A Ponzi scheme is a financial scam in which a promoter offers investors unusually high or consistent returns on an investment. The gullible investors give the schemer their money and, at first, they receive the promised high returns. This in turn attracts new investors who give the schemer even more money. However, the schemer never actually makes any investments or earns any profits. Instead, he or she pays the returns to the investors from their own money or money paid by later investors. Sooner or later (often much later) Ponzi schemes break down when not enough money comes in from new investors to pay off all the promised returns to earlier investors.
Ponzi schemes were named for Charles Ponzi, an Italian immigrant who carried out a notorious investment scam involving postal reply coupons in the 1920s. However, such schemes have been around for centuries. By far the most famous Ponzi scheme was the one perpetrated by securities trader Bernard Madoff, which was discovered in 2008 and ended up costing hundreds of investors an estimated $65 billion in losses. However, much smaller Ponzi schemes go on all the time. Like Madoff's scheme, which went on for over 20 years, they often last for some time before being discovered.
In reaction to the terrible losses suffered by Madoff's victims, the IRS has enacted some special tax rules that make it much easier for Ponzi scheme victims to deduct their losses from their income taxes. Such deductions don't make up for all the losses suffered through Ponzi schemes, but they do help.
Under the IRS rules, an investor in a Ponzi scheme is entitled to deduct his or her losses as a theft loss, instead of a capital loss from an investment. This is good for the investors because the deduction for capital losses from investments is normally limited to a maximum of $3,000 per year. There is no such limit for theft losses. In addition, investment theft losses are not subject to the limitations applicable to personal casualty and theft losses. The loss is deductible as an itemized deduction. It is not subject to the 10% of adjusted gross income reduction or the $100 reduction that applies to many personal casualty and theft loss deductions. A theft loss deduction that creates a net operating loss for the taxpayer can be carried back three years and forward 20 years. This enables a victim to get a refund on prior taxes paid for those prior years.
The theft loss is deductible in the year the fraud is discovered, except to the extent the investor has a claim against the Ponzi schemer with a reasonable prospect of recovery. The IRS says that determining the year of discovery and applying the "reasonable prospect of recovery" test to any particular theft is highly fact-intensive and can be the source of controversy.
To help Ponzi scheme victims, the IRS has created a special "safe-harbor rule" under which it will automatically accept Ponzi-type theft losses. Under this rule, the IRS will deem the loss to be the result of theft if: (1) the scheme's promoter was charged under state or federal law with fraud, embezzlement, or a similar crime; or (2) the promoter was the subject of a state or federal criminal complaint alleging commission of such a crime, and (3) either there was some evidence of an admission of guilt by the promoter or a trustee was appointed to freeze the assets of the scheme.
The amount of the theft loss includes the investor's unrecovered investment, including income as reported in past years. Defrauded investors generally can claim a theft loss deduction not only for the net amount invested, but also for the so-called "fictitious income" that the scheme's promoter credited to the investor's account and which the investor reported as income on his or her tax returns for years prior to discovery of the scheme. For more details, see IRS Revenue Ruling 2009-9 and IRS Revenue Procedure 2009-20.