REPORT NO.3 - Is the Safe Harbor Worth it?

DOWNLOAD #3 REPORT to your computer as a .pdf. or read it below.
The Madoff Tax Losses - Is the Safe Harbor Worth it?

Much has been written about the two documents released by the I.R.S. regarding the taxation of Ponzi schemes. There is Revenue Ruling 2009-9 (the "Rev. Rul.") in which the I.R.S. has clarified much of the unsettled law in this area. Likewise there is Revenue Procedure 2009-20 (the "Rev. Proc.") which provides an uncomplicated path through the law and will be helpful to thousands of Madoff victims who will have a short route to cash refunds from tax losses. This will be sorely needed by many. This is provided in what the I.R.S. calls a "safe harbor" procedure.
The two documents by IRS are a good package and drafted in record time for any government agency. The I.R.S. worked well.

HOWEVER, IT IS IMPORTANT TO REMEMBER IRS IS NOT IN BUSINESS TO GIVE BACK MONEY. The "safe harbor" needs to be carefully studied because it is a safe harbor that could be extremely expensive from a tax standpoint. It might be a safe harbor but the tax cost to dock your boat in this harbor could be very high.

ONE VERY SIMPLISTIC EXAMPLE. Assume that there is $30 Billion ofMadoff losses that would be able to receive theft loss tax benefits. Assume this Madoff income or amounts of principal, when taxed were in the highest tax brackets. This is because most earners of Madoff phantom income had other sources of taxable income.

Therefore, again to keep it simple, assume the average tax bracket is 35% for the Madoff income included in prior years. Taxes collected [10.5 Billion] (35% x $30 Billion).
Assume these Madoff losses are deducted in 2008 and used against income for the years 2003 through 2007 as loss carry backs from the theft loss deduction.

This will mean that Madoff income and Madoff investments of principal that have been taxed at the highest brackets will be carried back and applied against all of the income in a particular year. To a large extent these losses will offset income in each prior year that was earned at lower rates. Income and principal taxed at 35% might be offsetting income in a carry back year taxed at only 15%.
The amount of any refund from the loss carry back will suffer accordingly. If it is assumed that the refund paid on the $30 Billion in tax was a refund based at an average 25% tax rate, (25% x $30 Billion) the refunds paid to the taxpayer would total ($7.5 Billion). In this case the I.R.S. has made $3.0 Billion ($10.5 Billion in tax - 7.5 Billion in refunds)

Furthermore, the I.R.S. will have kept the $10.5 Billion in tax revenue for years without paying interest.

For reasons like this and for many other situations many Madoff victims may choose not to avail themselves of the safe harbor of Rev. Proc. 2009-20. This is especially so since the legal guidance offered by Rev. Ruling 2009-9 is so helpful.

I have chosen to use the Chart on the following page to explain and compare the effects of the Revenue Ruling and the Safe Harbor. I have also attached both the Ruling and the Procedure as an Appendix. I believe the Chart shows that for many taxpayers the "tax rights" that must be waived to take advantage of the "tax benefits" of the safe harbor could be very expensive and unnecessary. Many taxpayers will find that the tax benefits available by relying on the Revenue Ruling and the state of the law are preferable alternatives to the benefits of the safe harbor.

The Chart refers to a series of footnotes that are discussed as a narrative in this Report No. 3. As the Chart is being described and in closing we will look at some of the tax planning concepts that must be considered before choosing between the safe harbor and the law.

Introduction to the Chart
Prior to the issuance of Revenue Ruling 2009-9 there was a good deal of case law interpreting various aspects of the theft loss deduction. The cases relied on, were at times 40 to 50 years old and many reflect the absence of the type of forensic accounting that can be accomplished today. For this reason and others, though there was a great deal of case law interpreting the statutes and regulations, there remained a great deal of confusion on where certain lines were drawn. The Internal Revenue Service has done an extremely good job of clarifying that confusion by way of the Revenue Ruling. These clarifications are very helpful whether one chooses to be covered by the safe harbor or not.

The Chart shows that there are certain benefits to using the safe harbor, but it also shows that most of the tax benefits granted by the safe harbor are no different from the tax benefits that the taxpayer would receive under the law as interpreted by the Revenue Ruling. However to achieve these benefits, the safe harbor requires that the taxpayer must waive potential valuable tax rights.
Finally, the Chart shows the I.R.S. is using a not so subtle form of administrative coercion to force the use of the safe harbor by announcing that those who do not choose the safe harbor may be subject to stricter standards of proof and an increased audit potential .

Therefore, it is imperative that Madoff victims meet with their accountants and financial advisors that have the knowledge and facilities to provide proper spread sheets that will compare the economic effect of the use of the safe harbor versus that of the reliance on the law in each individual situation.

The chart shows another extremely important economic factor. Under the alternatives to the safe harbor, Madoff victims could be entitled to significant interest payments on the I.R.S. refunds from amended returns and claw backs that are calculated on prior years, some of which may have occurred long ago.

The theft loss refunds under the safe harbor will not carry interest if they are timely paid once a claim is filed.

(click here to enlarge chart)

The Footnotes
1. A Ponzi Scheme Loss is a Theft Loss Deductible as an Ordinary Loss.

Both the Revenue Ruling and the Revenue Procedure agree that a loss from a Ponzi scheme is a theft loss for tax purposes. The Revenue Ruling is a good guide to the standard that must be met for a loss to be considered a theft.
Both the Revenue Ruling and the Revenue Procedure. also make it clear that a theft loss from a Ponzi scheme is an ordinary loss and not a capital loss.
2. The Amount of the Loss (Basis) and Phantom Income.

The Revenue Ruling and the Revenue Procedure both acknowledge that the amount of a theft loss resulting from a Ponzi scheme is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn. Furthermore, both agree that if an amount is reported to the investor as income in years prior to the year of discovery of the theft and the investor includes the amount in gross income; then the amount of the theft loss is increased by the purportedly reinvested amount (the "Phantom Income").

The Revenue Ruling says it best:

The amount of a theft loss resulting from a fraudulent investment arrangement is generally the initial amount invested in the arrangement, plus any additional investments, less amounts withdrawn, if any, reduced by reimbursements or other recoveries and reduced by claims as to which there is a reasonable prospect of recovery. If an amount is reported to the investor as income in years prior to the year of discovery of the theft, the investor included the amount in gross income, and the investor reinvests the amount in the arrangement, this amount increases the deductible theft loss.

3. Five Year Loss Carry Back of Net Operating Losses.

The safe harbor provides that the Section 1211 of the American Recovery and Reinvestment Act amends the IRS code to allow certain taxpayers, including individuals, to be eligible to elect a 3, 4 or 5 year net operating loss carry back that is applicable only to net operating losses in the year 2008. The Revenue Ruling also interpreted this change in the law to apply to individual investors. The Revenue Ruling that is attached is very instructive on the requirements that must be met to qualify for the five year carry back and the legal reasons why it does apply to individual Ponzi scheme victims.
4. The Deduction is not Reduced by the Application of Certain Percentage or Dollar Limitations.

The Revenue Ruling makes it clear that the theft loss is an itemized deduction and that several Code Sections that typically apply limitations to deductions are not applicable to theft losses from a Ponzi scheme. The 2% limit on itemized deductions does not apply to the theft loss; nor does the overall limit of itemized deductions that is based on a percentage of adjusted gross income apply. Finally, the $100 exclusion that must be met before taking a deduction for personal theft losses does not apply to Ponzi Scheme theft losses.
The safe harbor grants the same treatment.
5. Respect for Pass through Entities.

The safe harbor directly comments on the treatment of investors in Ponzi schemes through entities that are separate and apart from the Ponzi victims, such as partnerships. The safe harbor states that an investor that would otherwise be qualified for a theft loss will not be considered to be qualified to claim that deduction under the safe harbor. Instead, the safe harbor states that the actual fund or entity itself in which a Madoff investors has invested in will be considered the qualified investor for purposes of the safe harbor.
There have been comments by I.R.S. officials and commentators that pass through entities such as partnerships and Sub Chapter S companies will report Madoff losses to each investor on their Schedule K-1 so that investors who can not use the safe harbor may file for their losses under the standard rules applied to pass through entities.
These "indirect investors" who want to avail themselves of the safe harbor need to make sure that the pass through entity in which they have invested is a "qualified investor" and complies with the safe harbor procedures.
Furthermore, in determining whether the five year extended loss carry back period will apply, again the I.R.S. will look to the pass through entity and its gross receipts. The five year carry back is only available to qualified investors whose annual gross receipts for 2006, 2007 and 2008 do not exceed $15 Million.
The safe harbor considers the discovery year to be the year in which an indictment, an information or a complaint is filed against the perpetrator(s) of the Ponz i scheme.
6. Year of Discovery and Deductibility-2008.

