how do i write off a ponzi scheme investment. I need specifics, not the IRS publication "2009-9. Like what forms need to be filled out and submitted? Thank you
Likewise, if you paid income tax on income that was not "real" income, you will need an accountant or tax professional to help you claim the loss or amend your prior returns.
You are allowed to claim an Itemized Deduction for Theft Loss in Schedule A. Since you were the victim of a Ponzi Scheme this theft loss is not limited to the $100.00 floor or 10%-of-AGI limits and it can create a Net Operating Loss. You have two options:
- The IRS has provided safe harbor rules for computing losses from Ponzi-type schemes. The rules allow a deduction of 95% (75% for taxpayers suing third parties) of the net investment, less any actual recovery and potential insurance recovery (Rev. Proc. 2009- 20). Taxpayers using the safe harbor complete Section C of Form 4684. Appendix A of Rev. Proc. 2009-20 is not required.
- Taxpayers who cannot or choose not to use the safe harbor rules may claim a loss in the year the theft is discovered or amend returns for open years to recalculate income for those years by removing phantom income (Rev. Rul. 2009-9; PMTA 2013-003). Losses within IRAs are limited to the taxpayer’s basis in the IRA and are deductible after the distribution of his entire interest in the IRA. (INFO 2010-0234)
Regardless of how you choose to report the loss, you must do so through Schedule A. Unfortunately TurboTax does not have the forms necessary to deduct a Theft Loss from a Fraudulent Investment Transaction. We recommend that you visit a local Tax Professional to handle your situation.
Follow up question
- I took the Ponzi scheme safe harbor (deducted 75% of theft loss) on schedule A (via form 4684) in my 2017 return. Have 25% left over for tax free future recoveries (starting to come in) under the tax benefit rule.
- Ponzi scheme company went into bankruptcy and was taken over by Receivership. Receiver liquidated the assets and is in the process of paying back the recoveries. Receivership also had to settle tort claims with investor group so the investors don't sue the Receiver (since they just became the Ponzi scheme company).
- Received one recovery payout from the Receiver so far. Also got a 1099 from the Receiver for the tort claim settlement portion of this payout. Total payout is slightly higher than the 25% loss not yet deducted. Ponzi scheme theft loss safe harbor treatment states the future recoveries <= undeducted portion (25% in my case) falls under tax benefit rule and are not added to gross income and therefore not taxed.
My question is
- If I include this 1099 to my gross income, how do I eliminate it from calculating tax liabilities? According to tax benefit rule, I should be able to not claim <= 25% as income. The only way to do that is to not include the 1099.
- There will be further recoveries and potentially more 1099s. What if a future 1099 amount straddles and goes above the 25% undeducted loss? I know I have to add to gross income for all recoveries > 25%. But then how do I report the fraction of the 1099 that is above the 25%?
My guess is I don't include these 1099s to my Turbotax even though the issuer reports them to IRS. Instead, I just calculate and include all recoveries > 25% as misc income on the tax year of the recovery. Is this correct?
Slowly learning more info. Seems recoveries from insurance and asset liquidation provide tax free treatment opportunities (if unused theft loss deductions are available) while punitive recoveries (tort settlements) are taxable with 1099s. A bit surprising receivership issued 1099 for the tort settlement portion of the recovery. Recovery came from liquidating assets, really kind of crappy portion for converted into taxable recovery treatment.
You may be misreading or not understanding the Tax Benefit Rule. Until you recover the amount that reduced your income, the 25% may not come into play or reduce the current income. The proration in the examples is two different types of state tax which are used to determine the amount that actually reduced income and income tax. Ultimately, it is determined based on how much your tax was reduced by the deduction. Worksheet 2 will help you determine the amount you must recover.
Tax benefit rule. IRS Publication 525
You must include a recovery in your income in the year you receive it up to the amount by which the deduction or credit you took for the recovered amount reduced your tax in the earlier year. For this purpose, any increase to an amount carried over to the current year that resulted from the deduction or credit is considered to have reduced your tax in the earlier year.
Since the 75% used for your Ponzi Scheme loss was used 100% to reduce income, until that is recovered through your settlements received, I believe all settlement proceeds are taxable income. Once that is recovered the remainder will not be taxable. Again, Worksheet 2 in the publication will help you figure out the amount you must include in your income.
