On December 10, 2008, Bernard Madoff admitted to his sons that his investments were “all one big lie.” As of December 2008, the losses were estimated to be $65 billion, making it the largest investor fraud in history. Madoff was sentenced to 150 years in prison.

Much was reported in the media about Bernie Madoff and his “Ponzi scheme.” In a Ponzi Scheme, the party perpetrating the fraud receives cash or property from investors, purports to earn income for the investors, and reports to the investors income amounts that are wholly or partially fictitious. The payments, if any, of income or principal are made from cash or property that other investors made in the fraudulent arrangement. The party perpetrating the fraud criminally appropriates some or all of the investors’ cash or property.

One of the first examples of a Ponzi-type scheme occurred in 1899 when William “520 per cent” Miller opened for business as the Franklin Sydicate and promised a 10% WEEKLY return. Ponzi himself did business in 1920, and promised investors he would double their money in 90 days.

Much was also reported on the famous people who had invested and lost millions in Bernie Madoff’s scheme, including the owners of the NY Mets and Philadelphia Eagles, real estate magnate Mortimer Zuckerman, a charity of Steven Spielberg, the foundation of nobel laureate Elie Wiesel, and many other celebrities such as Sandy Koufax, Kevin Bacon, Kyra Sedgwick, Jeffrey Katzenberg and many more.

The IRS treats Ponzi losses as theft losses from transactions entered into for profit. As such they are deducted as itemized deductions which are not subject to the limits imposed on itemized deductions in other circumstances. They are also available to be carried back or forward in the calculation of personal net operating losses.

The loss is to be deducted in the year of discovery. Recognizing that the determination of a theft loss from a Ponzi scheme investment cannot always be easily determined in the year the loss is discovered, the IRS has provided investors with a safe harbor provision.

The amount of the loss is the “qualified investment”, calculated as follows:

  • The total amount of cash (or the basis of property) invested in the arrangement in all of the years; plus
  • The total amount reported to the taxpayer as net income that the investor included in income for federal tax purposes for all taxable years prior to the discovery year, including years barred by the statute of limitations;
  • Less the total amount of cash or property that the investor withdrew in all years designated as income or principal.

If the investor does not intend to pursue recovery, the deduction is 95% of the qualified investment.

The laws are much more complicated when recovery is pursued, or when some of the loss is recovered. Also, since itemized deductions are not deductible on many state returns, the deductibility of Ponzi scheme losses varies by state. For instance, Connecticut does not allow the deduction, but California does.

Please contact your GBQ tax advisor if you feel you have been a victim.

Article written by:
Anne Lemmon
Tax Senior

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