## Facts

- An individual, cash-basis taxpayer invested funds with a promoter who claimed to act as an investment advisor and broker and was given power of attorney to trade securities.
- The taxpayer made an initial investment and later added additional contributions.
- The promoter issued periodic account statements and tax-reporting forms showing purported investment gains and income over multiple years.
- The taxpayer reported the purported income on federal returns in the years shown on the statements.
- The taxpayer received at least one distribution before the fraud was discovered.
- In a later year, authorities discovered the arrangement was a Ponzi scheme involving criminal fraud/embezzlement; only a small fraction of investor funds remained.
- The taxpayer received no reimbursement in the discovery year.

## Issues

1. Whether the investor’s loss from criminal fraud/embezzlement is a theft loss under § 165 or a capital loss.
2. Whether the loss is subject to the personal theft-loss limits of § 165(h) or the itemized-deduction limits of §§ 67 and 68.
3. In which year the loss is deductible under § 165(e) and the “reasonable prospect of recovery” doctrine.
4. How to compute the amount of the deductible loss, including treatment of previously reported “phantom income” and withdrawals.
5. Whether the loss can create or increase a net operating loss under § 172.
6. Whether § 1341 (claim of right) applies to allow recomputation of prior years.
7. Whether the mitigation provisions (§§ 1311–1314) apply to permit adjustments to otherwise closed years.

## Decision

- The loss was characterized as a theft loss under § 165, not a capital loss, because it arose from criminal fraud/embezzlement rather than a sale or exchange of a capital asset.
- The loss was treated as incurred in a transaction entered into for profit under § 165(c)(2), and therefore was not subject to § 165(h) personal theft-loss limitations or the itemized-deduction limitations of §§ 67 and 68.
- The loss was deductible in the year the theft was discovered, reduced by any portion for which the taxpayer had a reasonable prospect of recovery.
- The amount of the loss was computed generally as: total cash invested plus amounts previously included in income from the arrangement, minus withdrawals/distributions and minus expected recoveries (e.g., insurance or other reimbursements).
- The theft loss could create or increase a net operating loss under § 172, subject to generally applicable NOL rules.
- Section 1341 did not apply because the taxpayer was not restoring amounts previously received under a claim of right.
- The mitigation provisions (§§ 1311–1314) did not apply to reopen closed years based on the theft loss.

## Legal Principles

- A loss from criminal fraud or embezzlement in an investment arrangement is a “theft loss” under § 165 when the taxpayer’s property is wrongfully taken; it is not a capital loss absent a sale or exchange.
- Theft losses from transactions entered into for profit fall under § 165(c)(2), and are not subject to personal theft-loss limits in § 165(h) or the itemized-deduction limitations in §§ 67 and 68.
- Under § 165(e), a theft loss is generally deductible in the year of discovery, but only to the extent the loss is not compensated by claims with a reasonable prospect of recovery.
- The deductible amount may include previously taxed amounts reported as income from the scheme when those amounts were not actually realized, and must be reduced by withdrawals and expected recoveries to avoid double tax benefits.
- A theft loss under § 165(c)(2) may be included in computing an NOL under § 172.
- Section 1341 requires a repayment/restoration of amounts previously included in income under a claim of right; victim losses from a Ponzi scheme do not satisfy that condition.
- The mitigation provisions apply only to specified categories of determinations and errors; a Ponzi-scheme theft loss does not, by itself, trigger mitigation relief.

## Conclusion

The ruling set out the IRS’s position that Ponzi-scheme investor losses are ordinary theft losses deductible in the discovery year (subject to recovery prospects), computed by reference to invested funds and previously taxed phantom income net of withdrawals and recoveries, may generate NOLs, and do not permit relief under § 1341 or the mitigation provisions.


Rev. Rul. 2009-9, 2009-1 C.B. 735 (2009)