REPORTING MADOFF INVESTOR LOSSES
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Reporting Madoff Investor Losses Page 1 of 26
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Tax News
Journal Preview (WG&L)
Business Entities (WG&L)
REPORTING MADOFF INVESTOR LOSSES, Business Entities (WG&L)
DEFRAUDED INVESTORS
REPORTING MADOFF INVESTOR LOSSES
Investors who are defrauded in Ponzi schemes should evaluate the available tax choices
and planning strategies that offer some relief for their losses.
Author: JERALD DAVID AUGUST and RICARDO A. ANTARAMIAN
Jerald David August, the Editor-in-Chief of this Journal, is a partner in the West
Palm Beach, Florida, and Philadelphia, Pennsylvania, offices of the law firm of Fox
Rothschild LLP, is co-chair of the firm's Tax & Estates Department, and is a widely
published tax and estate planning authority. Ricardo A. Antaramian is an
associate in the West Palm Beach office of Fox Rothschild LLP.
Bernard L Madoff was arrested on 12/11/08 on a single count of securities fraud. The criminal
complaint alleges that Madoff “unlawfully, willfully and knowingly” defrauded investors of billons of
dollars by purchasing securities with investors' money and paying purported gains to prior investors
with the investment funds received from other investors even though the securities purchased actually
lost value. 1 Madoff's recent arrest and the collapse of the Ponzi scheme he orchestrated have further
battered already bereaved investors. At the time that this article was written, Madoff had just pled
guilty in federal court in New York to fraud, money laundering, and perjury. 2 From a tax perspective,
perhaps within the next few months there will be a degree of certainty as to what happened to the
funds Madoff took from the numerous individual and institutional investors.
It is surprising, if not alarming, that the types of investors who entrusted Madoff with money ran the
gamut from investment funds to individuals who trusted Madoff with gaining a fair investment return
on almost all of their wealth. The adverse effect of Madoff's downfall will extend not only to those who
have lost their investments, but also to former investors who had initially breathed a sigh of relief
knowing that their investment had been safely withdrawn prior to the exposure of Madoff's operations.
That is, investors who recovered funds may find that they also have legal hurdles to climb. 3 Sadly,
other types of fraudulent schemes have been unearthed that also raise issues and questions concerning
how investors who have lost their funds, including reinvested profits, should report and treat their
losses for federal income tax purposes.
The U.S. federal income tax consequences that these investors face are not as simplistic as they may
first appear, and the results may seem counterintuitive, surprising, or unfair. Important reporting and
compliance issues must be considered in the effort to recoup lost investment dollars through the
application of the Code rules on losses, thefts, and refunds for prior years' overpayments in tax.
In addition, state income tax implications must also be considered. Not all states will use the definition
of federal taxable income in taking an investor's losses into account, so there may be differing
administrative procedures for processing a net operating loss (NOL) or a claim for refund of prior years'
taxes. The loss of funds from a Ponzi scheme 4 also creates potential tax effects on donative transfers,
including transfers to charities of funds or other investments that held positions on investments in
Bernard L. Madoff Securities LLC (BMIS) or similar funds.
http://foxshweb1:65000/Admin/Marketing/Publications/ReportingMadoffInvestorLosses.... 12/29/2010Reporting Madoff Investor Losses Page 2 of 26 This article provides guidance as to the many factors that must be taken into account in determining a defrauded investor's course of action with respect to his or her federal income tax returns. The focus here will be on the individual investor who may have invested funds in a Ponzi scheme (like the reported Madoff scandal) directly or indirectly through another fund or entity, such as an investment partnership. Because a variety of fraudulent investment schemes have surfaced in recent months, this article uses the generic label of Ponzi scheme when describing the tax issues related to the Madoff fraud and similar schemes. Deductibility of Losses: Section 165 A taxpayer's business or investment loss is generally recognized for federal income tax purposes in the year in which the ownership interest is disposed of in a taxable transaction. Alternatively, a taxable event may be reported by an individual who owns an interest in a pass-through entity where the entity engages in a taxable disposition of a specific asset used in a trade or business or held for investment. 5 In contrast to a sale, a measurable decline in market value of an investment generally is not the appropriate time for reporting a deductible loss for federal income tax purposes. 6 The rationale, obviously, is that there must be a “realization” event, which is a fundamental tenet of our annual year reporting period. 7 Where the decline in value of an asset is absolute, e.g., the underlying investment (stock, security, or debt instrument) becomes worthless, a loss may be reported in the year in which the worthlessness is established by the taxpayer. 8 Under Section 165(c), however, losses incurred by individuals may be deducted only if they are incurred in a trade or business, per Section 165(c)(1), or a transaction entered into for profit, per Section 165(c)(2). Where an individual's loss is caused by fire, storm, shipwreck, or other casualty or theft, the loss is deductible under Section 165(c)(3). It is presumed that Section 165(c)(3) losses are subsumed within the first two categories when there is overlap. More specifically, when an individual's property that is damaged by casualty was used in the taxpayer's trade or business, or the property was held for investment, the loss is deductible under Sections 165(c)(1) and 165(c)(2), respectively, and is not subject to limitations applicable to personal casualty losses. 9 If a theft loss 10 is incurred outside of a trade or business, or the property is not held for investment, it is a personal casualty theft that cannot be deducted in full because of the special “cut-down” rule contained Section 165(h). In all cases, Section 165(a) permits losses to be deducted only if “not compensated for by insurance or otherwise.” Expenses incurred in obtaining reimbursement for a casualty loss are part of the loss or an offset against the recovery. 11 If in the year the theft loss is discovered there is no objectively reasonable prospect of a recovery, the entire amount of the loss is deductible in that year. If any subsequent recovery is received, the tax benefit rule under Section 1311 should be applied. 