Financial scams, including sophisticated Ponzi schemes, target people of all backgrounds. However, it is a lesser-known fact that victims may not be entitled to complete protection or relief on tax costs associated with transactions involved in certain financial scams. The inadequacies in this developing legal area might become more disturbing as artificial intelligence (AI) introduces a fresh twist to fraud.
AI is sharpening the sophistication and legitimacy of scams by making it easier to hoodwink taxpayers. Scammers are harnessing AI to synthesize voice recordings resembling those of people known to the targeted taxpayer, presumably collected from cellphone calls and messages. Furthermore, they utilize AI to collate information about taxpayers’ ownership of individual retirement accounts and qualified plans, allowing them to spoof the phone numbers of the companies managing these plans to ensure a credible number displays on the call. Read more.
To keep their Ponzi-type schemes unnoticed, scammers often fabricate fraudulent statements reporting ethereal income to investors. This leads to investors paying taxes on income they never actually earned. When the deception is finally detected, investors typically lose the amount they invested, excluding any fictitious earnings issued to them and likely received from the new cohort of investors.
Before the Tax Cuts and Jobs Act enacted in December 2017, taxpayers could declare a qualifying theft loss as a miscellaneous itemized deduction—subject to a limitation of 2% or more of their adjusted gross income. However, since the IRS give a favorable tax treatment in a specific Ponzi-type investment schemes, this deduction might be reinstated as of January 1, 2026.
Following the 2009 guilty plea by Bernie Madoff, infamous for running the largest Ponzi scheme in US history, IRS issued Rev. Rul. 2009-9 to cover losses for investors in similar circumstances. With specific requirements met, the ruling offered victims the right to theft loss rather than capital loss treatment under Section 165(h) of the tax code. This treatment proved more advantageous as it permitted taxpayers to deduct their losses in the year the fraud was discovered rather than the year(s) the fraud took place.
Regrettably, this relief only applies if the theft has a profit motive: the taxpayer must have invested in a fund projected to generate future profits, unaware that it was a Ponzi scheme. Moving money based on a fictional threat to a loved one or shifting funds to an untraceable account on the scammer’s recommendation won’t qualify for these special provisions.
The theft loss provisions also exclude victims whose investments were stolen out of their individual retirement accounts (IRAs) or similar tax-deferred accounts. Tax-relief for those who take distributions from these accounts under false pretenses has been an area of silence for both the IRS and Congress so far.
This burgeoning area of tax law justifies the need to discuss potential tax relief with a professional. As legitimate Ponzi schemes are becoming more conventional with new forms of fraud continually being concocted, every taxpayer should be aware of the existing limitations.
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