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IRS Guidance on Madoff and Other Ponzi Scheme Losses is Taxpayer Friendly

By John Grumbacher
March 2009
People: Richard W. Talkov*

The IRS has just announced that it will not challenge losses claimed by innocent victims of the Madoff and other Ponzi schemes, if they agree to calculate their loss and follow certain procedures in accordance with a safeharbor. Most of Madoff’s victims who invested directly with him will find the safe harbor quite favorable. Key aspects of the safe harbor are:

  • Certainty that a loss can be claimed on the 2008 tax returns of Madoff victims.
  • Certainty that the loss is not subject to various limitations that might otherwise reduce the tax benefits now available to victims.
  • Certainty that tax losses can be claimed for fictitious income previously reported on a victim’s federal income tax return.
  • Certainty that unused losses from Madoff or other Ponzi schemes can be carried back 3 years, with up to an additional 2 carry back years if the victim otherwise meets the $15 million gross receipts test under the new rules of the American Recovery and Reinvestment Act of 2009.

The attractiveness of the safe-harbor for those who invested through feeder funds is somewhat less clear, due to questions not answered in the issued guidance.

In general terms, the safe-harbor will allow a direct investor to claim a tax deduction equal to 95% of the amount lost, with that result then reduced by potential insurance recoveries, such as from SIPC. The loss, before the 5% haircut, is calculated by aggregating the amount invested in the fraudulent scheme with the amount the investor reported as income in prior years and deducting withdrawals. A very important aspect of the safe-harbor is that it allows a victim to claim a loss for all of the fictitious income that had been reported to the IRS on the victim’s tax returns.

Another attractive aspect of the safe-harbor is that it allows the loss to be claimed in the year of discovery, which is clearly 2008 for Madoff’s victims. If the safe harbor is not elected, the IRS can be expected to argue that the loss is not allowable until the year in which the investor can show that there was no reasonable expectation of a recovery on the claims against Madoff and others.

Under the safe-harbor, a 25% haircut (rather than the 5% haircut) will apply to victims who make claims for recovery against certain third parties. Attempts to recover from SIPC or other insurers or to recover from the perpetrator of the fraud are allowed without causing the additional 20% haircut to apply. Thus, direct investors with Madoff clearly can file claims against the trustee and with SIPC without suffering the additional 20% haircut.

The loss allowed under the safe harbor is an ordinary, casualty loss. The IRS has stated that the amount of the loss will not be reduced by either the 10% of adjusted gross income or the $100 per occurrence adjustments that often applicable to casualty losses. The loss will be allowed without the reduction that arguably might have applied for 2% of the taxpayer’s adjusted gross income or the general 3% reduction for itemized deductions as a whole and generally will be allowable for alternative minimum tax purposes.

The loss will be a business loss and can create a net operating loss that can be carried back for at least three years. An additional up to two carryback years are available for taxpayers whose gross receipts over the preceding three years averaged less than $15 million.

While quite favorable, the IRS guidance leaves a number of open questions that we hope federal and state taxing authorities will address, including:

  • Where the investment was through a feeder fund, it appears that it is the fund, rather than the indirect investor, which is entitled to elect the safe harbor. Unfortunately, the guidance does not explicitly address whether the indirect investor is bound by any election filed by the fund or what consequences follow if the indirect investor makes a claim against a fund that did not, itself, participate in the Ponzi scheme.
  • For those states that do not allow net operating loss carrybacks and carryforwards, will a taxpayer election of the federal safe harbor bar amended state returns for prior years claiming that the victim was not taxable on fictitious income reported in those years? We look to each state to provide guidance on this question. Massachusetts has confirmed that since it does not allow individual theft loss deductions, the federal safe harbor is not applicable. However, Massachusetts has advised that individuals who paid Massachusetts income tax on fictitious income from Madoff and other Ponzi schemes consider filing a claim for refund from any tax paid in error by applying to the Commissioner for an abatement of tax. Generally, taxpayers can file claims for refund up to 3 years from the original due date of the tax return, determined without extensions of time to file. Most will need to file for 2005 refunds by April 15 of this year, which is fast approaching.
  • Confirmation that if the trustee successfully claws back some of the funds previously withdrawn, the investor will be entitled to a further theft loss in the year of payment.

If you have any questions about how this guidance may affect your personal tax situation, please feel free to contact one of the individuals listed below.

John Grumbacher

Richard Talkov*
*Mr. Talkov is an accountant and not an attorney.

This overview should not be construed as legal advice or legal opinion on any specific facts or circumstances. The contents are intended for general informational purposes only, and you are urged to consult your own lawyer concerning your situation and any specific legal questions you may have.

Pursuant to IRS Circular 230, please be advised that, to the extent this communication contains any federal tax advice, it is not intended to be, was not written to be and cannot be used by any taxpayer for the purpose of (i) avoiding penalties under U.S. federal tax law or (ii) promoting, marketing or recommending to another taxpayer any transaction or matter addressed herein.

© 2009 Goulston & Storrs – A Professional Corporation All Rights Reserved

* Not an attorney
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