12 Where there is a claim filed during the year in which the loss occurs and there is a reasonable prospect for recovery, “no portion of the loss” that may be reimbursed by the claim is deductible until it becomes reasonably certain whether a recovery will be received. 13 In other words, a deduction may currently be taken for the amount by which the loss exceeds the taxpayer's insurance policy limit, e.g., Securities Investor Protection Corporation (SIPC) limitation of $500,000 on lost brokerage account funds. Where part of a loss has not been taken because the taxpayer has filed a claim that may result in the recovery of some portion of the loss, any loss realized on the eventual non-recovery of the claim, or its abandonment, is deductible in the year in which the loss is permitted to be recognized. 14 Despite the difference in the time for reporting the loss or gain from the sale of an asset as compared to the proper time for reporting a theft loss, the tax law has attempted to treat these two categories of loss (or gain) similarly. 15 Nevertheless, the law has long permitted a taxpayer to claim a loss under Section 165 for losses incurred in a trade or business, losses incurred in a transaction entered into for profit, and, in addition, certain casualty or theft losses. 16 The dumping of business, investment, and personal casualty losses into one Code section is present in the “hodge pot” dumping ground contained in Section 1231(a). 17 http://foxshweb1:65000/Admin/Marketing/Publications/ReportingMadoffInvestorLosses.... 12/29/2010
Reporting Madoff Investor Losses Page 3 of 26
Section 165(h)
An individual's uncompensated personal casualty “theft” losses are allowed only to the extent that the
losses exceed $100 (if the theft loss deduction is claimed for 2009, the threshold is increased to $500,
but is again reduced to $100 starting in 2010). 18 A second limitation restricts the deduction to the
extent that net casualty losses exceed 10% of the taxpayer's adjusted gross income. 19 The first step
in calculating the second limitation is that the amount of the personal casualty loss must be
determined; this amount is the uncompensated theft loss in excess of the $500 threshold mentioned
above. 20 The second step requires that the personal casualty gain amount be computed as gain from
the involuntary conversion of the casualty loss property. This could occur, for example, if insurance
proceeds in excess of the adjusted basis of the loss property are received. 21 If there is an excess of
personal casualty losses over personal casualty gains, the gains must be included in the taxpayer's
gross income as ordinary income, the losses are deductible to the extent of gains included in gross
income (with the effect of causing no increase or decrease to gross income), and any losses in excess
of the personal casualty gains are deductible to the extent that they exceed 10% of the taxpayer's
adjusted gross income. If a theft loss is not compensated by insurance, the entire loss will be
deductible subject to the $100 floor and 10% limitation. In either case, the deductible loss is an
itemized deduction against ordinary income. 22
Other important limitations apply to personal theft loss deductions under Section 165(c)(3): 23
(1.) Married individuals who file a joint return are treated as a single individual for purposes of
computing the other limitations under Section 165(h). 24
(2.) For purposes of computing the Section 165(h)(2) 10% limitation for an estate or trust, the
adjusted gross income is determined in the same manner as in the case of an individual except
that administration costs of the estate or trust can be deducted when computing adjusted gross
income. 25
(3.) No loss is allowed under Section 165(c)(3) if the loss has already been claimed for estate tax
purposes on the estate tax return. 26
In proving the amount of the deductible loss, a taxpayer who has insurance or some other reasonable
prospect of recovery with respect to stolen property, must file a timely claim even if the claim does not
eventually result in restitution. 27 Thus, for example, if a taxpayer has a personal casualty “theft” loss
of $1 million and has insurance that covers $500,000 of the loss, the failure to timely file the claim for
the insurance limits the reportable loss to $500,000.
Special rules are also provided for application of the NOL provisions to noncorporate taxpayers.
Generally, a taxpayer's deductions that are not related to a trade or business are taken into account
only for purposes of determining the NOL with respect to the taxpayer's nonbusiness income. 28 The
losses cannot be used to generate NOLs that are carried over to other years. An exception is made for
losses allowable under Sections 165(c)(2) and (3) that are treated as attributable to the taxpayer's
trade or business even though arising from the loss of personal or investment property. 29 In contrast
to the general rule, which allows a carryback of NOLs for only two years, an individual may carry back
theft losses up to three years. 30 The general carryforward of 20 years remains unchanged for
individuals who suffer theft losses. 31
While the rules for determining the extent of a theft loss deduction are contained predominantly in
Section 165, amounts used in the computations may be subject to other Code provisions. In
determining the theft loss deduction, an individual taxpayer's adjusted gross income is used for
purposes of determining the 10% limitation. This leads to a potential adjustment as a result of the
application of the alternative minimum tax rules even though theft loss deductions under Sections 165
(c)(2) and (3) are not miscellaneous itemized deductions subject to denial or reduction by Section 56.
32
A potential adjustment could arise if the alternative minimum adjusted gross income is different
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from adjusted gross income, because for purposes of computing the 10% limitation of Section 165(h)
the alternative minimum adjusted gross income would be used (assuming the taxpayer is subject to
the alternative minimum tax for the year in which the theft loss deduction can be properly claimed).
The tax year that a taxpayer may claim a theft loss deduction is the year in which the loss is discovered
and not the year in which the theft actually occurred. 33 In determining the year of discovery, “[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.” 34 This standard may cause some difficulties for investors who
discovered the theft loss in a more recent year but who should have discovered it, based on the
reasonable person standard, in an earlier tax year. Another point to keep in mind is that a distinction
exists between a theft and a loss.
