KBL – certified public accountants and advisors

This is a follow up to our recent piece entitled “More Questions Than Answers Regarding the Handling of Tax Write-Offs for Madoff Victims.” In that piece we questioned how tax write-offs from the Madoff losses should be handled on the victims’ 2008 tax returns.

In addition to their investments into Madoff funds, Madoff investors reported earnings from their investments with him through the years. Accordingly, these investors paid taxes on these phantom profits and theoretically should be entitled to refunds of the taxes they paid.

Several lawyers and tax professionals believed that many of those who invested with Madoff should have been allowed to deduct these losses as ordinary losses which would offset ordinary income. These professionals also believed that the victims that invested with Madoff should not be subject to limits that apply to personal casualty or theft losses per the Internal Revenue Service Code. Under the Code, personal casualty or theft losses are recognized to the extent that those losses exceeded 10% of your adjusted gross income, after reducing each loss by $100. To the extent that eligible losses exceeded gross income, those losses could be carried back three years or forward 20 years. These professionals believed that the Madoff losses should have been allowed in full on your 2008 tax return without limitation.

The Internal Revenue Service has issued guidelines that will allow tax relief for victims of Ponzi schemes including Madoff victims who were levied for investment earnings that turned out to be nonexistent. Both IRS announcements provide guidance to impacted taxpayers regarding the federal income tax treatment of the loss of investment assets as a result of a Ponzi scheme. The IRS announcements allow, if a safe harbor election is made with disclosure, a 2008 ordinary deduction not subject to itemized deduction limitations. The amount of the deduction would be the sum of the investor’s original investment amount, additional investment amounts, and amounts reported as taxable income, reduced by distributions received by the investor during the investment period. The amount so computed is defined as the “Qualified Investment.” Further, the IRS provides that a taxpayer may elect a net operating loss carryback for up to five years, for a 2008 net operating loss deduction, which could be created as result of deducting the Qualified Investment.

The IRS expects that statements provided to investors by Madoff's fund, showing the amounts they invested, should be sufficient documentation to establish loss amounts for filing tax claims.

The IRS guidance also provides for a safe harbor for determining the theft loss amount considering a taxpayer’s potential recovery of a portion of his or her investment. In general, a taxpayer who is not pursuing a claim against any third party may deduct 95 percent of his or her Qualified Investment less any recoveries from the Securities Investor Protection Corporation ("SIPC"). A taxpayer who is pursuing claims against third parties may deduct 75 percent of his or her Qualified Investment less any expected SIPC recovery. If SIPC or third party recoveries are not realized, the remaining balance of the loss or any excess recovery should be reported as a deduction or income in a future year.

The SIPC has begun sending out the first checks to Madoff victims. Investors are eligible for up to $500,000 from the organization and have until July to file claims. Around $1.6 billion or so is currently available to the SIPC.

The IRS guidance also indicates that only the direct investors in Madoff may deduct the theft loss; therefore, investors in so-called feeder funds cannot deduct the theft loss. The proper method is for the feeder fund to claim the theft loss and then report each partner’s share of the loss on a Schedule K-1, as a separately stated item.

Sen. Charles Schumer, D-N.Y., a member of the Finance Committee who has been pushing for tax relief for victims of Ponzi schemes, said that with the new guidelines the IRS "has done the right thing."

"In most every area where there was a major dispute, they have sided with the victims," Schumer said. "These victims were not only sophisticated financial professionals, but also ordinary people who believed they were making safe, responsible investments for their future. The steps announced mean victims won't owe taxes on income they never received."

By some estimates, the IRS could be out as much as $17 billion in lost tax revenue from refunds to investors who earned fictitious profits in the Madoff scheme.