Not All Scam Victims Can Rely on Theft Loss Provisions for Relief

Financial scams and Ponzi-type schemes target all walks of life. Unfortunately, victims may not be entitled to comprehensive protection or relief from tax costs associated with the transactions involved in certain financial scams.

The shortcomings in this developing area of law may become more problematic as artificial intelligence introduces a new dimension to fraud.

AI is enhancing the sophistication and legitimacy of scams by making it easier to scam taxpayers. One use of AI includes using voice recordings that are generated from real voices of people the taxpayer knows, which is presumably based on cell phone calls and messages.

Scammers are using AI to connect information about taxpayers’ ownership of individual retirement accounts and qualified plans, so they can spoof the phone numbers of the companies administering these plans to ensure the fake number is displayed on the call.

Theft Loss Deduction

To avoid discovery of a Ponzi-type scheme, scammers often generate fraudulent statements reporting phantom income to the investors, which results in the investors paying taxes on income that was never earned. When the deception is detected, investors generally lose the amount of funds they invested—less any fraudulent earnings issued that the investor actually received, which likely came from new investors.

Before the Tax Cuts and Jobs Act was enacted in December 2017, taxpayers could deduct a qualifying theft loss as a miscellaneous itemized deduction—subject to a limitation equal to or exceeding 2% of adjusted gross income. Although this deduction might be restored to taxpayers as of Jan. 1, 2026, the IRS also separately provided favorable tax treatment to taxpayers affected by a Ponzi-type investment scheme.

Following the 2009 guilty plea of Bernie Madoff, who ran the largest Ponzi scheme in US history, the IRS issued Rev. Rul. 2009-9 to provide relief for investors that suffered losses in similar circumstances. Under Rev. Rul. 2009-9, taxpayers who incurred losses after investing in a Ponzi-type scheme were entitled to theft loss, not capital loss, treatment under Section 165(h) of the tax code—provided certain requirements are met.

Theft loss treatment is more advantageous because only a maximum of $3,000 of capital losses can be offset against ordinary income each year, after first offsetting net capital gains for the year. The remaining capital losses can be carried forward indefinitely for offset against capital gains.

Theft losses, however, are treated as ordinary losses, which offsets ordinary income. They must be deducted in the year the theft is discovered rather than the year(s) in which the fraud occurred.

These theft loss provisions only apply if the theft comprises a profit motive—that is, if the theft is based on the taxpayer investing in a fund that is expected to generate future profits, not realizing the fund is a Ponzi scheme.

Taxpayers who transfer funds to a scammer for other reasons can’t use these special provisions. Two such common scenarios are sending money in the belief it will save a loved one from harm, jail, or other woes; and moving money from an investment or bank account to an untraceable account recommended by the scammer based on a warning that the funds might be misappropriated if not moved.

Before 2018, some of these other taxpayers could have relied on Section 165(e). Theft loss deductions under Section 165(e), however, are suspended through Dec. 31, 2025, unless the loss is attributable to a federally declared disaster. Even once reinstated, Section 165(e) deductions will be restricted to the 2% of AGI limit on miscellaneous itemized deductions.

Tax-Deferred Accounts

The theft loss provisions exclude investors whose investments were stolen out of IRAs or similar tax-deferred accounts. The exclusion intended to prevent a duplicate deduction afforded to tax-deferred accounts, where the taxpayer first claimed a deduction for the original contribution into the account. Because the earnings are also tax-deferred, all distributions are taxable from the account.

Scammers often induce taxpayers to take distributions from IRAs or other tax-preferred accounts. Because the individual account owner purposefully makes the distribution, the IRS has generally viewed these distributions as taxable.

This determination fails to consider that the distribution was requested under false pretenses because the taxpayer didn’t realize they were being conned into moving retirement funds to an account that would be immediately stolen by a scammer. In some cases, though, thieves abduct accounts by embezzling funds before they’re received by the individual taxpayer.

The IRS and Congress have been silent on the scope of relief available to prevent taxpayers from incurring taxes on distributions taken out of tax-deferred accounts under fraudulent means where the taxpayer never exercised control of the distribution.

Section 72 states that income includes amounts received under an annuity or nonannuity distribution—generally from IRAs, 401(k) plans, and pension plans. Under this standard, taxpayers whose funds are unwittingly diverted from a pension plan or retirement account may be able to argue against taxation if the beneficiary or annuitant never had control over the disbursement.

A taxpayer whose retirement account is directly accessed by an embezzler or hacker, and who never receives the distribution, may not fit Section 72’s receipt requirement. However, a taxpayer who directly withdraws funds from the tax-deferred account and transfers the funds to the scammer may have difficulty arguing that the disbursement wasn’t received under Section 72.

Takeaways

Theft loss provisions may provide relief for theft losses with a business or profit motive. Rev. Rul. 72-112, however, broadly provides that theft includes any “felonious taking of money or property by which a taxpayer sustains a loss.”

But the tax code hasn’t expanded this definition in a manner that provides meaningful tax relief to persons targeted by fraudulent schemes that differ from Ponzi-type schemes. Because this is a developing area of tax law, it is important to consult with a tax professional to explore available tax relief.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Cindy Hull, a CPA and attorney, is tax controversy manager in Washington National Tax at RSM US, with focus on IRS collection procedures, examinations, and appeals.

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