The safe harbor, like the law both find that a Ponzi scheme will be treated as a theft loss and as a theft loss it is deductible in the year of discovery.
The safe harbor provides a specific definition of the discovery year by linking the year of discovery to a year in which certain actionsmay be taken against the perpetrators of a Ponzi scheme. The safe harbor provides that the taxpayers who do not follow the safe harbor must establish "that the theft loss was discovered in the year the taxpayer claims the deduction".

The safe harbor considers the discovery year to be the year in which an indictment, an information or a complaint is filed against the perpetrator(s) of the Ponzi scheme.

The taxpayer who is not choosing the "safe harbor" may have the responsibility to prove under the existing law that the year 2008 was the year of discovery. In essence I.R.S. is saying to the taxpayer prove there was a theft loss and prove the taxpayer knew about it in 2008.
The facts here speak for themselves. Madoff was arrested in December 2008 for crimes that would qualify as the theft under the safe harbor and the general law. Furthermore, Madoff's arrest and crimes were of broad public knowledge before the end of the year 2008. It would be rare to find even non Madoff related individuals who had not heard about the scheme by 12/31/08. In most cases, the taxpayer's records are meticulous.
The law and the Revenue Ruling interpret "the year of discovery" for theft losses in a more liberal way than the requirements of the safe harbor. The safe harbor requires that certain specific actions be taken by authorities before a theft loss is discovered for tax purposes. The law does not require that the taxpayer go to that extent to have a theft loss.
The case law defines the proof needed to pinpoint the year of discovery as follows:

A loss is considered to be discovered when a reasonable man in similar circumstances would have realized the fact that he had suffered a theft loss.

The year of discovery has also been described as:

"The proper year in which to claim a theft loss . . . being the year when the taxpayer in fact discovers the loss".

This author believes that the typical Madoff taxpayer will be in the position to prove, if necessary, that as far as they are concerned, the Madoff loss is in the year 2008. A review of the facts here finds that Madoff was indicted for his crimes in 2008. The safe harbor would find that this is sufficient enough. However, there is much more to the evidence that can prove that 2008 was the year of discovery.
Since the Madoff investment was so critical to many economic plans, every Madoff investor who had discovered the theft in 2008 will most likely have document upon document of proof. This will be in the form of communications between the taxpayers and their lawyers, accountants, family members and others. It will include documents received from the trustee in receivership and numerous professionals soliciting services and email communications. The list of evidence goes on.
As to the year of discovery, it would seem the I.R.S. will have very little direct evidence to overcome a well prepared tax return reflecting the strength of the taxpayer's position and the strength and depth of the proof of that position.
Finally, for whatever it is worth, the Revenue Ruling uses a factual example with facts much like the Madoff case and acknowledges that the year 2008 would be the year of discovery at least for victims in the ruling.
On the whole, when it comes to the year of discovery, the actual factual situations for the typical Madoff victims that do not accept the safe harbor are very similar to those that accept the safe harbor. Certainly, there will be highly unusual situations that will not fit thismold.
While there are no guarantees it would seem that the case law; the particular facts regarding the Madoff theft; and the finding by I.R.S. in the Revenue Procedure that the year of discovery was 2008, are all powerful proof for equal treatment on the issue of the year of discovery for all Madoff victims that are similarly situated whether the safe harbor rules would apply or not.
7. Amount of Loss in the Year of Discovery.

In their statements, the Revenue Ruling and the safe harbor both acknowledge as a legal matter that the determination of the year of discovery which is the year for the deduction of the theft loss and the determination of the amount of the deduction in the year of discovery are two different exercises.
The safe harbor actually acknowledges this legal principle by establishing percentage amounts of deductibility for the loss in the year of discovery.
Both acknowledge that if, in the year of discovery, there exists a claim for reimbursement with respect to which there is a reasonable prospect of recovery, no portion of the loss for which reimbursement may be received is deductible in that year. However, the portion for which there is no prospect of recovery is deductible in the year of discovery.
In the safe harbor, the I.R.S. makes a factual determination for all Ponzi schemes and not just Madoff. This determination is that a certain percentage amount of a theft loss can be deducted in the year of discovery of a Ponzi scheme when calculating the ultimate amount of the deductible loss.
The safe harbor provides two specific amounts that may be claimed as the amount of loss in the year of discovery. Those amounts fall into two categories. The Madoff victim will be permitted to take the amount of the entire theft loss and deduct 95% of that amount so long as the taxpayer is not seeking any third party recovery for theft loss tax purposes.
In the event that the Madoff investor is pursuing or intends to pursue any recovery from third parties, then the amount deductible in the year of discovery will be limited to 75% of the deductible loss.
A Revenue Ruling only comments on the law. It gives legal guidelines as to the timing of deductibility of a loss but cannot comment on the specific amount of the loss in the year of discovery. The Revenue Procedure says that if a taxpayer does not use the safe harbor it will be up to the taxpayer to rely on the case law in this area to prove that the 95% and 75% figures used in the safe harbor are accurate or close enough to be relied on by ALL Madoff victims.
It is important here to keep in mind that whether a taxpayer uses the Rev. Rul. or the safe harbor, whether the amount of the theft loss that is being deducted in 2008 is 75%, 85% or 95% of the total theft loss; the balance of the theft loss that is not claimed in the year of discovery (2008) will be claimed in a later year when it is clear that no further recovery will be available. No theft loss deduction is "lost" just because it is not deducted in the year of discovery.
The taxpayer who does not use the Safe Harbor may still claim the 95% and 75% figures as correct. However, that taxpayer is going to be required to prove that the 95% and 75% figures used by the I.R.S. are accurate for the taxpayer's situation using evidence that is separate and apart from the I.R.S. findings. The I.R.S. has definitely done many taxpayers a favor in the safe harbor by determining a fixed percentage for Ponzi scheme loss in the year of discovery. However, for Madoff victims, the law may provide a similar result if there is the right proof to back it up.
The law provides that the taxpayer would be permitted to take 100% of the loss in the year of discovery minus any amounts for which there is a reasonable prospect of recovery. To determine what the safe harbor provides to the taxpayer, another comparative chart is necessary.

The chart shows that the forensic accountant can provide the taxpayer with the critical proof that is needed to support the taxpayer's calculation of the reasonable recovery expected in the year 2008.

If one does not use the safe harbor to pin down the amount of the loss in the year of discovery, success may depend upon the state of the taxpayer's books and records and the expertise of the taxpayer's tax lawyer and accountant.

Certainly if there is no solid proof of the taxpayer's potential recovery amount or lack thereof, the taxpayer may be well advised to take the safe harbor.

The Doctrine of Equality of Treatment and the Nature of a Safe Harbor
While tax law as a general rule does not look at the equities of a taxpayer's situation, Madoff and other Ponzi schemes might warrant that type of treatment.
To begin with, one needs to understand what generally is meant by a safe harbor and the "doctrine of equality of treatment".
A safe harbor is typically an I.R.S. procedure that permits taxpayer's certain tax treatment without administrative question because the permitted tax treatment is well within the outside boundaries of what I.R.S. believes is the law.
Furthermore, there is a Doctrine of Equality of Treatment that is applied sparingly but nevertheless requires the I.R.S. to exercise its discretion in a manner so that similarly situated taxpayers are treated equally.
It would seem difficult for the I.R.S. to make a factual finding that all of the taxpayers suffering Ponzi scheme theft losses, wherever and whenever they may be, will be permitted a deduction at certain fixed rates at 95% and 75%; while denying these same rates of deduction to a select group of similarly situated taxpayers who choose not to do it the I.R.S. way.
Quantifying the Amount of Theft Loss in Year of Discovery

(click here to enlarge chart)

The Waiver of Tax Rights
Footnotes 1 through 7 compared the benefits of the safe harbor with the law as described by the Revenue Ruling.
Footnotes 8, 9 and 10 explore The Waiver of Potential Benefits in exchange for the benefits of the safe harbor and how costly that harbor may be from a tax standpoint.

