By Richard Levychin, CPA

Investors still reeling from devastating losses from Bernard Madoff’s alleged multi-billion dollar Ponzi scheme are now faced with another issue: how to account for the losses on their tax returns.

At first glance it appears that these losses should be classified as capital losses. However, the Internal Revenue Code places an annual limitation of $3,000 per year on capital losses. For example, someone looking to treat the transaction as a capital loss on their tax return and for someone who has a loss of $33,000 it would take 11 years to receive the benefit of these losses assuming that they have no future capital gains to offset these losses, while for someone with a $330,000 loss it would take 110 years to receive the benefit of these losses assuming that they have no future capital gains to offset these losses. Accordingly, Madoff victims will be looking for solid guidance and documentation from tax professionals and the Internal Revenue Service in order to be able to present these losses on their tax returns as ordinary, as opposed to capital, so that they can receive the related tax benefits sooner.

Several lawyers and tax professionals believe that many of those who invested with Madoff may be able to deduct these losses as ordinary losses which would offset ordinary income. These professionals also believe 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 exceed gross income, those losses can be carried back three years or forward 20 years. These professionals believe that the Madoff losses should be allowed in full on your 2008 tax return without limitation.

Then there is the question of what investors should do about taxes paid in previous years on Madoff investment income that they thought they received, but in actuality was simply illusory. Should these returns be amended with the “investment income” from the Madoff investments being restated to zero, with a corresponding request for tax refunds for taxes paid on this illusory “investment income”? How would investors go about figuring out how much they lost or how far back in time they could go to calculate these losses? And what about those investors who received payouts from Madoff? How would you account for those from a tax perspective given the current information? Worse still, if you are subsequently required to return these payments, how would you account for those repayments from a tax perspective?

As for the Internal Revenue Service, they are still trying to figure out all of the moving pieces and cannot be counted on to issue any guidance anytime soon. However, in a previous federal tax case involving a Ponzi scheme, the victims were able to only deduct their original investment as a theft loss. Taxes paid on phantom income were not allowed to be part of the theft loss. That is not the kind of news Madoff victims want to hear.

Also, the Code does not allow you to take a loss as long as there is a reasonable possibility of recovery. This would delay taking the deduction until all claims for potential recovery are resolved.

Many law firms and accounting firms have set up special “Madoff” groups focused on Madoff-related tax issues and proposed ways to address these tax issues. However, without specific guidance from the IRS, these groups are faced with far more questions than answers.

None of the above provides any clarity to Madoff victims that were looking to a substantial tax refund as what would probably be the only form of relief that they would receive from the Madoff fiasco.

So what should Madoff victims do? Filing a protective tax claim for all open tax years in order to keep those years open before the three year statute of limitations runs out would be a good place to start. In addition, filing an extension on your 2008 tax return would also be a good idea, even though there is no guarantee that the IRS will provide guidance by the October extended filing date.

Taking the position that the Madoff losses are ordinary losses and should be treated as ordinary as opposed to capital losses on your tax return, even with full disclosure on the return, would probably result in the IRS not accepting those returns and could subject the tax filers to potential penalties and related interest. The bottom line is that Madoff victims should speak with a professional tax preparer to understand their options.