On December 11, 2008, Bernard Madoff, former NASDAQ chairman, was arrested and charged with a securities fraud whose $50 billion of losses, if proved, would make it the biggest Ponzi scheme in history. While Madoff’s system was typical of a Ponzi scheme in its structure—paying returns to investors out of the money received from subsequent investors rather than from profit—his strategy was unique. Instead of offering suspiciously high returns to a group of investors with whom he had personal relationships, Madoff offered steady returns to a wider clientele, extending his reach through an international network of hedge funds that funneled their clients’ money into his scheme.
In March 2009, the IRS issued Rev. Rul. 2009-9 and Rev. Proc. 2009-20, which provided guidance on the tax treatment of theft losses from Ponzi-type schemes. Although it is evident from the provisions of Rev. Proc. 2009-20 that it was intended to offer a 2008 theft loss deduction to victims of the Madoff scheme, its provisions apply to victims of all Ponzi-type thefts.
The content of Rev. Rul. 2009-9 and Rev. Proc. 2009-20 was covered in the May 2009 issue of The Tax Adviser (“IRS Issues Guidance on Losses from Ponzi Schemes,” p. 334). This item will address some practical issues that practitioners may encounter in preparing returns for taxpayers who have been victims of the Madoff Ponzi scheme.
Determining Whether a Loss Is a Theft Loss
Regs. Sec. 1.165-8(d) states that theft is “deemed to include, but shall not necessarily be limited to, larceny, embezzlement, and robbery.” Rev. Rul. 72-112 expands on this definition by defining “theft” as a taking of property that was illegal under the law of the jurisdiction in which it occurred and was done with criminal intent. Various IRS pronouncements and court cases have distinguished between theft losses and other types of losses (e.g., worthless securities, bad debt, gifts, etc.). These pronouncements and cases are the topic of other articles and thus will not be discussed in this item; however, it is important to note that the Madoff Ponzi scheme’s unique nature may raise issues that have not been previously addressed. For example, certain funds used swap transactions to leverage their investments into the Madoff strategy. In addition to multiplying the amount of the fund’s losses, the use of such Madoff derivatives presents some complex and ambiguous tax issues that remain unanswered, including whether the affected investors in the swap transactions will be eligible for an ordinary loss. To the extent that the losses from the swap transaction are considered ordinary under other Code provisions, taxpayers may concede that such losses are not theft losses; however, to the extent that the losses from the swap transaction are considered capital losses, taxpayers can be expected to advance arguments that such losses are theft losses.
In Rev. Proc. 2009-20, the Service and Treasury acknowledge that whether and when investors meet the requirements for claiming a theft loss for an investment in a Ponzi scheme are highly factual determinations that taxpayers often cannot make with certainty in the year the loss is discovered. The revenue procedure goes on to indicate that the safe harbor’s purpose is to provide a uniform manner for taxpayers to determine their theft losses, and it explicitly states that use of the safe harbor is optional (i.e., use of the safe harbor requires an election).
The revenue procedure permits taxpayers who choose to use the safe harbor to deduct either 75% or 95% of the loss in the discovery year. Section 4.04 of Rev. Proc. 2009-20 defines the discovery year as the year in which the indictment, information, or complaint establishing the qualified loss is filed. For the Madoff Ponzi scheme’s victims, the discovery year is 2008.
The use of the safe harbor is limited to “qualified investors” as defined in Rev. Proc. 2009-20, §4.03. This section effectively precludes persons that had actual knowledge of the investment arrangement’s fraudulent nature prior to its becoming known to the general public from using the safe harbor. It also limits the use of the safe harbor to investors that transferred cash or other property to the fraudulent arrangement, thus ruling out investors who invested in the fraudulent arrangement through a fund or other entity. Presumably, however, such indirect investors may claim a safe-harbor deduction if the fund or other entity makes the safe-harbor election.
Section 8.01 of Rev. Proc. 2009-20 explicitly states that taxpayers who do not use the safe harbor to claim a theft loss must establish that the loss was from theft, that the theft was discovered in the year the taxpayer claims the deduction, and that no claim for reimbursement of any portion of the loss exists for which there is a reasonable prospect of recovery in the year in which the taxpayer claims the loss.