8. Waiver of the Right to File Amended Returns.

The safe harbor requires that the Madoff victims forego the opportunity to file amended returns for those years that are still open by the statute of limitations. However, by amending a prior return instead of taking a theft loss deduction, a taxpayer can eliminate only the taxpayer's Madoff "phantom income" from the taxable income in the prior years. This will typically be the high bracket income. This manner of recouping loss in a Ponzi scheme generally has been acceptable under the law in limited circumstances. The theory is that if there was no "real income" at the time it was reported, the phantom income can be eliminated as taxable income instead of being claimed as a theft loss. In the Madoff situation this theory would seem to have a lot of merit. It is bolstered by statements by authorities that there was a lack of any real trading by Madoff for years.
Amending a prior return permits the taxpayer to eliminateMadoff income for the years 2005 through 2007 and other open years (if the statute of limitations for 2005 has been preserved). Many taxpayers will receive a significant benefit by amending their returns instead of claiming the theft loss for prior years. By amending prior returns to eliminate Madoff income, the taxpayers will generally be receiving a refund only for their Madoff "phantom income" tax payments. This will typically be from the higher tax brackets thus, a deduction obtained from amending tax returns to eliminate only the Madoff income may be more valuable than a theft loss deduction. Furthermore, refunds from amended returns may carry interest from the year of overpayment. (see below)
A taxpayer's waiver of this right to file amended returns could be very costly, depending upon the amount of the losses, the year of the losses and the taxpayers' financial situation in both the past and in the future.
The ability to use Madoff tax losses at the highest brackets by amending prior tax returns will leave more of those losses available to be carried forward into future years as opposed to being used to offset income from prior years and lower tax brackets. To the extent that amended returns do not use up all of the tax losses, these excess losses can be claimed as theft losses in the year 2008 and can then be used as a 20 year carry forward against ordinary income. With the Federal income tax already destined to become higher and state and cities raising their income taxes, theft loss deductions that are carried forward may have significantly more value in the future. They may in the future provide deductions for income that could be subject to federal, city and state income taxes totaling in excess of 50%.
9. Claw backs and the Right to Use Code Section 1341.

The safe harbor insists that the taxpayer waive their right to Internal Revenue Code Section 1341. Code Section 1341 in essence provides that if a taxpayer paid tax on income that the taxpayer claimed a right to a prior year and the taxpayer then was required to pay that income in a different year, the taxpayer would be able to take the deduction either in the year in which the payback or claw back was made or in the year that the income which was clawed back was taxed. This is the case even if the statute of limitations is closed in the year that the original tax was paid.
The Revenue Ruling did comment on the use of this Code Section 1341 and stated that it was not applicable under the circumstances of the Revenue Ruling. However, the Revenue Ruling did not go far enough since it did not describe or comment on whether Code Section 1341 applies to a claw back situation. A full discussion of a taxpayer's possible rights under Code Section 1341 is beyond the scope of this Report. However, many taxpayers that are required to make claw backs might find that Code Section 1341 would apply to their clawbacks and that waiving the rights to the use of this section could be extremely costly.
The tax bracket comparisons here could be significantly different for those taxpayers who may have to pay claw backs in future years. Taxpayers that pay claw backs and have very little taxable income in future years may take a deduction for the amount of the claw back payment. However, those taxpayers might make only minimal use of the claw back deduction. By using Code Section 1341 there is the potential for taxpayers to claim that claw back payments should be applied against taxable income in old years (otherwise closed by the statute of limitations) where they would be much more valuable as tax deductions if income was reported at high tax brackets in these years.
For example, a claw back of $500,000 that provides a tax refund of only 15% in a year when income is low, ($75,000); might provide a cash return at the 35% high tax bracket from a prior high tax bracket year of ($175,000). The difference of 20% in the brackets is $100,000 of real money. Furthermore, the interest paid on a refund going back in years could be significant. By waiving the benefits of Code Section 1341 the taxpayer eliminates the potential for these increased earnings from tax refunds.
10. Interest on Refunds.

An unstated benefit in the Ruling and the Revenue Procedure that is being waived when taxpayers choose the safe harbor is the possibility of receiving interest paid in those circumstances where either the use of Code Section 1341 or the use of amended returns will result in refunds.
Taxpayers that receive refunds as a result of the safe harbor will receive those refunds as a result of the loss carry back to prior years from the year 2008. Tax refunds from the carry back of net operating losses are calculated from the filing date in the year in which the net operating loss arose.
Furthermore, in the case of a refund from such a loss, the interest will start on the filing of the claim, plus a further interest free 45 day period within which I.R.S. may pay the claim after it is filed.
However, where the refund of an overpayment as a result of an amended tax return or because of Section 1341, the interest on that refund amount is calculated from the prior year when the overpayment was made.
11. I.R.S. Administrate Issues.

Finally we reach Footnote No. 11. This deals with the Internal Revenue Service indications that there may be administrative difficulty for tax returns byMadoff victims that do not choose to use the safe harbor. The Service has clearly stated that those people who do not choose the safe harbor will need to be concerned with proving the year of the theft loss and proving the amount of the theft loss under the existing rules. However, this statement by I.R.S. is tempered since it also states that taxpayers that are not covered by the safe harbor will also not be challenged on the issue of whether "phantom income" is deductible when the phantom income amounts shown on the taxpayer's return were based on information received from the Ponzi scheme, in the taxable years.
Finally, the Service added a caveat that tax returns claiming Ponzi scheme type deductions that do not use the safe harbor may be subject to increased audit exposure.
12. Tax Planning.

There are many that may significantly benefit by making use of the safe harbor. For many, the Revenue Ruling and the law will be helpful. This will depend upon each individual circumstance. Large Madoff tax losses and smaller ones all need to pay attention to the traps and opportunities.
Taxpayer's that use the "safe harbor" are also going to need sound advice on the valuation of their SIPC claims. They must focus on how this might reduce the amount of the theft loss in the year 2008. For example, a taxpayer with a maximum $500,000 Madoff loss and a claim against SIPC for $500,000 that is not resolved by the time the tax return is filed, may be forced to delay claiming any theft loss deduction in 2008 since there is a "reasonable prospect of recovery" of the investor's loss. The inability to use the theft loss in 2008 could significantly affect the amount of any tax refund.

Amended Returns Might Permit The Madoff Victims To Have Their Tax Benefits And A SIPC Recovery.

ESTATES AND TRUSTS

There will be a host of estate and income tax issues that will not be covered by the safe harbor and that have not been answered by the Revenue Ruling. Not to be overlooked is the effect on the deductibility of theft losses from a standpoint of an income tax versus an estate tax value.
IRA'S AND PENSIONS

Losses in IRAs and Pension accounts will generally not be deductible for tax purposes since they represent the loss of funds with no tax basis. However, there may be recoveries of funds by these entities or claw backs that will be taken from them that will need to be addressed if millions are not to be lost in potential tax deductions.
LOSS CARRY FORWARDS

One also can not overlook the general tax planning thinking that needs to occur in planning for loss carry forwards that may result from the Madoff tax theft. In the case amended returns have been filed, it is also important to file for the theft loss in year 2008 for the balance of losses. This will apply to those who take advantage of the safe harbor and those who do not. Going forward there will be many who will have Madoff tax losses to offset against future income. These losses may be permitted for a period of 20 years from the date of discovery of the theft. These future tax losses may go unused and be wasted for taxpayers who pass away. Those that have greatly reduced income against which tax deductions may be used will need special attention if those deductions are not to be wasted.
A good deal of thinking is in order for family members and related parties to determine how to legally take the best advantage of the Madoff tax loss that are carried forward. They could be very valuable or wasted assets.

There will be many tax planning tools available to meet these needs.

Richard S. Lehman, Esq.

Located in the Dorot & Bensimon P.L. Domestic & International Tax Law Office

2000 Glades Road, Suite 312

Boca Raton, FL.  33431

Phone: 561-368-1113

Ask your tax return professional about filing claim prior to April 15

VERY IMPORTANT -- (The following is not legal or tax advice and cannot be relied on in any manner.) Richard Lehman, P.A., is suggesting that you ask the professional who is filing your tax return for 2008, whether prior to April 15 it would be prudent to file protective claims for federal and state income tax purposes for 2005 and any earlier years that remain open. Protective claims are designed to hold the statute of limitation open until final decisions are made regarding the use of Madoff tax losses.

Richard Lehman will also be posting Report No. 3 shortly. This Report No. 3 will consider the Internal Revenue Service guidelines and will focus on those persons who will not take advantage of the ”safe harbor” provided by Revenue Procedure 2009-20.