The applicable standard for purposes of Section 165(c)(3) looks to what year the loss is discovered
(and not just the year the theft occurred). This rule will complicate matters when a claim is made for
reimbursement (e.g., from insurance), because the regulations delay the theft loss deduction until the
tax year in which it can be ascertained with reasonable certainty whether reimbursement will be
received. 35
If an investor has a claim for reimbursement, a theft loss deduction will have to wait until the tax year
in which it can be established that reimbursement will not be forthcoming. 36 But a deduction for part
of the loss may be available despite these rules. If, in the year the theft loss is discovered, there also is
a claim for reimbursement with respect to the loss, the portion of the loss that is not covered by the
claim for reimbursement is allowable for that year if there is a reasonable prospect of recovery for the
claim. 37 A deduction for the portion of the loss for which a claim for reimbursement was made can be
taken only when it can be determined with reasonable certainty whether reimbursement will be
received. 38
Elements of a Theft Loss
A taxpayer claiming a theft loss deduction must prove by a preponderance of the evidence that the
theft actually occurred. 39 To meet this burden, a taxpayer must establish:
(1.) That a theft occurred under the law of the jurisdiction where the alleged theft occurred.
(2.) The amount of the theft loss.
(3.) The date on which the loss from the theft was discovered. 40
For purposes of Section 165, the term “theft” has been judicially recognized as intended to cover “any
criminal appropriation of another's property, including theft by larceny, embezzlement, obtaining
money by false pretenses, and any other form of guile.” 41 It is not necessary to establish the exact
nature of the crime under state law; rather, it is sufficient to show that a taxpayer parted with his
money as a result of deceit and trick that amounted to a “criminal appropriation with felonious intent.”
42
A conviction for theft under the law of the relevant jurisdiction may “establish conclusively the
existence of a theft for purposes of” Section 165, but it is not absolutely necessary. In establishing that
a theft occurred, a taxpayer “may choose not to move against the thief in a state proceedings and still
not be excluded from the benefit of” a theft loss deduction.
The IRS, in a Chief Council Advice, recently explained that a “loss that is the direct result of fraud or
theft is deductible under [Section] 165, even though the theft is accomplished through a purported
borrowing or offer to sell a security.” 43 For example, false representations made to shareholders of a
company in order to induce the shareholders to vote in favor of a merger that resulted in the
shareholders exchanging their stock for stock that was worth substantially less than represented
qualified as theft for federal income tax purposes. 44
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In the context of debt instruments, a taxpayer was entitled to a theft loss deduction under Section 165
(c)(3) when he had been induced to lend money to a corporation after reviewing financial statements
that were fraudulently prepared. 45 It appears, however, that the Service will not consider every
securities violation a theft on the basis that “a loss or taking of property is generally not a required
element of securities fraud.” 46 It is questionable that the CCA felt Section 165(c)(3) and not Section
165(c)(2) was controlling.
An important question that must be asked by Madoff investors is whether a conviction or confession of
guilt under federal law suffices for purposes of establishing that a theft occurred. Being able to rely
solely on the government's efforts would be convenient for defrauded investors, because they could
easily meet their burden of establishing that they suffered a theft loss. Unfortunately, that convenience
is not likely to be had as the Tax Court has held that a theft loss under federal criminal law does not
suffice for purposes of establishing that a theft occurred. Rather, the court held that a theft loss must
be established under the law of the state in which the loss was sustained, whether by a conviction or in
the more general sense as discussed above. 47 While a “mere mysterious disappearance” is not enough
to establish a theft, sufficient evidence for a “successful criminal or civil lawsuit against a particular
alleged thief” is not required, nor is the taxpayer required to identify the thieves. 48
Distinguishing Investment From “Personal” Theft Loss
As mentioned earlier, a deduction for losses could potentially be claimed under Section 165(c)(2), if the
losses are incurred in a transaction that was entered into for profit but not connected with a trade or
business. 49 If the losses are due to theft, a taxpayer may try to deduct the loss under Section 165(c)
(3). 50 Since defrauded taxpayers may have options as to which Code provision they can cite in support
of their claimed losses, the question is which provision should they rely on when they claiming their
losses? To reach an answer, it is necessary to determine whether the loss can be categorized as being
related to a transaction entered into for profit.
A transaction that is entered into for profit but not connected with a trade or business “refer[s] to all
transactions induced primarily by a profit motive.” 51 That is, it is not necessary that profit is the sole
motive for entering into a transaction, but it is necessary that profit is the primary motive. 52 Loan
transactions have been judicially excluded from qualifying as transactions entered into for profit under
Section 165(c)(2), even though there is the expectation of a profit in the form of interest. 53 Under
certain circumstances, a transaction that may have been originally labeled a loan may be treated as an
investment in a partnership. If the “lender” did not make any attempt to collect the debt and did not
share in any of the joint venture's assets with other creditors, the purported loan may be deemed an
investment in the joint venture such that a loss may be treated as a business or investment loss. 54
Due to the disparate treatment between theft losses arising from business or investment activity,
versus losses resulting from the theft of personal assets, the Ponzi scheme situation presents a
challenge in distinguishing between:
(1.) A theft of personal funds that the taxpayer, in good faith, erroneously thought were invested
in a separate or pooled fund.
(2.) A theft of funds from an existing separate or pooled fund in which the taxpayer had an
interest.
Should it matter whether the theft occurred at the inception of the taxpayer's investment for federal
income tax purposes? That is, should the dividing line between a personal casualty loss under Section
165(h) and a theft loss from a personal investment under Section 165(c)(2) turn on when the theft
occurred? Arguably not. Further, what should happen if interim earnings are falsely reported to the
investor by the Ponzi scheme promoter—either with respect to a direct investment fund, or, indirectly
through a partnership or other fund—and, in turn, are erroneously included in an individual investor's
gross income?
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In this situation, the victim-investor is not only divested of his or her initial capital investment, but he
or she is also out of pocket for income taxes paid on false earnings that were reported in information
filings provided by the fraudulent promoter. Should these amounts be included in the taxpayer's cost
basis when he or she claims a theft loss? Alternatively, if an investor opts to file amended returns to
claim refunds for overpayments of tax (i.e., for having paid tax on false earnings), is he or she subject
to the general three year limitation on claims for refunds?