Despite Rev. Proc. 2009-20’s stipulation of 2008 as the year in which a taxpayer can deduct Madoff theft losses under the safe harbor, it is not certain that a taxpayer who does not use the safe harbor could claim a Madoff theft loss deduction in 2008. It is possible that the Service could make an argument that the taxpayer must defer the loss to a future year because as of December 31, 2008, the trustee of the Madoff bankruptcy estate had not completed his investigation into Madoff’s assets.
In addition, for taxpayers who invested with Madoff through another investment fund, the IRS could argue that as of December 31, 2008, such taxpayers had a realistic prospect of recovery in the form of lawsuits against third parties and that the amount of the potential third-party recovery could not be reasonably estimated. Thus, taxpayers for whom a 2008 theft loss is valuable must carefully consider whether it is necessary to use the safe harbor in order to ensure a 2008 theft loss deduction.
By making the safe-harbor election, however, taxpayers are precluded from the following:
- Deducting losses in excess of the 75%/95% amount in the discovery year;
- Filing returns or amended returns to exclude or recharacterize income reported with respect to the investment arrangement in tax years preceding the discovery year;
- Applying the claim-of-right provisions of Sec. 1341; or
- Applying the doctrine of equitable recoupment or the mitigation provisions in Secs. 1311–1314.
Although use of the safe harbor, which will result in a 2008 theft loss for victims of the Madoff Ponzi scheme, may be advantageous for many taxpayers, it is possible that certain victims of the Madoff Ponzi scheme may prefer to defer the loss to a future year. Perhaps the taxpayer realized a significant capital gain in 2008 and prior years (taxable at 15%) but expects a significant amount of ordinary income in the future that, under President Obama’s proposed budget, would be taxed at a rate of 39.6%.
Section 5.02 of Rev. Proc. 2009-20 provides that an investor can deduct 95% of the qualified investment in the discovery year as long as the investor is not pursuing third-party recovery; however, the percentage is 75% for an investor who is pursuing third-party recovery. Taxpayers who compute the amount of their safe-harbor deduction using the 95% are required to sign a statement—under penalties of perjury—that they have not pursued and do not intend to pursue any potential third-party recovery.
Section 4.10 of Rev. Proc. 2009-20 defines the term “potential third-party recovery” as the amount of all actual or potential claims for recovery that are not attributable to potential insurance/Securities Investor Protection Corporation (SIPC) recovery and potential direct recovery (e.g., against the responsible group).
Unfortunately, Rev. Proc. 2009-20 does not define how to determine whether an investor is “pursuing” third-party recovery. By way of illustration, consider the following two examples:
Example 1—class action lawsuits: Investor X (who is not otherwise pursuing third-party recovery) is included in a class action suit. Does X’s passive inclusion as a member of the class cause him to be considered as pursuing third-party recovery?
Funds that decide to make the safe-harbor election in particular will need to carefully consider whether to compute the amount of the theft loss deduction using 75% or 95%. Investors can be expected to pressure funds that are not currently pursuing third-party recovery to calculate the loss using the 95% rate; however, such funds should carefully consider the impact of using the 95% rate on the safe-harbor election should they decide to pursue third-party recovery in the future.
Example 2—lawsuit against feeder funds: Y is an investor in Fund A, which holds a direct account with Bernard L. Madoff Investment Securities, LLC (BMIS). Although A is not pursuing third-party recovery, Y is pursuing recovery against A. A files its tax return using the safe harbor and reports a theft loss equal to 95% of its qualified investment.
Can Y deduct 95% of the theft loss reported on its Schedule K-1 issued by Fund A, or is Y required to reduce the amount of the deduction to 75% or some other amount? Unfortunately, Rev. Proc. 2009- 20 does not address this issue.
Amending Returns to Eliminate Fictitious Income
Rev. Rul. 2009-9 concludes that the amount of a theft loss is increased by the amount of the fictitious income (e.g., amounts reported to the investor as income prior to the fraudulent arrangement’s discovery) that is reinvested in the fraudulent arrangement.
