunate investors have is that the IRS has now clarified the favorable tax treatment of Ponzi scheme losses.

A Ponzi scheme is a fraudulent investment operation that pays returns to investors from their own money or money paid by subsequent investors rather than from any actual profit earned. The Ponzi scheme usually offers returns that other investments cannot guarantee in order to entice new investors, in the form of short-term returns that are either abnormally high or unusually consistent. The perpetuation of the returns that a Ponzi scheme advertises and pays requires an ever-increasing flow of money from new and existing investors in order to keep the scheme going.

The scheme is named after Charles Ponzi, who became notorious for using the technique after emigrating from Italy to the United States in 1903. Ponzi did not invent the scheme (Charles Dickens’ 1857 novel Little Dorrit described such a scheme decades before Ponzi was born, for example), but his operation took in so much money that it was the first to become known throughout the United States. His original scheme was in theory based on arbitraging international reply coupons for postage stamps, but soon diverted investors’ money to support payments to earlier investors and Ponzi’s personal wealth.

The names Ponzi – and now Madoff – will forever be remembered by the countless number of victims who trusted and then were left financially destroyed. The Madoff case prompted the Internal Revenue into tightening up some previously vague language concerning the disposition of Ponzi scheme losses.

In general, losses from investments are treated as capital losses which are offset by capital gains plus $3,000 annually. Losses from a theft under IRC Section 135 are typically categorized as a “personal casualty and theft loss” and are treated as itemized deductions less ten percent of the taxpayer’s adjusted income and one hundred dollars.

The Internal Revenue Service permits a Ponzi scheme victim to claim a net operating loss that can be carried back or forward to generate a refund of taxes previously paid. The deduction is claimed in the year the taxpayer discovered or became aware of the fraud. The taxpayer’s basis for the losses includes previously reported income less distributions.

Charles Ponzi was released after three and a half years in prison. He was deported to his homeland, Italy, as he hadn’t ever become an American citizen. His charismatic confidence had faded, and when he left the prison gates, he was met by an angry crowd. He told reporters before he left:

“I went looking for trouble, and I found it.”

Bernie Madoff is now in jail after entering his guilty plea. He faces spending the rest of his life in prison, and up to $170 billion in restitution.

If you have any questions, please contact Larry Goldsmith, J.D., C.P.A., C.F.F.A.