An important distinction between Sections 165(c)(2) and (c)(3) relates to the amount that may be
deducted as a loss. Generally, a taxpayer's deduction for a theft loss is limited to the lesser of either
the fair market value of the stolen property or its adjusted basis as determined under Reg. 1.1011-1.
55
If the theft loss is claimed under Section 165(c)(2), however, the deduction is the adjusted basis of
the property if the fair market value of the property has fallen below its adjusted basis. 56 Furthermore,
a deduction claimed under Section 165(c)(3) is subject to the Section 165(h) limitations discussed
above. For individuals who transferred to Madoff property other than cash, careful consideration should
be given to the full effect of these limitations in deciding to claim a deduction under Section 165(c)(3).
If the property had a low adjusted basis or if its fair market value had fallen below its adjusted basis,
the operation of the above rules will severely limit the loss deduction. 57
A second distinction appears in GCM 38161, where the IRS stated that Section 165(c)(3) preempted
Section 165(c)(2) on the ground that more specific provisions of the Code override more general, less
specific provisions. 58 This led to the conclusion that “where a taxpayer suffers a loss resulting from a
theft in a transaction entered into for profit, and the situation falls within the literal language of both
Sections 165(c)(2) and 165(c)(3), Section 165(c)(3) controls.” 59 Although the views expressed in GCM
38161 were never finalized into an adopted revenue ruling, one might conclude that theft losses are
deductible only under Section 165(c)(3). This conclusion would not be inconsistent with CCA
200305028, where the Service addressed whether investor victims of a Ponzi scheme could deduct
their losses under Section 165(a). The Service did not address the application of Section 165(c)(2) to
losses arising from a Ponzi scheme, but it nevertheless concluded that the theft losses may be
deductible under Section 165(c)(3). 60
Fortunately for investors, the position set forth in GCM 38161 is no longer applicable, as Section 165(c)
(3) was amended to exclude theft losses with respect to property connected with a trade or business or
a transaction entered into for profit. 61 This means that Madoff investors should be able to claim a theft
loss under Section 165(c)(2). 62
IRS Guidance
On 3/17/09, the IRS issued Rev. Rul. 2009-9 63 and Rev. Proc. 2009-20, 64 which address how certain
defrauded Ponzi scheme investors should claim theft losses on their federal income tax returns. The
facts in Rev. Rul. 2009-9 concern an individual who invested in a Ponzi scheme. The individual reported
phantom income from the scheme, but also withdrew a small amount of the total amount invested and
purportedly earned. The IRS concluded that the investor's theft losses arising from a Ponzi scheme
were ordinary losses deductible under Section 165(c)(2), because the opening of an investment
account was a transaction entered into for profit The IRS's conclusion is significant because that means
that the investor's losses are not subject to the limitations of Sections 67, 68, or 165(h).
The theft loss deduction, according to the Service, may be claimed in the year in which the theft is
discovered to the extent there is no claim for reimbursement or other recovery for which there is a
reasonable prospect of recovery. Amounts recovered in later years that reduced the deduction will not
be includable in the taxpayer's gross income when recovered. If, however, the recovery is greater than
the reduction in the theft loss deduction, the taxpayer will be required to include the excess amount in
gross income under the tax benefit rule. 65
In computing the deduction, a taxpayer must calculate the sum of:
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(1.) The initial amount invested.
(2.) Any additional investments.
(3.) Any income on the investments that was included in the taxpayer's gross income.
This sum is then reduced by any amounts that were withdrawn and by any reimbursements,
recoveries, and claims for which there is a reasonable prospect of recovery. 66 Considering the state of
the economy and the falling stock market, many investors may not have sufficient income in the year
the deduction is taken to entirely offset the theft losses claimed. Accordingly, the Service may allow a
NOL carryback and carryover under Section 172.
What is interesting is that the Service is allowing individuals to apply the elective extended NOL
carryback period that was enacted under the American Recovery and Reinvestment Act of 2009 (the
“Act”). The Act allows eligible small businesses to elect to carry back NOLs for up to five years. 67 That
is, the IRS is treating individuals as sole proprietorships that can qualify for the extended NOL
carryback on the ground that Section 172(d)(4)(C) treats Sections 165(c)(2) and (3) theft losses as
business losses even when sustained by an individual. Thus, individual investors may apply the
nonelective three-year carryback or the elective five-year maximum carryback (but only for “applicable
2008 net operating losses”). 68
While helpful, the Ruling does not address issues relating to investments through partnerships or other
entities, or investments held by corporations and tax-exempt entities. 69 Consequently, investors
holding indirect investments could still face difficult tax issues and evidentiary problems.
IRS Procedure for Claiming Ponzi Scheme Theft Losses
Rev. Proc. 2009-20 provides a safe harbor for certain taxpayers with Ponzi scheme investment losses.
The procedure claims that following the instructions will help taxpayers avoid “potentially difficult
problems of proof” in ascertaining the amount of the theft loss, thereby alleviating the “compliance and
administrative burdens” that taxpayers and the Service would otherwise face. 70
The safe harbor procedure applies only to qualified investors who invested in specified fraudulent
arrangements and who suffered qualified losses as a result. Qualified investors are persons:
(1.) Who may generally deduct theft losses under Section 165 and Reg. 165-8.
(2.) Who did not have actual knowledge of the fraudulent nature of the investment scheme prior
to its exposure to the public.
(3.) With respect to which the scheme is not a tax shelter under Section 6662(d)(2)(C)(ii).
(4.) Who contributed cash or other property to the scheme. 71
Persons that invested through funds or other entities are not considered qualified investors. An entity
or fund that is separate from such persons for federal income tax purposes and that invested in the
scheme, however, may be considered a qualified investor. 72
If an investor follows the procedures in the Rev. Proc. 2009-20, the IRS announced that it will not
challenge:
(1.) That the loss is deductable as a theft loss,
(2.) The year in which the deduction may be taken is the year in which the scheme's organizer is
indicted (i.e., the year of discovery is the year in which the organizer is indicted).