It should be noted that this conclusion is very favorable to the investors because it is inconsistent with the holding in Kaplan, No. 8:05-cv-1236-T-24 EAJ (M.D. Fla. 2007). In Kaplan, the court denied taxpayers a theft loss deduction for income allegedly earned on purported investments in a Ponzi scheme because the taxpayers could not produce evidence that such income ever existed; thus, the taxpayers could not show that such income was unlawfully taken (a prerequisite to the theft loss deduction).
Prior to the issuance of Rev. Rul. 2009-9, it was uncertain whether taxpayers would be able to recover taxes for fictitious income amounts attributable to years for which the statute of limitation had closed.
For taxpayers who choose to use the safe harbor, the only permissible treatment for fictitious income is to include it as basis for determining the amount of the theft loss to be deducted in the discovery year. Taxpayers who do not use the safe harbor have the option of filing amended returns for open years to exclude fictitious income; however, such taxpayers must establish that the amounts sought to be excluded in fact were not income that was actually or constructively received by the taxpayer (Rev. Proc. 2009-20, §8.02).
Despite this additional burden, in certain circumstances taxpayers may be able to increase the value of their theft loss tax refunds by opting out of the safe harbor and filing amended returns for open years. Taxpayers that are considering filing such amended returns should be mindful of the statute of limitation and may find it necessary to file protective refund claims.
SIPC Recovery Issues
Both Rev. Proc. 2009-20 and Rev. Rul. 2009-9 require taxpayers to address the amount (if any) to be received from the SIPC. The amount (if any) to be received may be affected by whether an investor was a direct investor that had an account at BMIS or an indirect investor in a fund that had an account at the firm. It is generally believed that the $500,000 SIPC limit will be determined on a per account basis, which means that the amount of SIPC recovery to an investor in a fund with many partners will be limited; however, even if the claims of indirect investors are initially rejected by the SIPC, it is possible that litigation may subsequently be brought against the SIPC to require that claims by indirect investors be covered.
In addition, it generally is believed that the amount of the SIPC recovery is limited to the investor’s net unrecovered investment and that the SIPC will not provide reimbursement for fictitious income.
Due to these complexities, tax preparers should refrain from calculating the amount of the SIPC recovery and should require that the client stipulate the amount, preferably based on the advice of the client’s attorney.
To use the safe-harbor provisions of Rev. Proc. 2009-20, a taxpayer must attach a statement—signed under penalties of perjury—to its tax returns stating that it has written documentation to support the amount of the loss; however, the revenue procedure does not specify the source, form, or required content of the documentation.
Many Madoff victims made their investments as early as 1992. Although the IRS does require taxpayers to maintain documentation to support their tax basis, in many instances the statements issued by BMIS indicated that all the positions in the account were liquidated as of the end of the year; thus, taxpayers may have discarded their records following the expiration of the three-year statute of limitation. For taxpayers that did not retain records, recreating the missing records may be next to impossible, especially given the large number of acquisitions/ mergers that have occurred among financial institutions. Even the Service has indicated it may provide transcripts to taxpayers only for the past six years.
Madoff investors will likely have copies of recent BMIS statements; however, it is possible that the IRS could challenge whether the amounts reported on these statements represent the taxpayer’s basis in its BMIS investment.
Partnership Allocation Issues
When a theft occurs at the partnership or other passthrough entity level, only the partnership or other passthrough entity may make the safe-harbor election. The partnership presumably will then allocate the safe-harbor theft loss amount to its partners and report the amount of the safe-harbor loss on the Schedule K-1 it issues to each partner.
The Code allows securities partnerships to use alternative methods to allocate realized gains and losses (see Bellamy, “Tax Allocations for Securities Partnerships,” 34 The Tax Adviser 473 (August 2003)). Although all methods are required to preserve the character and other tax attributes of each item of gain or loss, which are determined under a consistently applied approach, the different methods can render different results. Thus, the allocation method used by the partnership can affect the amount of the Madoff theft loss allocated to the taxpayer.
