The IRS has issued Rev. Proc. 2011-58 addressing situations in which a lead figure involved in an investment theft loss known as a Ponzi scheme dies before being charged with criminal theft.

Background. A Ponzi scheme is a fraudulent investment scheme in which an individual or company purports to invest assets on behalf of investors but criminally appropriates some or all of the assets. If the investor wants to withdraw funds, the schemers will usually pay from the victim′s own investment, or from money paid in by other investors, rather than from true earnings on the investment. Fictitious investment earnings may even be reported back to the investors on fake information documents, such as Form 1099-DIV. Sooner or later though, such schemes collapse and the victims are left with heavy investment losses.

In 2009, following the Bernie Madoff indictment, the IRS released extensive guidance for affected taxpayers. Rev. Rul. 2009-9 covers the character, timing, and amount of investment losses resulting from criminal actions. Rev. Proc. 2009-20 provides an optional safe harbor method for eligible taxpayers to deduct theft losses from Ponzi schemes and other fraudulent investment transactions.

The investment theft loss and safe harbor guidelines are as follows:

• To qualify for this special tax relief, a qualified investor must have transferred cash or other property to the fraudulent arrangement.
• Some type of legal action must have been brought against the lead figure (or figures) responsible for the fraudulent arrangement, such as a federal or state indictment or criminal complaint. Note: The legal action need not have been brought by the taxpayer; nor does the taxpayer have to be involved in any class action suit.
• The loss is claimed in the discovery year–the year in which the indictment or other legal action is brought against the lead figure.
• The loss–referred to as the "qualified investment"–includes cash and the basis of other property invested in the fraudulent scheme, plus "phantom" income on which the investor paid tax in prior years, less any cash or property withdrawn from the arrangement.
• The deductible theft loss is the qualified investment × 95% (75% if the investor is pursuing any potential third–party recovery) less any actual recovery and less any potential insurance or SIPC recovery.
• The deductible theft loss is claimed in Section B of Form 4684, Casualties and Thefts. An investment theft loss is considered a business loss and thus not subject to the $100 floor or 10% of AGI limitation. Mark "Revenue Procedure 2009–20" at the top of the form.
• The taxpayer must also complete and sign the Statement by Taxpayer Using the Procedures in Rev. Proc. 2009–20 to Determine a Theft Loss Deduction Related to a Fraudulent Investment Arrangement. The statement can be found on pp. 13–14 of Rev. Proc. 2009-20.
• The IRS will not challenge the amount of a deductible theft loss claimed in the discovery year and calculated according to Rev. Proc. 2009–20 guidance, provided a taxpayer can establish the unrecovered amount of the original investment net income reported from the arrangement.

Updated IRS guidance. Rev. Proc. 2011–58 explains that following the 2009 guidance, some of the lead figures involved in Ponzi schemes have died before being charged with criminal theft. Thus, one of the requirements for applying the optional safe harbor method of claiming the investment theft loss–namely that an indictment or other state or federal criminal complaint was brought against the lead figure–has not been met with respect to these individuals.

Under the new revenue procedure, if a taxpayer sustained a loss from a fraudulent arrangement meeting all of the guidelines of Rev. Proc. 2009–20 and for which all of the following are true, then the loss from the arrangement qualifies for the optional safe harbor treatment.

1. The lead figure (or figures) has been charged with one or more federal or state civil complaints filed with a court or in an administrative agency enforcement proceeding,
2. The civil complaint alleges facts that comprise substantially all of the elements of a specified fraudulent arrangement,
3. The death of the lead figure precludes indictment or other criminal complaint against the lead figure, and
4. A receiver or trustee has been appointed with respect to the arrangement or arrangement assets have been frozen.

The discovery year (the year in which the loss is claimed) is the later of the year in which the civil complaint is filed or the year in which the death of the lead figure occurs.
Rev. Proc. 2011–58 modifies Rev. Proc. 2009–20 and applies to losses for which the discovery year begins after December 31, 2007.