(3.) The amount of the deduction.
The deduction amount is 95% of the qualified investment if no recovery is sought against a third-party
and 75% of the qualified investment if recovery is sought (or intended to be sought) against a third-
party, less any amounts actually recovered and any potential insurance and SIPC recoveries. 73 If
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additional amounts are subsequently recovered, such amounts are be includable in gross income; if
additional amounts are not recovered but were excluded from the initial deduction on the basis that
they were potentially recoverable, a subsequent deduction may be appropriate. 74
Rev. Proc. 2009-20 further provides that taxpayers who choose to not make use of the safe harbor will
be required to comply with all of the “generally applicable provisions governing the deductibility of
losses under Section 165.” The effect of not complying with the safe harbor is that the taxpayer will
have to prove all of the elements of a theft loss, including:
That a theft took place under state law.
The year in which the theft was discovered.
The amount of the theft.
That there is no reasonable prospect of recovery as to amounts sought to be deducted.
In addition, a taxpayer who decides to file amended returns to exclude amounts previously reported as
income from the scheme will be required to establish that those amounts were not actually or
constructively received by the taxpayer. A taxpayer may, however, include in basis amounts previously
reported as income (including phantom income) in tax years that are now barred under Section 6511,
as long as amounts that are included can be established and are consistent with information received
from the fraudulent arrangement (i.e., with respect to which the taxpayer received a Form 1099).
Many taxpayers likely will take advantage of the safe harbor even thought the recent guidance does
not answer several important questions, as it may be the only viable alternative for those investors
who do not have the ability or desire to contend with the IRS.
Partnership Losses
Many defrauded investors, instead of directly investing with BMIS (the promoter), invested through
independent entities, such as partnerships and limited liability companies that were organized to make
investments with Madoff or other Ponzi scheme promoters. The funds may have been deposited with
money managers to invest in various stocks and securities, but the money managers decided to invest
the deposits in investor funds managed by Madoff.
Investors who indirectly placed their money with Madoff through a partnership or fund invariably will
face additional complexities when claiming a theft loss deduction due to their indirect participation in a
fiscally transparent entity. Because these entities are treated as partnerships, tax items from the
entities, including theft losses of partnership property, must be determined at the partnership level and
not at the partner level. 75 The partnership must report and prove all partnership items, including a
theft loss. A partner cannot simply include on his or her return what he or she estimates as his or her
share of partnership losses. In addition, for certain partnerships, tax items are determined at the
partnership level under the entity-level audit procedures. 76
Determining whether a loss from a particular investment should be deducted at the partnership level is
critically important. For example, in River City Ranches #1 Ltd., TC Memo 2003-150, RIA TC Memo
¶2003-150, 85 CCH TCM 1365 , the IRS made a final partnership administrative adjustment for a
group of affiliated tax shelter partnerships, where the partnerships were invested in sheep breeding
operations that were fraudulent investments schemes consummated by the organizer. 77 The organizer
was convicted of conspiracy to commit mail fraud, bankruptcy fraud, and money laundering. Because of
the substantial losses suffered, investors argued that the losses should be deductible at the partnership
level so that the losses could be used to offset the partnership-level adjustments that had been made
by the IRS. The court, however, found that the losses were suffered by each investor individually and
not by the partnership as an entity. In other words, the fraud and theft was not perpetrated on the
partnerships even though the partnerships were the vehicle through which the fraud was carried out.
Rather, the fraud was directed at the individual partners, and, therefore, the court held that any losses
resulting from the fraud could be reported only by the individual investors. In reaching this conclusion,
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the court emphasized the following factors:
(1.) A theft from all the partners of a partnership does not necessarily give rise to a theft from
the partnership itself.
(2.) No theft from the partnership occurred under state law even though the partnerships were
the targets of the organizer's deceptive practices, because the partnerships were used as the
vehicle to defraud the partners.
(3.) Charges levied against the organizer did not include any charges for embezzlement of
partnership property. 78
A potential strategy that partners may employ so as to accelerate their deduction, albeit at the cost of
foregoing any potential recovery obtained through the partnership, is to abandon the partnership
interest and claim a loss as to the partnership interest. The benefit of abandoning a partnership interest
is that the potential exists to treat the resulting loss as an ordinary loss. A thorough analysis of the
specific circumstances should be conducted, because there is also the potential for the loss to be
characterized as a capital loss which may provide a substantially lower tax benefit than if a partner had
simply taken his share of partnership losses and claimed a theft loss deduction under Section 165(c).
This disparate treatment was illustrated in Rev. Rul. 93-80, 79 where the Service analyzed two different
scenarios where a partner abandoned his partnership interest.
The first scenario involved a partner who abandoned his interest in an insolvent partnership, but who
shared equally in the partnership's nonrecourse liabilities with the other partners. The loss resulting
from the abandonment of this interest was characterized as a capital loss because of the deemed
distribution (of money) resulting from the shared liabilities. The Service cited Citron, 97 TC 200 (1991)
and proclaimed that the entire loss will be treated as a capital loss even if there is only a de minimis
actual or deemed distribution. In the second scenario, a partner abandoned his interest in an insolvent
limited partnership. The distinguishing factor that allowed the partner to treat the loss from the
abandonment as ordinary was that the partner was a limited partner and, as such, could not share in
the partnership's liabilities in determining his basis. Because no partnership liabilities could be allocated
to the limited partner, there was no deemed (or actual) distribution of partnership assets causing the
loss to be characterized as an ordinary loss. 80
The holding in Rev. Rul. 93-80 creates a potential planning opportunity for investors who invested with
Madoff through an entity treated as a partnership for federal income tax purposes. As mentioned
above, investors who abandon their partnership interest in favor of seeking an ordinary deduction for
the loss would renounce any recovery that the partnership may ultimately obtain from the bankruptcy
estate or through independent lawsuits against third parties. The benefit, however, would be that the
deduction would not only be ordinary (assuming there is no deemed or actual distribution of
partnership property), but the limitations of Section 165(h) would be inapplicable, as the loss would fall
under Section 165(c)(2). 81
Partnerships can take advantage of the safe harbor in Rev. Proc. 2009-20. Because the determination
to apply the safe harbor must be made at the partnership level, however, partners may have
competing interests in that some may not want the partnership to claim the safe harbor. This can
become an especially troublesome issue where the investment was made through tiered partnerships,
as each partnership will arguably be required to claim the safe harbor alternative.