Consider, for example, the following issue related to the allocation of the SIPC recovery amounts received by a partnership:
Example 3: Partnership ABCD is formed in 1997 and each partner contributes $250,000 for a 25% interest in the partnership. The $1 million is invested with BMIS in 1997. By 2007, fictitious income of $1 million had been reinvested, bringing the total value of the BMIS account to $2 million. At the end of 2007, Partner A withdraws his 25% interest from the partnership, leaving a balance of $1,500,000, consisting of a net unrecovered investment of $750,000 and fictitious income of $750,000. On January 1, 2008, Partner E invests $500,000 in the partnership, increasing the BMIS account balance to $2 million, consisting of a net unrecovered investment of $1,250,000 and fictitious income of $750,000. The partnership receives an SIPC recovery of $500,000, which constitutes 50% of its net unrecovered investment and allocates $125,000 to each partner. Under this methodology, the amount of the SIPC recovery allocated to Partner E constitutes 25% of her $500,000 net unrecovered investment, while the amount of the SIPC recovery allocated to Partners B, C, and D is 50% of their $250,000 net unrecovered investment.
If a partner reports items on his or her tax return that are not consistent with the items as reported on Schedule K-1 from a partnership, S corporation, estate, or trust, Form 8082, Notice of Inconsistent Treatment or Administrative Adjustment Request (AAR), must be attached to the partner’s return. Form 8082 is required not only when the taxpayer disagrees with the amounts reported on the Schedule K-1 but also if the partnership has not filed a tax return or issued a Schedule K-1 by the time the individual must file his or her tax return (including extensions), as may be the case with a fund that, as a result of its Madoff and/or other losses and/or investor lawsuits, is unable to timely file its tax return.
Reportable Transaction Issues
Regs. Sec. 1.6011-4(a) requires every taxpayer that has participated in a reportable transaction and is required to file a tax return to attach to its return a disclosure on Form 8886, Reportable Transaction Disclosure Statement. The fact that a transaction is reportable does not affect the legal determination of whether the taxpayer’s treatment of the transaction is proper.
Included among the categories of reportable transactions are loss transactions. A loss transaction is any transaction that results in the taxpayer’s claiming a loss under Sec. 165 that surpasses the following thresholds specified in Regs. Sec. 1.6011-4(b)(5)(i):
- For corporations, $10 million in any single tax year or $20 million in any combination of tax years.
- For partnerships that have only corporations as partners (even if the losses do not flow through to the partners), $10 million in any single tax year or $20 million in any combination of tax years.
- For all other partnerships (even if the losses do not flow through to the partners), $2 million in any single tax year or $4 million in any combination of tax years.
- For individuals, S corporations, or trusts (whether or not any losses flow through to one or more shareholders or beneficiaries), $2 million in any single tax year or $4 million in any combination of tax years.
- For individuals or trusts (whether or not the loss flows through from an S corporation or partnership), $50,000 in any single tax year if the loss arises from a Sec. 988 transaction (relating to foreign currency).
In determining whether a transaction results in a loss that exceeds the threshold amounts, only losses claimed in the tax year that the transaction is entered into and the five succeeding tax years are combined.
The IRS was aware that many nonabusive transactions could result in Sec. 165 losses. To address this situation, the Service announced several exceptions to this definition. Section 4.03 of Rev. Proc. 2004-66 provides an exception for theft losses under Sec. 165(c)(3); however, because Rev. Rul. 2009-9 specifies that Ponzi-type losses are deductible under Sec. 165(c)(2), this exception is not available. Thus, to the extent that a Ponzi-type theft loss exceeds the applicable thresholds, the taxpayer may be required to report the loss on Form 8886.
Net Operating Loss Issues
Rev. Rul. 2009-9 explicitly states that Sec. 172(d)(4)(c) treats any deduction for theft losses allowable under Secs. 165(c) (2) or (3) as a business deduction and that a theft loss an individual sustains after December 31, 2007, is considered a loss from a “sole proprietorship” within the meaning of Sec. 172(b)(1)(F)(iii). Accordingly, an individual taxpayer may be eligible to elect either a three-, four-, or fiveyear net operating loss (NOL), provided the $15 million gross receipts test in Sec. 172(b)(1)(H)(iv) is satisfied.
When a theft loss results in a net operating loss, tax preparers should be careful to analyze whether to elect to forgo the NOL carryback and, if the NOL is to be carried back, whether to elect either a three-, four-, or five-year expanded carryback period.
