Wikipedia: "A Ponzi scheme (named after con artist Charles Ponzi) is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from profit earned by the individual or organization running the operation. The Ponzi scheme usually entices new investors by offering higher returns than other investments, in the form of short-term returns that are either abnormally high or unusually consistent. Perpetuation of the high returns requires an ever-increasing flow of money from new investors to keep the scheme going."
The IRS calls a Ponzi scheme a Specified Fraudulent Arrangement: an arrangement in which a party (the lead figure) receives cash or property from investors; (ii) purports to earn income for the investors; (iii) reports income amounts to the investors that are partially or wholly fictitious; (iv) makes payments, if any, of purported income or principal to some investors from amounts that other investors invested in the fraudulent arrangement; and (v) appropriates some or all of the investors' cash or property.
The Madoff affair is a classic example of a Ponzi scheme. On December 10, 2008, Bernard Madoff made an admission to his sons that his investments were "all one big lie". The following day he was arrested and charged with a single count of securities fraud. The losses were estimated to be $65 billion, making it the largest investor fraud in history. Madoff was sentenced to 150 years in prison.
The IRS issued rulings to provide that Ponzi scheme victims who aren't suing to recover their losses can generally deduct up to 95% of their qualified losses - minus any potential recoveries from insurance or the Securities Investor Protection Corp. - in the year the fraud is discovered. Those pursuing third-party recoveries can deduct 75% of relevant investments, after potential recoveries. The Securities Investor Protection Corp., SIPC, is an organization designed to help investors at failed brokerage firms.
In the rulings, the IRS provides that victims are not subject to limits that apply to personal casualty or theft losses and could carry back net operating losses five years to offset taxes paid, or forward 20 years. Under prior rules, many investors had to subtract $100 and 10% of their adjusted gross income from their loss deductions, and could carry back losses only three years, or forward 20 years.
In another change, the IRS said investors can include their principal, as well as any so-called phantom income they have received over the years, in their theft-loss deductions. Previously, the IRS allowed some Ponzi scheme victims to deduct only their principal as a theft loss, not phantom income.
In general, the tax code treats losses on investment securities as capital losses. Capital losses can only be deducted from realized capital gains and from $3,000 ($1,500 if you use married filing separate status) of ordinary income. Any leftover capital losses get carried forward to the following year, and the same limitation rule applies all over again. It can take years to fully deduct big capital losses.
On the other hand, ordinary losses can be written off against any type of income. If you have a big ordinary loss that exceeds what you can deduct in the loss year, the excess can create a net operating loss which can be carried back to previous years to obtain refunds for prior years, or carried forward to be deducted against income in future years, which is especially attractive if tax rates go up.
The IRS rulings provide that it will allow the favorable ordinary loss treatment for investment theft losses. Basically, such losses occur when your money is never actually used for the intended purpose of acquiring investment assets. The Madoff cased is a classic example. Money collected from later investors is used to cover income distributions and withdrawals paid to earlier investors.
If some amount of the loss is eventually recovered, the investor may have income in a subsequent year, depending on the actual amount of the loss recovered. Investors in Ponzi Schemes can be forced to pay back additional moneys earned from the Ponzi Scheme years before it exploded. This is what is known as a "clawback".
For example, Madoff's victims may recover some of their lost funds through the efforts of the Trustee's, Irving Picard's, recovery efforts. So far, he's recovered about $1.5 billion in assets to be split among customers with estimated losses of $19.4 billion. Picard has also filed lawsuits to recover another $15 billion from some of the Madoff firm's institutional clients and individuals, but how much of that will be clawed back remains to be seen. On March 19, the owners of the Mets, Saul Katz and Fred Wilpon, settled Irving Picard's clawback lawsuit against them for $162 million.
Carmel Lobello, writing for Death & Taxes, reports that Jeffry Picower, who died while swimming in the pool of his Palm Beach mansion last fall was Madoff's single largest beneficiary. His widow Barbara agreed to a massive settlement. The Trustees will receive all of the $7.2 billion the Picowers earned through Madoff's fraud. "We will return every penny received from almost 35 years of investing with Bernard Madoff," she said in a statement. "I believe the Madoff Ponzi scheme was deplorable, and I am deeply saddened by the tragic impact it continues to have on the lives of its victims. It is my hope that this settlement will ease that suffering." Mrs. Picower's generosity will make it possible for Madoff victims to recover about half of their losses.