There are going to be many factual situations in which Madoff victims will find there is significantly more value from a tax standpoint to choose to NOT take advantage of the “safe harbor” but instead will choose to follow the law as it now has been clearly defined in Revenue Ruling 2009-9.

You will be notified by email when Report No 3 is posted. Make sure you are on our list - sign up here if you have not already.

Florida tax attorney Richard Lehman recently spoke with Channel 5 WPTV about the Bernard Madoff case and the tax recovery options for victims.

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Bernard Madoff Pleads Guilty - Tax Recovery Advice for Victims (WPBF)
Florida tax attorney Richard Lehman recently spoke with Channel 25 WPBF about the Bernard Madoff case and the tax recovery options for victims.

Questionnaire For Madoff Victims Evaluating SIPC And Litigation Options - by Steven M. Katzman

1. Who introduced you to Madoff and/or his firm?
2. Do you know whether they received commissions or other forms of compensation?
3. Did anyone recommend and/or evaluate these investments for you?
4. Did anyone monitor, supervise or evaluate the performance of these investments during the time you were investing?
5. What is the total amount of cash that you have put in? (A schedule of amounts and dates of funds invested would be even more helpful).
6. What funds did you withdraw from your account? (A schedule of withdrawals, including dates and amounts, would be even more helpful).
7. If you invested with a brokerage firm, feeder firm or other third party, rather than directly with Madoff Investments, have you had any communications with them regarding your account after the Madoff Ponzi scheme was publically disclosed? If so, what were they? (If any were in writing, it would be most helpful to see them).
8. Do you have homeowner’s insurance, a liability or umbrella policy, or other insurance which might cover a “theft” loss?

If you've been a victim of Bernie Madoff 'Ponzi Scheme" you wont' want to miss this presentation

"WEALTH & WISDOM" on WXEL/Channel 42 - PBS Station WXEL
A focus on taxation, litigation and The Bernie Madoff Theft
This informatinve 8-PART SERIES will air:
January 16, 23, 30, February 6, 13, 20, 27, March 6, 2009
Featuring prominent Palm Beach County attorneys:
Steven M. Katzman & Richard S. Lehman

For more information call: 561-477-7774 or 561-368-1113 -- All WXEL Segments will be posted here as they become available.

PODCAST: (Audio Only)

PART 4: Friday, February 6, 2009


PART3: Friday, January 30, 2009


PART1: Friday, January 16, 2009


VIDEOS:

February 6, 2009 Segment (PART 4A &B ) WXEL Wealth & Wisdom show.

Claiming loss in 2008. Do you have enough facts together about this Madoff loss to benefit you on your 2008 taxes? Filing for an extension on your 2008 taxes - should you do it?



January 30th Segment (PART 3A & B)-WXEL Wealth & Wisdom show.

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PART1:
Friday, January 16, 2009
segment

"WEALTH & WISDOM" WXEL/Palm Beach, FL Featuring prominent Palm Beach County attorneys: Steven M. Katzman & Richard S. Lehman

If you have problems viewing this video - here is direct link to video site

Bernard Madoff Tax Loss - REPORT NO. 2

DOWNLOAD #2 REPORT to your computer as a .pdf. or read it below


Introduction

Report No. 1 introduced the reader to a key phrase. The phrase is a reasonable prospect of recovery. This phrase determines whether a deduction for the theft loss in a Ponzi scheme, such as Madoff's, should be taken in the year it is discovered or some other future year. The law does not permit the deduction to be claimed in a year prior to the year of discovery.

SINCE THE TIMING OF THE THEFT LOSS DEDUCTION IS CRITICAL TO THE REAL ECONOMICS OF THE RECOVERY, THIS PHRASE IS ALL IMPORTANT.¹

Therefore, before considering tax planning opportunities, this Report will study the phrase a reasonable prospect of recovery in more depth.

The phrase finds its origin in the early internal revenue codes that permitted a theft loss deduction for losses sustained in a taxable year but did not define the word sustained. Therefore, prior to 1954 the law was unsettled as to when a loss was sustained. This caused taxpayers to often lose their tax deduction for a theft loss when the statute of limitations had run on prior years; and it was later found that a loss had been sustained in one of those prior years that was no longer open for change.

The new law in 1954, that still applies today, adopted the principle that generally a theft was sustained in the year of discovery. However, this definition was tempered since it only applies to that portion or all of the theft loss that the taxpayer could identify as not having any reasonable prospect of recovery. Until it was clear that a loss was assured and closed and completed, there would be no deduction. The law attempts to make sure there is no deduction in the year of discovery or any other year unless the loss is assured.

The law tries to draw a fine line here. On one hand whether there is a reasonable prospect is a subjective matter in the eyes of the taxpayer. For example, at the year’s end 2008, many Madoff victims having heard about total losses and claw backs and questions of SIPC coverage may have believed there was no reasonable prospect of recovery at all.

However, on the other hand, the courts tell us that this subjective reasonable belief must be measured against objective facts.

There is no set of fixed rules that clearly define the taxpayer’s reasonable prospect of a recovery, that will result in a limitation of a taxpayer’s theft loss deduction in the year of discovery. However, it is possible to have a grasp of the concept by reviewing court statements defining the concept. We will also look at general principles that have emerged from the court cases and review two cases that could be said to represent the extreme ends of the spectrum of just what is a reasonable prospect of recovery.

Note 1: As explained in Report No. 1, most taxpayers will want to claim their theft loss deduction(s) starting in 2008 for maximum tax benefits and to take advantage of the legal standard that governs the allowance of the theft loss deduction in the year of its discovery.

One court has defined the reasonable prospect of recovery as follows:

This court must determine what was a reasonable expectation as of the close of the taxable year for which the deduction is claimed. The situation is not to be viewed through the eyes of the incorrigible optimist and hence, claims for recovery whose potential for success are remote or nebulous will not demand a postponement of the deduction. The standard is to be applied by foresight, and hence, we do not look at facts whose existence or production for use in later proceedings was not reasonably foreseeable as of the close of the particular year. Nor does the fact of a future settlement or favorable judicial action on the claim control our determination if we find that as of the close of the particular year, no reasonable prospect of recovery existed.

. . . a determination of whether a loss was in fact sustained in a particular year cannot fairly be made by confining the tier of facts to an examination of the taxpayer’s beliefs and actions. Such an issue of necessity requires a practical approach, all pertinent facts and circumstances being open to inspection and consideration regardless of their objective or subjective nature.

In determining whether a reasonable prospect of recovery existed as of the year of discovery, we start from the premise that petitioner is not required to avoid both the scullion role of the incorrigible optimist and the charbdian character of the estygian pessimist. The standard to be applied is the  

EXERCISE OF SOUND BUSINESS JUDGMENT BASED UPON AS COMPLETE INFORMATION AS IS REASONABLY OBTAINABLE.

Another court has stated it as:

The reasonableness of a taxpayer’s prospect of recovery is primarily tested objectively, although a court may consider to a limited extent evidence of the taxpayer’s objective contemporaneous assessment of his own prospect of recovery. “[t]he taxpayer’s attitude and conduct are not to be ignored, but to codify them as the decisive factor in every case is to surround the clear language of . .. [the statute] with an atmosphere of unreality and to impose grave obstacles to efficient tax administration.”

In addition to these general statements, the courts in deciding whether there is a prospect for a reasonable recovery have also agreed on several principles that provide further guidance:

(i) In determining the reasonableness of a taxpayer’s belief of loss the courts had to be practical and aware of the individual facts of a case.

(ii) The relevant facts and circumstances are those that are known or reasonably could be known as of the end of the tax year for which the loss deduction is claimed. The only test is foresight, not hindsight.

(iii) Both objective and subjective factors must be examined.

(iv) The taxpayer’s legal rights as of the end of the year of discovery are all important and need to be studied to make a proper decision.

(v) One of the facts and circumstances deserving of consideration is the probability of success on the merits of any claim brought by the taxpayer.

(vi) The filing of a lawsuit may give rise to an inference of a reasonable prospect of recovery. However, the inference is not conclusive nor mandatory. The inquiry should be directed to the probability of recovery as opposed to the mere possibility. A remote possibility of recovery is not enough; there must be a reasonable prospect of recovery at the time the deduction was claimed, not later.

The bottom line of the timing of the theft loss deduction is this.

Under the law a taxpayer who has suffered a theft loss shall take a theft loss deduction in the year the loss is sustained, which is the taxable year in which the taxpayer discovers the loss. However, if in the year the taxpayer discovers the loss, there exists a reasonable prospect of recovering some portion of the loss or all of the loss; the taxpayer must postpone the theft loss deduction for that portion or all of the loss that may reasonably be recovered.

