Form 4684 CPA explains how to deduct Ponzi scheme losses on Section B of Form 4684

Ponzi scheme losses are tax-deductible through Section B of Form 4684. Ponzi scams siphon off later investment funds to pay distributions and withdrawals to earlier investors. Typically, no true investment is ever made. Usually, Ponzi scheme operators issue fictitious reports to their investors and the IRS. So, the investor pays taxes on the fictitious gains and interest before the Ponzi scheme is unmasked. Apparently, Ponzi schemes are common enough for the IRS to issue special guidance on them.

“The IRS allows fantastic treatment for Ponzi scheme losses. But it would be nice for the government to provide better protection against them.”
- Gary Bode, Form 4684 CPA and tax accountant.

Normally, investment losses are capital losses, which usually only offset capital gains. It can years to use all of a capital gain loss. But the IRS views Ponzi scheme losses as theft, and are, therefore, ordinary losses which can offset ordinary income.

Tax Form Flow

Business: Section B of Form 4684 to Schedule K-1 to Schedule A of Form 1040.

Personal: Section B of Form 4684 to Schedule A of Form 1040.

Here’s what the IRS requires and allows

Even with favorable treatment, many IRS wrinkles exist.

• The losses must result from a Ponzi scheme as defined by the IRS.
• The losses are ordinary losses, not capital losses because the taxpayer entered the Ponzi scheme with the intent to make a profit.
• Losses are not subject to the $500 per event reduction.
• Losses are not subject to the 10% Adjusted Gross Income floor.
• Losses are reported in the year the Ponzi scheme is unmasked.
• Losses include cash and property contributed to the Ponzi scheme operator, net of distributions of course, and, any fictitious income you reported on prior tax returns.
• If the investor is not seeking recovery of Ponzi scheme funds, the safe harbor for the IRS is 95% of the losses as calculated above.
• If the investor is seeking recovery of Ponzi scheme funds, the IRS safe harbor limit is 75% of the losses.
• To qualify for the safe-harbor loss deduction, the taxpayer completes Form 4864, Casualties and Thefts, and a Statement from Appendix A of Rev. Proc. 2009-20.
• If your loss is greater than what you can use on the first tax return, the remainder is a Net Operating Loss that can be carried back and/or carried forward. The investor files amended tax returns for carry backs, which results in a tax refund.

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