Losses from Indirect Investment of Funds Used to Operate a Ponzi Scheme are Theft Losses.

In a recently released legal memorandum, the Internal Revenue Service (IRS) ruled that taxpayers' losses resulting from investments in funds that were used to operate a Ponzi scheme are theft losses under § 165, even though the taxpayers invested through individuals other than the perpetrator of the scheme, because the perpetrator intended to steal from the taxpayers.

In this case, each taxpayer invested in funds managed indirectly by fund managers. The taxpayers invested in the funds based on claims in an investment newsletter regarding the scheme perpetrator's qualities as a money manager. The newsletter, however, was not put out by the perpetrator, but rather by fund managers who extolled the investment expertise of the perpetrator.

Generally, a "specific intent" to deprive the victim of his property is an essential element of the crime, and "specific intent" requires a degree of privity between the perpetrator and the victim of the crime. Privity, is defined as a relation between parties that is held to be sufficiently close and direct to support a legal claim on behalf of or against another person with whom this relation exists. Because the taxpayers did not have any direct relationship with the perpetrator, they seemingly lacked privity with the perpetrator.

The Tax Court has addressed cases where taxpayers lack privity with the perpetrator in cases where the taxpayer has purchased stocks on the open market. In those cases, the court has held that there was no criminal intent on the part of the perpetrators to deprive the taxpayers of their property and therefore does not qualify as a theft loss. The taxpayers' turned over their property/assets to the perpetrators because of a market transaction, not because of the scheme itself.

In this case, however, the IRS determined that the taxpayers did have privity with the perpetrator even though they did not deal directly with the perpetrator. For guidance, the IRS looked to a series of Tax Court cases. In those cases, the taxpayers invested in Ponzi schemes through business associates instead of investing directly with the perpetrators of the scheme. The Tax Court held that there was no requirement for investors to have direct contact with the entity in which they are investing, and that the associate acted merely as a "conduit to the scheme" because the taxpayers handed over their funds with the sole purpose of investing in the perpetrator's Ponzi scheme.

Here, the IRS concluded that taxpayers directly invested in funds that the perpetrator used to operate the Ponzi scheme and that the perpetrator intended to appropriate the taxpayers' property from them. The fund managers' role in soliciting funds that were paid into the scheme does not deprive the taxpayers of privity with the perpetrator. Thus, the IRS ruled that the taxpayers' losses are theft losses, even though the taxpayers invested through individuals other than the primary perpetrator of the scheme.

To read the entire memo, click here.

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