Unfortunately, modern-era taxpayers sometimes suffer losses at the hands of unscrupulous financial “deal” promoters. Recently, the notorious Bernard Madoff was the perpetrator of such a scheme, which cost many taxpayers dearly.
And in 2009, the IRS took note of this particular scandal, and made it clear that a violation of federal criminal law can qualify Ponzi scheme losses for theft loss treatment under the Internal Revenue Code.
Taxpayers can deduct a loss suffered during a tax year and not compensated by insurance if such a loss is incurred in a trade or business, or a transaction entered into for profit if it arose from a theft.
The term “theft” includes, but is not limited to, larceny, embezzlement, and robbery. To deduct a theft loss, a taxpayer must show that “the loss resulted from a taking of property that is illegal under the law of the state where it occurred, and that the taking was done with criminal intent.” (Rev Rul 72-112) And generally, this requires that the perpetrator have specific intent to deprive the victim of his property, which in turn requires a degree of privity between the perpetrator and the victim.
But pursuant to a recent Chief Counsel Advice (CCA 201213022), IRS expressed the view that Ponzi scheme losses suffered by taxpayers are theft losses, under IRC Section 165, even though the taxpayers invested through individuals other than the perpetrator himself (such as a fund manager) because of the close connection or relationship among the parties.