If a taxpayer does not take a theft loss deduction for the entire loss in the year of discovery because the taxpayer has a reasonable prospect of recovering all or a portion of the loss, the theft loss deduction will be postponed until there is a recovery or there is a certainty that the postponed recovery will not happen. The theft loss deduction will not be lost by virtue of it being postponed.
During taxable years after the year of discovery, the taxpayer may take a theft loss deduction for that portion of any postponed losses when the taxpayer can ascertain with reasonable certainty that the reimbursement will in fact no longer be received. A taxpayer may ascertain with reasonable certainty whether he or she will be reimbursed by a settlement of the claim, by an adjudication of the claim or by an abandonment of the claim.

Lawsuits
Another way to try to appreciate the concept of a reasonable prospect of recovery is to review a few of the cases that were hotly contested and could be said to be on the extreme ends of the view of whether or not a taxpayer had a reasonable prospect of recovery. In reviewing these cases it is important to keep in mind that the presence or absence of a lawsuit seeking recovery is often a big factor in determining whether the taxpayer believed they would receive a recovery or not.
One court in weighing whether the presence of a lawsuit seeking recovery should determine whether the taxpayer had a reasonable prospect for recovery put it this way.

While we offer no detailed opinion as to the merits of the taxpayer’s legal position . . . we find that the taxpayer did have a reasonable prospect of recovering something. In arriving at this conclusion, we stress that the mere existence of a POSSIBLE claim or pending litigation will not alone warrant postponing loss recognition. There are many reasons for initiating lawsuits. In this case, taxpayer’s antitrust claim for treble damages exceeded 19 million dollars. Where the stakes are so high, a suit may be 100% JUSTIFIED even though the probability of recovery is miniscule. In short, although we offer no litmus paper test of reasonable prospect of recovery, we note that the inquiry should be directed to the probability of recovery as opposed to the mere possibility. Analyzing the rule in percentage terms, we would consider a 40 to 50 percent or better chance of recovery as being REASONABLE. A lawsuit might well be justified by a 10 percent chance.

Normally where a taxpayer is in good faith willing to go to the trouble and expense of instituting suit to recoup a theft type loss, the courts seem to find that as a matter of fact there was a sufficient chance of at least part recovery to justify that the taxpayer should defer the claim of a theft loss deduction until the litigation in question is concluded. This is not to suggest that in some cases the facts and circumstances will not show such litigation to be specious, speculative, or wholly without merit and that the taxpayer hence was not reasonable in waiting to claim the loss as a deduction.

Another court stated the importance of a lawsuit in determining a reasonable prospect of recovery as follows

. . . the mere existence of pending litigation won’t alone warrant postponing loss recognition. In determining whether there's a reasonable prospect of recovery, the inquiry should be directed to the probability of recovery as opposed to the mere possibility. And where the taxpayer’s chances of recovery in a lawsuit were in the realm of remote possibility rather than reasonable prospect, the court held that postponement of the loss deduction wasn’t required.

Case Law
Looking at the two cases that also will help define the reasonable prospect of recovery standard, we see two situations in which great efforts were made to seek a recovery of a loss, including extensive litigation. In both cases the courts did a complete analysis of the legal rights of the taxpayers and determined in one line of cases the taxpayer did not have a reasonable prospect of recovery even though the taxpayers never wrote the theft loss off of their corporate financial statements in the year of discovery; had tremendous lobbying efforts on their behalf both individually and through trade groups to recoup their losses from multiple sources; and in the case of one taxpayer (a bank) even had the perpetrators’ money deposited in their bank while the actions seeking recovery were ongoing. Since the victim, a bank had no legal rights to hold the deposited money; the funds were released from the victim bank to the perpetrator of the theft.

This was the situation when the Iranian government expropriated assets of U.S. companies in Iran with the fall of the Shah of Iran and the Iranian Hostage taking. In this case, the I.R.S. argued against permitting a theft loss in the year of discovery.

In spite of several potential areas of recovery, which did in fact later lead to recovery and consideration that was paid for confiscated assets; the court was convinced that no legal rights existed for recovery in the year of discovery. Without legal rights, efforts that may present only a possibility of recovery are not enough to stop the taxpayer from taking the theft loss deduction in the year of discovery.

On the other hand, while in the Iranian expropriation cases the existence of only possible legal rights did not foreclose the deduction, another court took a different view of the presence or absence of legal rights in the year of discovery. In this other court the I.R.S. insisted that a taxpayer must take his theft loss in the year of discovery because of the status of that taxpayer’s legal rights.

There, even though a taxpayer won litigation in the lower court awarding him a recovery, the Court found the lower court’s ruling was illogical and that in spite of the ruling allowing a recovery, the taxpayer had no real possibility of a recovery. The Court ruled that this taxpayer had no legal rights to recovery and was therefore forced to take the deduction in the year of discovery. The Court’s independent review of the litigation awarding the recovery was that the lower court’s opinion (which was in fact overruled) was wrong. Therefore, the taxpayer could not even rely on a successful lower court opinion to support his belief in the year of discovery that there would be a recovery.
Now you see why we have tax lawyers.

Tax Planning
The term tax planning usually envisions taking steps in advance of an economic transaction in order to maximize tax benefits from the profits that may occur from the transaction. There is also the concept of the post mortem tax planning which is found in the estate tax area and provides some flexibility for transactions and the setting of tax values after death.

Tax planning for the maximum tax benefits from the Madoff loss will have a little bit of both. The loss has already occurred, however, what remains is how the taxpayer will plan and implement his or her Madoff tax loss for maximum benefits now and in the future.

The tax planning for the most part will be to provide the taxpayer with appropriate projections of the use of the tax losses under differing circumstances so that the client will be able to understand the financial effect of various options that the tax loss and litigation recoveries may provide for. Since the theft loss may be carried back three years and carried forward 20 years, it is extremely valuable.

A litigation counsel as part of the team is critical to a successful professional product for several reasons. Each Madoff victim should understand every possible means of recovery that might be applied to the individual. Recoveries from SIPC and the IRS are not the only avenues of recovery that will be considered. As the facts unfold there may be more culprits of economic substance that can be a target of recovery.

Certain accountants, financial advisors, principals of feeder funds, boards of directors and the various Madoff bankrupt estates may be just a few of the potential sources of recovery. If these sources of recovery are viable, the Madoff victim will need to carefully weigh the pluses and minuses of the postponed tax benefits that may result from a victim choosing to actively pursue certain areas of recovery. As in all economic matters, the emphasis should always be on the maximum recovery of money from third parties before relying on the recovery from tax benefits.

This author believes that the tax planning should result in a professional work product that will most likely accompany an amended return or similar type of I.R.S. filing. The document will most likely be the work product of at least three of the client’s advisors. This should consist of their accountant or an accountant specialized in this area; a tax attorney and litigation counsel.

The theft loss tax benefits that one does not claim immediately will not necessarily be lost but may be realized at a later point in time when there is finality to each respective area of recovery that a victim has chosen to pursue.

For example, a taxpayer who files a SIPC claim expecting to recover $500,000 from SIPC may not claim a theft loss on that $500,000 in the year of discovery. The taxpayer should not however be prohibited from claiming a theft loss on Madoff losses in excess of $500,000.
Assume SIPC ultimately pays the $500,000 claim for only $300,000 in the year 2010. At that point, in 2010, the taxpayer would claim a further theft loss of $200,000.

The litigation lawyer will not only be necessary to analyze avenues of recovery and litigation claims, the litigator will also be important as an expert who is well versed regarding the viability or non viability of any claims for recovery. Therefore he or she will be very helpful in the taxpayer determining those avenues to pursue and those avenues that should be discontinued if their continuation would provide the I.R.S. with a strong argument to not permit the theft loss in the year of discovery, 2008.

The third essential expert is the tax lawyer who will need to coordinate all of the matters in light of the taxpayer's objectives and various legal standards that will need to be met to achieve those objectives.

With the professional team in place, the steps generally will be as follows:

1. Records.
The taxpayer must gather as complete a collection as possible of all financial records for as far back as one can find that involved theMadoff investment. This should include statements, tax returns and in some cases even estate tax returns.

2. Basis Calculations.
A determination of the taxpayer's tax basis in theMadoff loss must be undertaken. This basis needs to be calculated for each separate account as there may be different tax treatments and basis for estates, trusts, individuals, both American and non residents, corporations both domestic and foreign and charities.

