In CCA 201213022, the IRS permitted a theft-loss deduction for a taxpayer’s investment in a Ponzi scheme even though the investment was not directly with the perpetrator of the scheme. In this case, the taxpayer invested in funds for which the perpetrator of the fraud served as an investment advisor. The taxpayer learned of the fund through a newsletter published by the perpetrator’s associate, which discussed the perpetrator’s skills as an investment manager.

In order to claim a theft-loss deduction, a taxpayer must show there is privity (a relationship) between himself and the perpetrator of the fraud. Privity is required because the fraudulent act must be a crime, and for it to be a crime the perpetrator must usually have a specific intent to deprive the victim of his property. The IRS concluded that the necessary privity existed because the perpetrator, although technically only an investment advisor to the fund in which the taxpayer invested, clearly controlled the investment activity of that fund and was able to use the assets of the fund in his criminal scheme.

The privity issue became very prominent after the Bernard Madoff Ponzi scheme came to light. Some investors had invested directly with Mr. Madoff, and the IRS provided safe harbor procedures for them to claim a theft-loss deduction. Other investors, however, invested indirectly with Mr. Madoff through feeder funds that invested with him. In many cases, investors in the feeder funds did not even know that the fund in which they had invested in turn invested with Mr. Madoff, until the losses surfaced. The IRS took the position that these feeder fund investors did not have the necessary privity with Mr. Madoff to claim a theft loss with respect to their investment in the feeder fund. Instead, the feeder fund would have to claim a theft loss and pass the loss through to its partners on Forms K-1.

CCA 201213022 does not go so far as to sanction a direct theft-loss deduction by a feeder fund investor. It permits a deduction only when the fund in which the taxpayer invested is effectively managed by the perpetrator of the fraud.