Date Published: Jan 2009 San Francisco Business Times

Recently, it was discovered that Bernard Madoff was operating a Ponzi scheme that victimized numerous high profile investors. A Ponzi scheme is a fraudulent investment operation that pays returns from money received by subsequent investors rather than from any profits or earnings generated from the venture. Such a scheme typically offers extremely high returns in order to attract new investors. Ponzi schemes require a constant flow of money from investors to keep the operation going. Sooner or later, all Ponzi schemes are destined to fail because it cannot attract enough investors to keep the scheme going and the investors lose the money they invested in the scheme.

So, is there any recourse for the investors who were victimized by Madoff? Sadly, they probably cannot recover the funds they invested the scheme. However, the investors may be able to claim a tax deduction for a portion of the money they lost in the Ponzi scheme. The Internal Revenue Code allows a deduction for a loss arising out of a theft.

In order to claim a theft loss for tax purposes, a victim of the Madoff Ponzi scheme must demonstrate that Bernard Madoff actions were a violation of federal or state law. The victims obviously made advances to Madoff on the strength of his assurances that they would receive generous returns on their investments. Clearly, the victims relied upon the misrepresentations of Madoff and they would not have invested in the scheme otherwise. As such, Madoff’s fraud in obtaining the victims’ money brings this case within applicable state criminal statutes in respect to obtaining money by ‘false representation or pretense’ and potentially under provisions of the United States Code which make it a federal crime to use mails to defraud.

The next question is when the victims of the Madoff scheme can deduct their losses. The Internal Revenue Code provides that a theft loss deduction shall be permitted in the year of discovery. However, the loss deduction is deferred if a taxpayer has a reasonable prospect of recovering the loss. Judging by the media reports, the victims of Madoff’s scheme discovered their loss in 2008. As such, it appears the victims of the Madoff scheme could claim a deduction on this year’s tax return for their losses. Unfortunately for the victims of Madoff, a theft loss deduction may have to be deferred for sometime in the future. This is because investigators have yet to determine if Madoff transferred funds to offshore bank accounts or used funds to purchase other assets. Since these funds could be used to repay Madoff’s victims, it may be some time before the Madoff’s victims can claim the theft loss deduction.

It should be noted that there may be limitations to this loss deduction. First, the deduction will not cover the first $500 of the loss. Second, a theft loss is allowable only to the extent it exceeds 10 percent of each victim’s adjusted gross income.

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