3. Sources of Recovery.
A detailed description should be made of the various sources of recovery that have been explored. In those areas where no recovery is possible or none sought, a taxpayer may want to formally renounce rights to certain forms of recovery to ensure that there is no question that the taxpayer had no reasonable belief of a prospect of recovery as to those rights.

4. Loss in Year of Discovery.
Once the sources of recovery have been inventoried a determination should be made regarding the maximum potential loss that can be deducted for the year 2008. It will be critical to prove that if a taxpayer is seeking a source of recovery that the recovery is not reflected as the possibility to recover an unlimited or maximum amount of recovery if that is not truly the case. Recoveries that are open ended in nature will harm the chances to claim the theft loss deduction in 2008.

5. Accounting Schedules and Forecasts.
Upon determining the amount of theft loss for which there is no potential for recovery in

2008, it is then important to prepare the appropriate accounting schedules. These should reflect the effect of the tax losses and the cash that may be recovered from amended returns and the tax free income that may be earned because theft losses may be carried forward for 20 years.
These projections will be critical. For example, there may be a fairly recent estate involved in which an estate tax has been paid on the Madoff funds that were inherited. If this is the case, this must be considered in the calculations as the estate tax deduction, if available, may have a value of 45% to the taxpayer versus the 35% benefit of the income tax deduction.
Furthermore, these projections should be useful for planning purposes. Calculations will be needed to keep track of the theft tax losses that will be deferred in those cases where the taxpayer believed there was a reasonable prospect of recovery. In those cases, in the event eventually there is a recovery, the recovery will not be subject to tax but will reduce any original unused theft tax losses. To the extent a recovery exceeds any theft tax loss, it will be subject to taxation.

Once these basic steps have been taken, so that the taxpayer is aware of all of the options, there will be a number of considerations; some of them that may need to be acted on quickly.

IN THE EVENT AN ESTATE TAX DEDUCTION MAY BE MORE VALUABLE THAN THE INCOME TAX DEDUCTION, IT WILL BE VERY IMPORTANT TO PAY ATTENTION TO THE STATUTE OF LIMITATIONS ON THE FILING OF THE FORM 706 ESTATE TAX RETURN.

There are many real life examples that will start the reader thinking about the maximum tax planning for the Madoff losses.

Assume an elderly victim of the Madoff theft may have significant unused theft tax losses that can only be used as a carry forward over the next 20 years. This income tax benefit might be cut short with the death of the Madoff victim. Is it possible to plan the family situation to preserve these losses or use them up on other income during the Madoff victim’s life?

One might ask in a town like Palm Beach, how many tax marriages or tax mergers might result. For example, unmarried Mr. X may be broke with a $20 Million theft tax loss that he cannot use going forward since he has little or no income. On the other hand, the widowed Mrs. Y may have an income stream of $4 Million a year and really hates to pay taxes. Does a joint income tax return that permits X’s net operating losses to be used by a future Mrs. X make this a wedding made in heaven?

In determining the value of tax losses, one will also have to consider whether the tax losses being carried forward during the 20 year period will actually be much more valuable than the tax loss that will be carried back. Will a multi trillion deficit result in taxes in the 40% and 50% tax range instead of the 35% tax range in the future?

THE NEXT REPORT NO. 3
WILL CONTINUE TO FOCUS ON TAX PLANNING.

Comments and questions have been coming in steadily and these will serve as a source for this continuing discussion since many readers have common issues.

During the entire course of this analysis it is extremely important to stress that the taxpayer should be careful not to take steps that will harm their position regarding the tax deductions. Though this may not be the best practice on all occasions, this author is generally advising clients to not file their year 2008 tax returns at the earliest possible date. Extension requests accompanied by the appropriate tax payments should provide taxpayers with more time to review unfolding events and take studied tax positions. The filing of the year 2008 income tax return early may commit the taxpayer to a position that is not in the taxpayer’s best interest. Since that position has been taken (without the benefit of many material facts) it could foreclose future tax options.

It is also to note that since April 15th, is fast approaching that relief procedures may be available for taxpayers who are concerned that their year 2005 tax returns (filed on April 15th, 2006) will be closed from a statute of limitations standpoint.

Richard S. Lehman, Esq.

Located in the Dorot & Bensimon P.L. Domestic & International Tax Law Office

2000 Glades Road, Suite 312

Boca Raton, FL.  33431

Phone: 561-368-1113

Pataki Seeks special Tax Deal for Madoff Victims

WASHINGTON, D.C. -- Former New York Gov. George E. Pataki has asked the U.S. Treasury to issue "guidance," which would grant investors who lost money in Bernard Madoff's alleged Ponzi scheme better tax treatment than has been allowed to victims of past frauds. Read Forbes full article

Bernard Madoff Tax Recovery - Theft Loss Tips

Please note: The entire 8-part series from the "WEALTH & WISDOM" show will be posted online once the video is available.

VIDEO 1 - Expert Advice

VIDEO 2 - Bernard Madoff Tax Recovery - Theft Loss

VIDEO 3 - Bernard Madoff Recovery - Richard Lehman and Steven Katzman

Bernard Madoff Tax Loss - REPORT NO. 1

DOWNLOAD #1 REPORT to your computer as a .pdf or read it below.
Introduction

The following is Report No. 1 in what is intended to be a series of reports focusing on the tax benefits available as a result of the Bernard Madoff fraud. These Reports are not intended to be and can not serve as legal advice to any reader. Each taxpayer has their own unique factual situation which is going to need to be reviewed by tax advisors and litigation counsel before any legal conclusions can be reached. The Reports are being made in a series form since there is still a great deal of facts to be uncovered in the Bernard Madoff fraud. These facts are going to be extremely important in coming to conclusions about tax positions.

Furthermore, there could be guidance from the I.R.S. in this particular situation or any number of other factors that require the subject matter to be updated on a continual basis. The Bernard Madoff fraud has resulted in much pain throughout the world. Hopefully some of this can be eased in the form of tax relief from either the U.S. or other countries whose citizens are entitled to permit their financial losses to be deducted from their taxes.

The Bernard Madoff Tax Losses – The Basics

The Bernard Madoff fraud was a Ponzi scheme and losses from Ponzi schemes are acknowledged by the I.R.S to be “theft losses”. They are deductible from a taxpayer’s ordinary income.
The theft loss tax deduction is an extremely valuable tax deduction and for most victims of the Madoff fraud the deduction will have a cash value equal to 35% or more depending upon state and city income taxes. Investors who are subject to federal, state, and city income tax may find that their recovery from the tax loss is equal to almost 50% of their theft loss.

As an alternative to claiming a deduction for a theft loss, in certain limited circumstances funds that have been paid to an investor from a Ponzi scheme, that were reported by that investor as “income” in a previous year, may instead be considered a return of the defrauded investor’s capital and not taxable income. If this is the case an investor might not claim a theft loss but might still file an amended tax return for some of the previous years and claim a tax refund of the tax paid on the improperly reported “income” in those year(s).

Furthermore, under limited circumstances, so long as the statute of limitations has not run; income taxes that have been paid by Ponzi investors on “phantom income” that represented fake profits that never existed may be recovered by filing amended returns and eliminating the phantom income as a taxable income item in open years.

There are several methods of tax recovery that are available to Ponzi scheme victims. However, each of these potential options of recovery have their limitations, restrictions, and strict requirements that must be met if one is to take advantage of the maximum tax benefits from the Madoff theft.
The two most critical mistakes that result in the loss of the maximum advantage of these tax deductions seem to be:

1. the failure to deduct the tax losses in the proper year, and


2. to enter into settlements that may turn the ordinary theft loss into a capital loss that will be of much less value. The latter can occur for example, if an investor were to accept shares of stock as part of a settlement and then those shares of stock (a capital asset) lost all of their value.

The benefits and the traps make it important to tax plan properly to maximize the tax losses. It is critical that tax advisors and litigation counsel work closely together in order to not foreclose any of the available options for Madoff victims to make use of tax losses. Hopefully, professionals working together will avoid costly mistakes.

In considering the various options of recovery available for tax losses some fundamental knowledge of the law is important. We are going to cover those fundamentals into the following order.