Refund for Erroneously Reported Phantom Income
No doubt some tax advisors are recommending that their clients claim refunds for prior “open” years by
filing amended returns that will eliminate or reduce the “phantom” income that was erroneously
reported. 82 From an equitable if not from a tax compliance perspective, filing a claim for refund (or at
least a protective claim for refund) for prior years' phantom income is logical, especially because many
investors did not receive actual distributions of income and were merely told that they had income for a
particular tax year (i.e., phantom income). Nevertheless, there is a risk that the Service will not accept
http://foxshweb1:65000/Admin/Marketing/Publications/ReportingMadoffInvestorLosses.... 12/29/2010Reporting Madoff Investor Losses Page 10 of 26 investors amended prior years' returns even if an allocable share of investment income was not actually or constructively received. The Service has previously taken the position that victims of a Ponzi scheme may not file an amended return to adjust interest income received in prior years even though the funds were subsequently stolen. 83 In FSA 1999942, the taxpayers lent money to a corporation that had promised high interest rates in return. Under the Ponzi scheme, the investors received postdated checks that they could cash when the date on the check became current or void and rollover the interest (and any principal paid) into a new loan. Eventually, the company filed for bankruptcy, and the Ponzi scheme was uncovered. One of the issues addressed in the FSA was whether the investors could amend prior returns to adjust the amount of interest income received. The Service, citing Burnet v. Sanford & Brooks Co., 9 AFTR 603, 282 US 359, 75 L Ed 383, 2 USTC ¶636, 1931-1 CB 363 (1931), for the proposition that each tax year's tax liability is determined with all events occurring in that tax year even though a different “aggregate result might occur in a later year,” concluded that the taxpayer may not file amended returns to restate the interest received in prior years. 84 More recently, the IRS again addressed whether investors in a Ponzi scheme may amend returns for open years on the basis that payments received from the scheme were not actually interest payments but were, instead, a nontaxable return of principal. 85 The same conclusion was reached. Namely, the IRS concluded that investors in a Ponzi scheme may not apply the open transaction doctrine to amend a prior year's return and adjust the income reported that was received pursuant to investment in the scheme. “[I]f a payment of income was, in fact, actually or constructively received, prior to the discovery of the fraud, [] an investor may not recharacterize [the income] as a return of capital under the open transaction doctrine.” 86 Two subtle points should be made with respect to this harsh rule. The first is that the Service looked to whether the income was “actually or constructively” received, which may allow investors who reported income, but for whom Madoff was unwilling or unable to pay, to amend their returns and adjust their income. The second point is that amounts received after the discovery of the fraud (pursuant to the reasonable person standard discussed earlier) can be properly treated as a return of capital instead of taxable income. 87 It becomes apparent, however, that there may be instances involving Ponzi schemes where the Service will not challenge a claim for refund of income taxes paid in prior years on income reported under the scheme. A non-docketed Significant Advice Review provides additional insight into the circumstances the Service will consider in allowing a claim for refund (i.e., allowing taxpayers to amend returns to reverse interest, dividends, and net gains from the sale of capital assets based on information provided by the Ponzi scheme operator). 88 The determination was that investors might not be entitled to refunds of income taxes paid on phantom income from the Ponzi scheme, but the Service suggested that a claim for refund for all or part of the income taxes paid may be allowed if the taxpayer recovered none or only part of his initial investment. The position appears to be that if an investor recovered all of his investment (actual or constructive receipt), the taxes paid on income from the scheme would not be refundable. 89 The effect of the Service's position is not as unfavorable as it may first appear. The position enunciated in the FSA, CCA, and NSAR should be tempered with a taxpayer's ability to amend returns and carryback a NOL that arises in the current year. In fact, the final point discussed in CCA 200451030 was that Ponzi scheme investors may carry back losses to prior years as NOLs under Section 172 for up to the three years prior to the year of the loss. 90 That position is in accord with the guidance recently issued by the Service. Disgorgement and Section 1341 In response to the criminal complaint filed against Madoff, the Securities and Exchange Commission http://foxshweb1:65000/Admin/Marketing/Publications/ReportingMadoffInvestorLosses.... 12/29/2010
Reporting Madoff Investor Losses Page 11 of 26 appointed a temporary receiver for BMIS. The SEC receiver was succeeded by a trustee from the SIPC, which commenced formal liquidation proceedings for BMIS. Through these proceedings, BMIS assets owned by customers are transferred to other brokers (if possible), a pro rata distribution of customer property is made, and BMIS is liquidated with any proceeds being collected for the benefit of its investors. 91 But as part of the liquidation, the trustee may pursue fraudulent transfer claims against investors that had withdrawn some or all of their investment prior to the commencement of the bankruptcy proceeding. 92 The reality is that investors who redeemed some or all of their Madoff investments, including principal and profit thereon, within two years of the date of the filing of the bankruptcy petition are at risk of being required to disgorge those amounts. 93 Investors that are required to disgorge principal and income that they previously received will need to determine how to treat the disgorged amounts for federal income tax purposes. Those who were unaware of the purported fraud and whose Madoff investments were part of their trade or business should not be precluded by Section 162(h) from deducting any amounts that are paid. Section 162(f) prevents taxpayers from claiming trade or business deductions for fines or similar penalties paid to a government for the violation of any law. 94 In the context of a bankruptcy proceeding, however, amounts paid to the trustee pursuant to section 548 of the Bankruptcy Code by investors with “clean hands” should not be treated as fines for the violation of a law. 95 A disgorgement pursuant to a bankruptcy proceeding is a determination under state law or the Bankruptcy Code that the trading profits should inure to the benefit of the corporation rather than to the particular investor. Support for this position can be found in the requirements of section 548(a)(1)(A) of the Bankruptcy Code and case law interpreting that provision, as there is no requirement that the trustee “allege or prove that the transferee had any intent to hinder, delay or defraud or any knowledge of the transferor's fraudulent intent.” 