Because tax rates may be different for different carryback years, in many instances it will be necessary for preparers to compute the value of the potential carryback for all four potential carryback years (two-, three-, four-, or five-year carryback). Because the Code requires consistent carryback treatment for both regular tax and alternative minimum tax (AMT) NOLs, preparers should compute not only the value of the regular tax carryback but also the value of the AMT carryback. It should be noted that the 90% of AMT income limitation was not lifted (as it was for the expanded carryback that was permitted for 2002 NOLs), so the carryforward and carryback of 2008 NOLs can offset only 90% of AMT income.
As a result of the Madoff Ponzi scheme, tax refunds may constitute a significant portion of an investor’s net worth. Understandably, such taxpayers may be anxious to file not only their tax returns for the discovery year but also the accompanying amended returns and/or tentative carryback claims to carry their theft losses back to prior years. In the case of fund investors, in many instances they will not receive their 2008 Schedule K-1s until September 15, 2009 (the extended due date for 2008 calendar-year partnerships, corporations, estates, and trusts). This may delay the receipt of the refund attributable to the overpayment of 2008 taxes.
Corporations may be entitled to an expedited refund using Form 4466, Corporation Application for Quick Refund of Overpayment of Estimated Tax. However, a corporation must file Form 4466 before the sixteenth day of the third month after the end of the tax year. An extension of time to file the corporation’s tax return does not extend the time for filing Form 4466.
Unfortunately, a quick refund is not available for individual taxpayers. Nonetheless, if the 2008 tax refund is attributable to the application of the taxpayer’s 2007 overpayment and the Madoff-related tax refunds constitute almost the entire remaining net worth of an investor, the taxpayer may wish to contact the IRS to see if the Service would be willing to adjust the taxpayer’s 2007 account to refund (versus apply) the 2007 overpayment.
In most instances, refunds attributable to the carryback of NOLs will be filed using either Form 1045, Application for Tentative Refund, or Form 1139, Corporate Application for Tentative Refund. Although Forms 1045 and 1139 ordinarily are due within 12 months after the tax year of the NOL, a taxpayer that seeks to make a timely Sec. 172(b)(1)(H) election using Form 1045, Form 1139, or an amended return must file the form within six months after the due date (excluding extensions) of the return for the tax year of the NOL (e.g., September 15, 2009, for calendar-year entities and October 15, 2009, for calendar-year individuals).
Sec. 6411(b), Regs. Sec. 1.6411-3(a), and Temp. Regs. Sec. 1.6411-3T(a) require the IRS to act on a claim for a tentative carryback refund within 90 days from the later of the date the application was filed or the last day of the month containing the last date prescribed by law (including extensions) for filing the return for the tax year of the NOL from which the carryback results. In the case of extended, calendar-year individual income tax returns for 2008 for which a tentative carryback claim is filed by October 31, 2009, the Service is not required to act on a claim until January 29, 2010.
If the amount of a taxpayer’s refund exceeds $1 million and the taxpayer requests that the IRS electronically deposit this amount, the taxpayer must attach Form 8302, Electronic Deposit of Tax Refund of $1 Million or More, to its refund claim.
If the amount of a taxpayer’s refund exceeds $2 million, Sec. 6405(a) provides that the IRS may not issue the refund until 30 days after it submits a report to the congressional Joint Committee on Taxation (JCT). The report must state the name of the person to whom the refund or credit is to be made, the amount, and a summary of the facts and the Service’s decision. Although the JCT has oversight as opposed to approval authority, if the JCT disagrees with or questions the Service’s position in the report, the Service’s general policy is to delay processing the refund until the dispute is resolved.
Although the availability of the safeharbor provisions of Rev. Proc. 2009-20 may be beneficial for many taxpayers, careful analysis will be required to determine the combination of tax strategies that will maximize the value of the theft losses incurred by a taxpayer. Given the complexity and number of outstanding issues that must be addressed by tax preparers in preparing returns that contain theft loss deductions related to the Madoff Ponzi scheme, if the IRS wishes to achieve its stated objective of alleviating the compliance and administrative burdens on both taxpayers and the IRS, it should issue additional guidance—in particular for the investors of the Madoff feeder funds—in time for such guidance to be applied to the preparation of 2008 tax returns.
Anthony Bakale is with Cohen & Company, Ltd., Baker Tilly International, Cleveland, OH.
For additional information about these items, contact Mr. Bakale at (216) 579-1040 or firstname.lastname@example.org.