• The Amount of the Theft Loss Deduction
• The Timing of the Theft Loss Deduction
• Tax Loss Carry Backs and Tax Loss Carry Forwards
• Deduction in the Year of Loss
• Deduction in Years Other Than the Year of Loss
• Other Sources of Tax Recovery
• Payments Received as a Return of Capital - Not Income
• “Phantom Income” Tax Treatment
• Tax Planning and the Practical Effects of the Tax Rules - Mistakes to Avoid.1/

The Amount of the Theft Loss

The amount of the theft loss that is deductible is calculated as the tax basis of the lost assets reduced by insurance proceeds recoverable and other claims for which there is a reasonable prospect of recovery.

To result in a tax loss the lost asset must have a tax basis.

If the theft is accomplished in a manner that results in the taxpayer’s failure to include the lost asset in income or if a taxpayer has claimed the amount of the loss as a different type of deduction no theft loss will be allowed. In such a case, there should be no deduction because the lost property would have a zero tax basis.

Note 1: This subject and a more thorough exploration of some of the critical issues raised in this Report No. 1 are discussed in Report No. 2 that will be published prior to February 1st, 2009.

Example:

A court denied any theft deduction loss for embezzled property where a taxpayer (“Employer”) had already received a tax benefit from the loss through the embezzler’s inflating the taxpayer’s cost of goods sold in order to accommodate the embezzlement. The taxpayer’s former comptroller, (“Employee”) had embezzled more than $700,000 over the preceding seven years. All the embezzlements were accomplished through fictitious charges by the Employee that increased the Employer’s cost of goods sold and reduced the Employer’s taxable income by the embezzled amount each year. There was an economic loss but not a tax loss since the tax loss had already been deducted.
Another example would be losses suffered by an I.R.A. or other deferred compensation plans where the amounts deposited into the plan for the beneficiary have never been included in the beneficiary’s income. There is no tax basis by the beneficiary in any of these funds.

However, in the Madoff situation, a tax payer should receive a basis for theft tax loss purposes for taxes paid on “phantom income” that was credited to the investor’s account, whether or not it was paid to that account by Madoff.

Furthermore, it is recognized that costs such as legal fees incurred in collecting on Ponzi schemes were deductible as a theft loss. Courts have found that these costs and others such as the costs of recovery or salvage are so closely identified with the theft loss itself as to add further theft losses.

BASIS FOR THEFT LOSS TAX DEDUCTION
Assume over the years that the taxpayer X invests $1.0 million with Bernard Madoff personally and $1.0 million is invested by taxpayer’s I.R.A. with Bernard Madoff. Assume that by 2008 that each account statement reflected an investment account equal to $2.0 million in taxpayer’s personal account and $2.0 million in taxpayer’s I.R.A. The taxpayer paid a federal income tax on all of the funds shown as income in the personal account. Assume both accounts totaling $4.0 Million are completely lost. The taxpayer’s tax loss (not economic loss) for recovery purposes is $2,000,000. Taxpayer invested $1.0 million and “earned” $1.0 million upon which taxes were paid. Had the taxpayer received a $100,000 distribution from the personal account in a prior year the basis for the loss purposes in the personal account would be $1.9 Million.

The taxpayer has no basis for a tax loss by the I.R.A. Those funds were never taxed, so their loss cannot result in deductible tax loss. In the event the taxpayer received a $100,000 distribution from the I.R.A. account there still would be no effect on tax basis. In this situation the I.R.A. distribution would have been received and a tax paid upon receipt. Clearly, the I.R.A. loss is an economic loss, but it is not translated into a deductible tax loss.

The Timing of the Theft Loss Tax Deduction:

This issue, the timing of the theft loss deduction, is the critical issue in the Madoff theft. Most likely, the vast majority of the victims of the fraud will want to claim a theft deduction for the year 2008. Such a claim, if submitted properly may result in the swiftest and largest cash recovery from the Bernard Madoff theft of all of the sources of recovery. This will be in the form of tax refunds. Furthermore, to the extent the theft losses are not all used as a claim for a refund of prior taxes paid, they will be available to offset future income starting as early as 2009.

There may be valid reasons for investors to claim the theft loss deduction in a year other than 2008. Therefore, the general rule described above will not fit every taxpayer. Furthermore, it may be more difficult to claim a deduction in 2008 if the investor, in the year 2008, took such steps as to file a claim in the bankruptcy courts and formally filed litigation claims against Madoff and any number of others, or took any other actions in 2008 that reflected high expectations of recovery of the Madoff theft.

However, as mentioned above and discussed further below, the Madoff loss, if not taken in 2008 as a “theft loss deduction” may be deductible in 2008 in a form of a deduction other than a theft loss.
The basic rules governing the theft tax loss deduction are straight forward:

• The theft loss deduction is a deduction of ordinary income


• The theft loss deduction may be carried back three (3) years and carried forward twenty (20) years.

When it comes to the proper timing of the theft loss deduction it gets more complicated. The basic rules that govern the proper year that the theft loss deduction should be claimed as a deduction are as follows:

• A tax deduction is allowed for any theft loss sustained during the taxable year and not compensated for by insurance or otherwise.

A theft loss is treated as sustained during the taxable year in which the taxpayer discovers the loss.

• However, a theft loss is not deductible in the taxable year in which the theft was discovered to the extent that a claim for reimbursement exists and there is areasonable prospect of recovery of the loss.


• If a theft loss cannot be deducted in all or any portion the year of discovery because a reasonable prospect of recovery of the loss exists, then the theft loss deduction must be taken in the year (s) that it can be ascertained with a reasonable Certainly that no further recovery will be received.


• If the taxpayer deducts a theft loss in the year of discovery because no reasonable prospect of recovery exists at that time and the taxpayer later receives compensation or reimbursement, the compensation or reimbursement does not cause a re-computation of the deduction; instead it is included in gross income for the year received.

There are two key phrases to keep in mind when reading these general rules about timing of the deduction. The first is “reasonable prospect of recovery”. The second phase is “ascertain with a reasonable certainty”. The effect of these phrases on the appropriate timing of a theft loss deduction is as follows:

• A taxpayer who suffers a theft loss should take that theft loss deduction in the year the loss is sustained, which is in the taxable year in which the taxpayer discovers the loss. However, if in the year the taxpayer discovers the loss there is a reasonable prospect of recovering all or some portion of the loss, the taxpayer must postpone taking the theft loss deduction to later years; unless the taxpayer can show that as to all or some portion of the loss there is no reasonable prospect of recovery.


• If the taxpayer does not take a theft loss deduction in the year of discovery, in the following years the taxpayer may not take a theft loss deduction until the year in which the taxpayer can ascertain with reasonable certainty whether the expected reimbursement will in fact be received or not.


• The bottom line is that taxpayers who claim a deduction in the year 2008 for a theft tax loss will require a simpler legal standard of proof to an entitlement to the deduction in that year; than those taxpayers who will be required to prove their entitlement to the theft loss deduction in any other year than the year of discovery.

What does this mean in practical terms?2/ We will look at two examples to answer this.

• Assume Taxpayer X invests $1.0 million with Bernie Madoff in January 1, 2004. Taxpayer’s account is credited every year with the Madoff Income and no distributions are made. Total Madoff Income is $500,000 by 2008.

Furthermore assume, the taxpayer had income from other sources for all the years in question equal to $300,000 per year. Assume taxpayer’s tax bracket on all of taxpayers’ income is 35%. The taxpayer treated the loss of his Madoff money in the year 2008 as a total loss and the taxpayer never believed any amount would be recovered.

Note 2: The distinctions between and the effects of the two key standards “reasonable prospect of recovery” and “to ascertain a recovery with a reasonable certainty”; are discussed in further depth in Report No. 2.

Theft Tax Loss
The Loss Carry Back and Carry Forward Rules – Year of Deduction 2008

Discussion:

1. Income from Madoff. During the four years of the taxpayer’s $1 Million investment the Madoff returns total $500,000. The taxpayer did not receive any distributions of any funds and paid his or her Federal income tax on the Madoff income from separate sources.


2. Income from other Sources. Income from sources separate from the Madoff income is $300,000 per year.


3. Total taxable Income. Taxable income for the years 2004 through 2007 include the Madoff taxable income and other income.


4. Tax Losses Applied. The Madoff theft was discovered in 2008 and a deduction is claimed for $1,500,000. The $1,500,000 tax loss is deducted first in the year 2008 and carried back for three years to 2005 where it is used to its fullest extent available. The same applies to 2006.


5. Taxable Income After Madoff Losses. By 2007 the loss is fully exhausted.
6. Tax Benefit. The total tax recovery is $525,000. (35% x $1,500,000).