96 Investors whose trade or business involved making investments with Madoff, such as investors who actively traded securities as part of their business, should be able to claim a deduction for repaid monies under Section 162(a). 97 Alternately, if an investor is an individual, a deduction may be available under Section 212 if the repayment is characterized as an expense incurred for the production of income. 98 If the trading/investment activities do not rise to the level of a trade or business, an investor may be able to claim a deduction under Section 165 if the repayment is treated (and accepted by the IRS) as a loss instead of an expense. 99 Uncertainty presently exists as to whether disgorgement payments can be properly treated as losses even though the Tax Court has stated that the “distinction between losses and expenses has generally been regarded as self-evident.” 100 Moreover, characterization of the payment can have considerable consequences on whether the item is deductible as an expense or as a loss, because a payment characterized as a capital expenditure will not be deductible under either Section 162 or 212. 101 Whether disgorgement payments are characterized as ordinary or capital losses is an issue that may be determined by looking at existing Tax Court precedent. This determination is made by looking to the “income tax significance” of the transaction giving rise to the payment. 102 Cases addressing the characterization of payments made under section 16(b) of the Securities and Exchange Act of 1934 (“section 16(b)”) are instructive in determining whether disgorgement payments by Madoff investors can be treated as ordinary or capital losses. Generally, these cases hold that disgorgement payments are capital losses, because the gain from the transaction giving rise to the taxpayer's liability under section 16(b) was capital (i.e., “the nature of the payment and the prior tax treatment are controlling”), in accordance with the Arrowsmith doctrine. 103 The IRS, in a Field Service Advice, has maintained the position that payments made by partners to settle a suit for breach of fiduciary duty were capital losses to the disgorging partners. 104 In applying the origin of the claim doctrine, the Service stated that the payments were capital expenditures incidental to the capital gain resulting from the excessive partnership distribution. 105 http://foxshweb1:65000/Admin/Marketing/Publications/ReportingMadoffInvestorLosses.... 12/29/2010
Reporting Madoff Investor Losses Page 12 of 26
Questions remain as to whether the holdings and reasoning in these insider trading cases will be
applied to disgorgement payments made by Madoff investors. Notably, there are obvious factual
distinctions between the disgorgement of insider profits and potential disgorgement payments made by
Madoff investors. Given the lack of relevant guidance, the Service should issue guidelines providing a
“relief” rule in this area.
With the threat that the bankruptcy trustee may seek disgorgement of monies from investors, it is
necessary to briefly examine the claim of right doctrine and Section 1341, as this will be the
mechanism by which affected investors will be able to obtain some relief should they be required to
make disgorgement payments. 106 The claim of right doctrine generally applies where a taxpayer has
previously received income that he believed to have been received without restriction, but which turned
out to have been erroneously received and must be repaid. 107 The following factors must exist for the
doctrine to apply:
(1.) An item was included in a taxpayer's gross income for a prior tax year because it appeared
that the taxpayer had an unrestricted right to the item.
(2.) A deduction is allowable in the current tax year because at some time after the tax year in
which the item was included in taxable income it was established that the taxpayer did not have
an unrestricted right to the item.
(3.) The amount of the deduction exceeds $3,000. 108
The benefit of Section 1341 is realized in the tax year in which the repayment is made. The tax
imposed for that tax year is the lesser of the tax determined by taking into account the deduction for
amounts repaid or the tax determined without any deduction for amounts repaid minus the decrease in
tax for the tax year in which the item was received (i.e., the decrease that would result solely from
excluding the item from gross income in the prior tax year). 109 If the decrease in tax for the prior tax
year exceeds the tax in the year of repayment, then the excess is considered an overpayment, and a
refund may be obtained in the latter year. 110 These rules may allow certain investors to recover part
of the income taxes paid with respect to income received and reported in a prior but now closed tax
year, if the investor makes the disgorgement payment in an open tax year. 111
Foreign investors who are required to disgorge monies received with respect to their Madoff
investments will face a different set of problems not only in attempting to apply Section 1341 but in
addressing tax issues arising in their home jurisdiction. As a general matter, nonresident aliens are not
subject to U.S. income taxation on capital gains. 112 If a foreign individual is engaged in a U.S. trade or
business during the year in which the capital asset is disposed, he or she will be subject to U.S.
taxation on gains that are effectively connected with the alien's U.S. trade or business. 113 Similarly, if
the alien is present in the U.S. for at least 183 days during the tax year of disposition and if the gains
are considered U.S.-source income, then the gains will be subject to a flat 30% U.S. federal income
tax. 114
A U.S. tax liability will also apply to the disposition if the taxpayer is a U.S. person by virtue of being a
resident alien under Sections 7701(a)(30) and (b) (i.e., meets the substantial presence test or holds a
U.S. green card). 115 Finally, a U.S. tax liability may result when a nonresident alien is involved in the
sale of a U.S. real property interest to which Section 89 applies.