With your TurboTax account open follow the steps below.
- Scroll to Less Common Income > Select Reimbursed deductions from a prior year > Start or Revisit
- Continue to follow the screens and enter your description and amount
Keep the worksheet in your files for your records.
Oops, logged in from a different account than madmanc20 but am the same poster 🙂
Really helpful for pointing out misunderstanding of tax benefit rule and where to enter for TTax. So then the fact that I receive 1099 or not is irrelevant? Just report all recoveries <= 75% as taxable in year of recovery and everything above 75% no need to report.
Thanks. Very helpful.
Went through pub 525 worksheet 2. Looks like it mainly redo deduction year standard/itemized deduction calculation with respect to cumulative recoveries so far.
Following up on this since 2 separate CPAs handling friend's ponzi scheme loss are doing differently than suggested here
- If claim 75% loss in prior year tax return. This means tax payer reasonably expect 25% recovery
- Tax benefit rule only applied after recovery exceed the estimated recovery (25% in this example)
Here is an article suggesting similar. See section "Subsequent year adjustments"
Here is the language on IRS Revenue Ruling 2009-09. A bit hard to read but I think states the recoveries are first untaxed up to the undeducted portion (underlined). Amount beyond this is taxed following tax benefit rule.
A may deduct the theft loss in Year 8, the year the theft loss is discovered, provided that the loss is not covered by a claim for reimbursement or other recovery as to which A has a reasonable prospect of recovery. To the extent that A’s deduction is reduced by such a claim, recoveries on the claim in a later taxable year are not includible in A’s gross income. If A recovers a greater amount in a later year, or an amount that initially was not covered by a claim as to which there was a reasonable prospect of recovery, the recovery is includible in A’s gross income in the later year under the tax benefit rule, to the extent the earlier deduction reduced A's income tax. See § 111; § 1.165-1(d)(2)(iii). Finally, if A recovers less than the amount that was covered by a claim as to which there was a reasonable prospect of recovery that reduced the deduction for theft in Year 8, an additional deduction is allowed in the year the amount of recovery is ascertained with reasonable certainty.
Have a follow up question regarding 1099-MISC received from Ponzi scheme loss recovery.
Received this because it was required by law for tort claim settlement. However, the recovery is non taxable (still recovering the non-deducted portion (25%) from prior year (2017) Ponzi scheme safe-harbor deduction)
I worry not including this 1099-MISC into Turbotax can trigger an audit since IRS received this 1099-MISC. However, there is no way to mark it non-taxable after entering into turbotax. Interview questions after 1099-MISC offers no option.
Is there anyway to do this? Or just not include it in the tax return? Will be saving records clearly indicating Ponzi scheme loss, safa harbor deduction, non taxable and taxable recoveries.
Assuming the proceeds from the court case reported to you on Form 1099-MISC are solely for the loss in the value of your investment, it does not need to be reported on your tax return. Instead, it reduces your "basis" (net investment) in the investment you made.
Report the disposition of your remaining investment by following these steps:
Federal>>Income & Expenses>>Stocks, Mutual Funds, Bonds, Other.
When you add the "sale", it will ask you if you did or will receive a Form 1099-B. When you answer "No", TurboTax will walk you through the entry of the disposition of your asset. Report "zero" for the "Proceeds", and report your net investment (after the court payment) in the "Cost or Other Basis". Use the date of the court ruling as the "Date sold or disposed".
If the Form 1099-MISC reports payments for something other than loss in the value of your investment, it may be taxable. Refer to IRS Publication 4345 for guidance on whether the payment is taxable.
More information from IRS Tax Relief Legal Encyclopedia for guidance:
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.
Thank you for the detail response.
The original Ponzi loss safe harbor deduction was under Sched A Other Misc Deductions. Therefore, the deduction reduced ordinary income.
If I track basis in Sched D, then taxable recoveries are treated as investments and subject to ST/LT and suspended CG loss. I have a bunch suspended CG loss and would eliminate all the taxable recoveries.
Doesn't quite make sense the Safe Harbor deduction reduced ordinary income and recoveries are treated as capital gains+loss. I of course would benefit greatly but seems like IRS would want to deduction and income treated similarly.
I do have the taxable/untaxable portion of the recoveries tracked precisely and maintained for records. Along with principle and phantom incomes for total loss value.