Ponzi schemes can affect anyone, and in the last several years, the IRS has taken the initiative to help taxpayers eliminate fictitious income generated by the scheme. If the taxpayer uses the safe harbor under Rev. Proc. 2009-20, they may elect to deduct 75% of their loss in the tax year of discovery as loss a theft even if pursuing a third-party recovery. If they are not pursuing a recovers 95% of the amount can be deducted. By using this safe harbor, investors are unable to amend returns or re-characterize income reported that deal with the Ponzi scheme.
What makes income “phantom.” Income considered phantom, is only constructively received or if paid, it is with the capital funds of the taxpayer or other investors to perpetuate and conceal the scheme. It cannot be earned as a promoter of the scheme.
There are a couple options for taxpayers if they do not use the safe harbor. The first is to deduct the theft loss under Sec. 165(c)(2). They would include the amount invested in the Ponzi scheme, including previously stated income and less cash withdrawn. The deduction can be taken in the year it was discovered, or if there is the possibility of recovery of the money, when that option no longer exists.
The second option is to amend returns for open years under Sec. 61. This allows you to remove constructively received income and treat withdrawals of cash previously reported as income as nontaxable return of capital. The taxpayer must establish the amount of fictitious income and treat the income as never occurring during the open years.
It can be a harsh reality to those involved in a Ponzi scheme. It is always important to research the investment before putting money in. Having a good financial advisor or accountant can be essential to investors making healthy choices for their portfolio.