Foreign investors can deduct theft losses, but the property to which the loss relates must have been
located in the U.S. 116 Even if the theft losses are not effectively connected with a U.S. trade or
business, it is necessary for the investor to have U.S.-source income against which to deduct the theft
loss. If a NOL results from the deduction in the current year, that loss could be carried back or forward
in accordance with Section 172.
1
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U.S. v. Madoff, No. 08 MAG 2735, 2008 WL 5197082 (DC N.Y., 2008).
2
The 11 counts to which Madoff pled guilty on 3/12/09 were:
Count 1: Securities fraud.
Count 2: Investment-adviser fraud.
Count 3: Mail fraud.
Count 4: Wire fraud.
Count 5: International money laundering, related to transfer of funds between New York
brokerage operation and London trading desk.
Count 6: International money laundering.
Count 7: Money laundering.
Count 8: False statements.
Count 9: Perjury.
Count 10: Making a false filing with the Securities and Exchange Commission.
Count 11: Theft from an employee-benefit plan, for failing to invest pension-fund assets on
behalf of about 35 labor-union pension plans.
3
See In re Bayou Group, LLC, 396 Bkrptcy. Rptr. 810 (Bkrptcy. DC N.Y., 2008); In re Agric. Research
and Tech. Group, Inc., 916 F2d 528 (CA-9, 1990).
4
In Rev. Proc. 2009-20, 2009-14 IRB 749, the IRS defines a Ponzi scheme as one “in which the party
perpetrating the fraud receives cash or property from investors, purports to earn income for the
investors, and reports to the investors income amounts that are wholly or partially fictitious. Payments,
if any, of purported income or principal to investors are made from cash or property that other
investors invested in the fraudulent arrangement. The party perpetrating the fraud criminally
appropriates some or all of the investors' cash or property.”
5
Sections 702(a), 703, 1001(a), 1001(c), 1366(a), and 1367(a); Regs. 1.165-1(b) and 1.1001-1.
Eisner v. Macomber, 3 AFTR 3020, 252 US 189, 64 L Ed 521, 1 USTC ¶32 (1920). See also, Section
1222 (“sale or exchange” requirement for capital gain or loss characterization). Helvering v. William
Flaccus Oak Leather Co., 25 AFTR 1236, 313 US 247, 85 L Ed 1310, 41-1 USTC ¶9427, 1941-1 CB 324
(1941). Section 165(c) also applies to trusts and estates per Section 641(b).
6
The realization requirement has yielded to statutory override, however. See Section 475 (dealer in
securities is required to mark to market certain securities held by the dealer; Section 475(f) allows a
trader in securities to elect to mark to market securities held in connection with the person's trade or
business as a trader in securities); Section 1092 (straddle transactions subject to special rules that
limit loss deductions and prevent the deferral of income and the conversion of ordinary income and
short-term capital gain into long-term capital gain); and Section 1296(a) (election of U.S. owner of
PFIC stock to make marked-to-market election in reporting otherwise unrealized gains or losses).
7
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Burnet v. Sanford & Brooks Co., 9 AFTR 603, 282 US 359, 75 L Ed 383, 2 USTC ¶636, 1931-1 CB 363
(1931). See Hershey Foods Corp., 76 TC 312 (1981) (“[A] transactional approach under which we
would wait to see the end result of an entire business venture before determining the proper tax
consequences might be thought by some to be more equitable, but that is not the approach used in our
system of income taxation). See also, Grauer, “The Supreme Court's Approach to Annual and
Transactional Accounting for Income Taxes: A Common Law Malfunction in a Statutory System?,” 21
Ga. L. Rev. 329 (1986).
8
See Section 165(g) (worthless securities); Section 166(a) (wholly or partially worthless business bad
debts); and Section 1244 (loss on small business stock). Section 165(g) prevents a taxpayer from
claiming ordinary loss treatment on the abandonment of a worthless security by providing that if a
“security” becomes worthless, the resulting loss is treated as loss from the sale or exchange of the
security on the last day of the tax year.
9
Section 162(a) allows the deduction of all “ordinary and necessary expenses” paid or incurred during
the tax year in carrying on any trade or business. Similarly, Section 212 provides for the deduction of
“ordinary and necessary expenses” paid or incurred for the production or collection of income or for the
management, conservation, or maintenance of property held for the production of income.
10
A loss attributable to “theft” requires that the loss is sourced from a criminal appropriation, as
determined by the law of the state in which the crime occurred. See Reg. 1.165-g(d); Kreiner, TC
Memo 1990-587, PH TCM ¶90587 .
11
See Spectre, TC Memo 1966-97, PH TCM ¶66097, 25 CCH TCM 519 (loss fully covered by insurance,
legal fees incurred in pursuing claims deductible); Jeffrey, TCM 19530520 .
12
See Regs. 1.165-1(d)(2)(ii) and (iii). Montgomery, 65 TC 511 (1975) (tax benefit rule).
13
Reg. 1.165-1(d)(2)(i). But see Hensler, Inc., 73 TC 168 (1979) (business expense deduction allowed
for repairs to business property damaged by casualty, despite possibility of insurance recovery).
14
Hills, 50 AFTR 2d 82-6070, 691 F2d 997, 82-2 USTC ¶9669 (CA-11, 1982) (theft loss deduction
allowed homeowner who chose not to seek insurance reimbursement; plain interpretation of statute
permitted deduction for losses that were not in fact compensated; duty to seek recovery of loss
property (relevant to timing of loss deduction) did not create duty to seek reimbursement from third
parties); Miller, 53 AFTR 2d 84-1252, 733 F2d 399, 84-1 USTC ¶9451 (CA-6, 1984). Cf. Alison, 42
AFTR 660, 344 US 167, 97 L Ed 186, 52-2 USTC ¶9571, 1953-1 CB 39 (1952).
15
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