Ponzi Scheme Victims: Theft or Investment Loss?

A married couple who became victims of a Ponzi scheme invested with a fund manager – not directly with the fraud perpetrator. So, was the loss a result of theft or investment?

The IRS previously ruled that investors who lost money in Bernard Madoff’s Ponzi scheme and other similar frauds are entitled to a theft loss deduction rather than an investment loss.

But the question remained unanswered of how the loss should be classified if the investment was made with a legitimate fund manager who invested in the fraudulent scheme.

This decision is important because a theft loss generally results in a greater tax benefit. It is treated as a fully deductible “ordinary” loss.

In contrast, investment losses are usually treated as capital losses, which offset capital gains. An individual taxpayer may deduct up to $3,000 in any year as a net loss, and excess capital losses are carried forward to future years.

The IRS answered the question in a Chief Counsel Memorandum (CCA 201213022), ruling that the couple was entitled to treat their loss as a theft loss.