Assume instead, that the taxpayer filed numerous lawsuits and believed in 2008 that from all of the lawsuits filed that there would be an unknown recovery amount. The taxpayer did not claim a loss deduction in that year. Assume that the taxpayer diligently pursued those lawsuits and abandoned them in 2012 with no recovery. Assume also from the years 2009 – 2028, that due to a change of circumstances the taxpayer’s income from other sources was reduced to $200,000 annually instead of $300,000 annually as shown in the first chart.

Theft Tax Loss
The Loss Carry Back and Carry Forward Rules – Year of Deduction 2012

It is clear that the delay in claiming the deduction until 2012 has been costly even though the same amount of tax of $525,000, was recovered. The last recovery in this example is in the year 2016 when the last $100,000 of tax loss is deducted, an 8 year delay of a cash tax benefit.

The Johnson Case – A Real Life Example of What Not to Do
There is one very recent case that involved a “Ponzi like” scheme perpetrated on a Palm Beach couple. This case has added a good deal of clarity to the law on the timing of the theft loss deduction and other related deductions.

In 1997 Palm Beach County residents Aben Johnson and Joan Johnson discovered they were the victims of a fraud scheme involving the purchase of gems and jewelry in which they had lost approximately $78 million. The scheme had lasted from 1988—1997. During almost the entire time of the fraud the Johnsons “income” from their investments in gems was the repayment of their own funds that were paid previously to the perpetrator. Though the Johnsons discovered the fraud in 1997 they did not take any formal actions against the perpetrators of the fraud in 1997. The Johnsons however, did undertake an investigation in 1997.

Clearly, the value of the theft loss deduction was of such a size, that the issue of the timing of the deductions warranted every argument in a tax lawyer’s arsenal. In the course of trying to convince the court of the proper year of the theft loss deduction, the court was asked to choose between the years 1997, 1998, 2001, and 2005.

The court, that decided the last of the three Johnson cases in January of 2008, provided a great deal of guidance for the intelligent treatment of the Madoff theft losses.

THE MAJOR PRINCIPLE SEEN IN EACH OF THE COURT’S DECISIONS IS THAT VICTIMS OF THE FRAUD WHO WANT TO TAKE THE THEFT LOSS DEDUCTION IN 2008, THE YEAR OF DISCOVERY, ARE WELL ADVISED TO SEPARATELY CONSIDER EACH OF THEIR POTENTIAL SOURCES OF RECOVERY, NOT ONLY MUST THEY DOCUMENT AND QUANTIFY EACH SEPARATE SOURCE OF RECOVERY. THEY ALSO MUST SEPARATELY PROVE THE LIMITATIONS TO EACH SOURCE OF RECOVERY. THEY MIGHT EVEN CONSIDER ABANDONING RIGHTS OF RECOVERY OF LITTLE OR NO VALUE IF A CONTINUING CLAIM MAY BE HARMFUL TO CLAIMING THE TAX DEDUCTION IN THE YEAR(S) OF MOST BENEFIT.

The court in the Johnson case confirmed that in the year of the discovery of the theft, the taxpayer could claim a deduction for that portion of a theft loss that the taxpayer could identify as not having a reasonable prospect for a recovery.

However, the Johnson’s tried to claim all of their theft losses in 1997, not just a designated provable portion that could not be recovered. Since in 1997 there appeared to be many avenues of recovery, this meant there was a “reasonable prospect of recovery” with an unknown amount. Therefore, the court denied the year deduction for the 1997, the year the loss was discovered.

The court found that the year of the discovery of a loss ordinarily should be the proper year of taking the loss. However, if there may be some reimbursement of the loss, and if the extent of the reimbursement is unknown or cannot be quantified in the year of discovery then the loss should not be taken in the year of discovery.

The taxpayers then claimed a major loss in 1998 and in 1998 the taxpayer made a better attempt to quantify the portion of the loss that would not be recovered. However, in 1998 the taxpayer admitted to the fact that they were using “estimates”. Consequently, the court denied any theft loss deduction in 1998.

Since 1998 was not the year of the discovery of the theft by the taxpayers the burden of proving the right to a deduction had changed. In 1998 the taxpayer had to prove not just that there was not a reasonable prospect of a recovery of any portion of the theft loss. The theft loss deduction was denied in 1998 because in that year, in order to receive a theft loss deduction, the taxpayer had to “ascertain with a reasonable certainty” that no further recovery of the loss was possible.

In denying the theft loss deduction for the 1998 the court pointed out that there are two different legal standards and even indicated that evidence that was insufficient to meet the standards of 1998, the year after the date of discovery; may have been sufficient to meet the standards of the year of discovery, 1997.
In denying the 1998 deduction the court stated:

• Several court decisions have tended to combine the “reasonable prospect of recovery” inquiry and the “ascertain with reasonable certainty” inquiry. However, these two inquiries are distinct and the standards to be applied are different . . .


• The taxpayers’ contention that the analysis of their lawyers and accountants is sufficient to “ascertain with reasonable certainty” standard is not supported. By their own admission, plaintiffs state that they made an “estimate” of the amount of recovery . . .


• The analysis performed by the lawyers and accountants may have been sufficient to determine whether there was a “reasonable prospect for recovery” in the year of discovery but it was not sufficient to “ascertain with reasonable certainty” the amount of reimbursement the plaintiffs would receive after a resolution of their reimbursement claims. Thus, the plaintiffs’ theft loss deduction in 1998 based on an “estimate” that was made well before the recovery process was resolved was premature and cannot be sustained.

Since the year 1998 was not the year the theft loss was discovered and since the Johnsons had decided to enter into extensive litigation by 1998, a theft loss deduction could not be taken until the Johnsons could ascertain with a reasonable certainty that the reimbursement will not be received for any portion of the loss.

Again the court’s words defined the higher standard for 1998.

• After having elected to pursue a claim for reimbursement for which there was a reasonable prospect of recovery, the plaintiffs did not “ascertain with reasonable certainty” in 1998 whether or not reimbursement would be received. To ascertain “reasonable with a certainty” whether or not such reimbursement will be received may be, for example, by a settlement of the claim, or by an adjudication of the claim, or by an abandonment of the claim.


• The requirement that a taxpayer “ascertain with reasonable certainty” means that a taxpayer must obtain a verifiable determination of the amount that she will receive, based on a resolution of the reimbursement claim before taking a theft loss deduction. Finally, requiring resolution of the claim with an objectively verifiable amount of loss is, as the government correctly notes, consistent with the plain meaning of “ascertain”… [as defined in a Dictionary of the English Language.]”

It was not before 2001 that the Johnson’s eventually clearly defined with certainty the amount of recovery they would receive and were entitled to a theft loss deduction for the unrecoverable amount.
It is obvious that obtaining the theft loss deduction for the year 2008 will involve as clear an understanding as possible of the characteristics of the two key legal phrases “reasonable prospect of a recovery” and “ascertain with a reasonable certainty”.

Other Sources of Tax Recovery
Investors may not need too be concerned about their ability to recover taxes paid on the phony “profits” that were being credited to investors’ accounts as taxable income. This is often referred to as “Phantom Income.”

Phantom Income in the Madoff accounts was typically reported over the years as taxable income on which taxes were paid. These amounts upon which taxes have been paid will be considered part of the investor’s basis and will be part of the loss amount for theft loss deduction whether the funds were actually paid in the account or not.

Furthermore, the tax benefits of the loss of Phantom Income can be accomplished in another way than the theft tax loss deduction.

In the same Johnson case previously discussed, the taxpayer proved to the court that in the last few years of the Johnson Ponzi scheme there never was any significant amount of capital. Therefore since new capital was simply passing through to pay off the investors with their own money, the court permitted the taxpayer to file amended returns that eliminated the Ponzi scheme “false income” or “phantom income” as taxable income.

There is one other theory of recovery. Again it may be only available in the situation where “Madoff Income” did not exist at all and that new money did little more than pass through the scheme to pay distributions to old money was not supported by any truth at all. However, under limited circumstances, taxpayers who have received actual cash payments from the Ponzi scheme have been permitted to amend previous returns reflecting those actual payments as a non-taxable return of capital.

Richard S. Lehman, Esq.

Located in the Dorot & Bensimon P.L. Domestic & International Tax Law Office

2000 Glades Road, Suite 312

Boca Raton, FL.  33431

Phone: 561-368-1113

New York Times Article

Wednesday January 7, 2009
New York Times
“For Victims of Schemes, The I.R.S. Can Be Flexible”
View full article