The tax laws may give investors defrauded by Mr. Madoff and his firm, Bernard Madoff Investment Securities LLC, a method for recovering some of the money they have lost, but the uncertainty and complexity of the rules may lead to disputes with the Internal Revenue Service (IRS). This information bulletin provides an overview of the issues. The application of the tax rules to any particular investor will depend on their precise circumstances. All investors in the one or more funds managed by Madoff (collectively referred to as the “Fund”) are urged to consult promptly with a tax advisor about their particular facts and circumstances.  

The primary tax issues facing all investors, however, will be (1) claiming losses for the money invested in the Fund and (2) recovering taxes already paid on fabricated earnings reported by the Fund in prior years.  

The Madoff securities firm is in a proceeding initiated under the Security Investors Protection Act (SIPA), as well as an extensive criminal investigation. At this time, the relative scarcity of hard facts prevents counsel from offering definitive advice on the tax issues. However, we believe an early meeting with your tax advisor is advisable and this bulletin will highlight the major issues that investors should consider from a tax viewpoint.

Theft Losses

Assuming that investigators establish that the losses are predominantly the result of the Fund’s Ponzi operation, the IRS is likely to concede that some portion, or all, of the losses qualify as allowable theft losses for tax purposes (subject to the rules described below). Several courts have already ruled on similar, albeit less notorious frauds, and found that the schemes amounted to theft. However, if the investigation shows that the investors contributed significant amounts that were lost through poor investment decisions by the Fund, the IRS may attempt to argue that a portion of the losses were due to bad investment decisions, but not theft. Any such position by the IRS would virtually assure litigation with the defrauded investors, but the possibility cannot be completely excluded.  

Under the tax law, a taxpayer must report the amount of allowable theft losses in the year the theft is discovered. This would likely mean that investors will have to report the loss on their 2008 tax returns. However, a regulation bars the loss if it is subject to insurance or reimbursement and states that the year of the loss is the year in which the amount of reimbursement is ascertained with reasonable certainty. Only the portion of the loss that has a reasonable prospect of recovery is non-deductible; any portion of the loss that has no reasonable prospect of recovery is deductible in the year discovered. Under SIPA, investors may be entitled to a certain amount of reimbursement from Securities Investor Protection Corporation, a government organization that protects investors from fraud (SIPC). SIPC may also recover assets of the Fund from various parties. Accordingly, the IRS may take the position that the amount of loss is not currently known and can only be claimed in some later year. It is important to consult with a tax advisor to file returns that protect the investor’s position regardless of the positions taken by the IRS.  

Under the Internal Revenue Code, the allowable amount of theft loss is reduced by 10 percent of the taxpayer’s adjusted gross income in the year of loss. If an investor’s allowable loss exceeds his or her total income for 2008, the investor is entitled to carry the loss back to the prior three tax years to seek a refund for any taxes paid in those years. If the losses exceed the taxes paid in those three years, the investor may carry the loss forward to offset income earned during the next 20 years.

The IRS may take the position that the amount of loss that each investor can claim is limited to the amount of money that was directly given to the Fund, reduced by any funds that were returned to the Investor from the Fund, and that a theft loss may not be reported as to fictitious income reported by the Fund. This issue will be affected by whether the investor included in taxable income the reported income of the Fund, which then can be claimed as basis, and whether any of the reported income was in fact earned by the Fund. The law in this area is not well-developed.  

Investors that received payments from the Fund during the last two years may also face the risk that those payments will be treated as a fraudulent conveyance, and must be repaid to the Fund. If a debtor, such as the Fund, transfers assets to a third party to avoid the claims of creditors, the money transferred out may be reclaimed during bankruptcy or similar proceedings. Any investor that was aware of the fraud being committed by the Fund and who received payments from the Fund might well be forced to give the funds back. Less clear is whether an investor that received a large payout during 2008 might be subject to this doctrine simply because it received a large payment. A bankruptcy court or SIPC might seek to enforce such a rule to ensure that all investors are treated equally.

Recovering Prior Taxes Paid on Fictitious Income

Investors likely have received one or more of the following tax forms from the Fund: Form 1099-INT (reporting interest income), 1099-DIV (reporting dividend income) or 1099-B (reporting proceeds from the sale of securities by a broker) in prior years. Investors would have included this information in their income tax returns and paid taxes on the reported income. To the extent these Form 1099s reported income that had never been earned by the investor, then investors may consider filing amended returns seeking a refund from the IRS and their state and/or local taxing authority of the taxes they paid on what turned out to be phantom income. As a general rule, investors can only seek refunds for tax returns filed within three years of the date of the refund claim. For example, the refund deadline for investors who file returns on April 15 each year, for the 2005 tax year expires on April 15, 2009 (three years after the April 15, 2006, filing date of the 2005 return). Unfortunately, refund claims for such timely filers are already barred for all tax years prior to 2005, so investors who had money with Madoff in earlier years may already be time-barred from getting refunds on taxes paid on the phantom income. Investors should consult tax advisors about these technical rules to avoid allowing a year that is open for a refund claim to become barred by the passage of time.  

It is unclear at this point whether the IRS will concede that all items of income reported to individual investors on the Forms 1099 were in fact erroneously reported as income. The investigation of the Fund may establish that the Fund actually did earn some income in prior years and that such income was properly allocable to investor accounts, so it is possible that the IRS may take the position that some of the earnings reported to investors on Forms 1099 are correct. At some point, the IRS may begin to issue guidance on the extent of allowable refund claims on fictitious 1099s issued by the Fund. In the meantime, however, investors should consult with their tax advisor to avoid allowing any refund year to become barred by the passage of time, even if the refund claims must be filed on a protective basis.  

Current law suggests that there are inconsistencies between the application of a theft loss deduction and the allowance of refunds on income taxes paid on phantom income. For example, the IRS may disallow theft loss deduction on earnings that were included in a tax return but never economically earned, while it allows a refund for the taxes paid on that income. If, however, the claim for refund is partially denied because the IRS asserts that the Fund had earned income in that year, then the theft loss deduction should be allowed. Madoff investors should seek counsel to determine the strategy or combination of strategies that is best suited for their particular tax circumstances.  

The tax rules surrounding the Madoff fraud are complex. Some investors are investigating alternative tax theories to avoid the three year refund cutoff rule and to find ways to seek recovery of Fund balances in excess of funds actually transferred to the Fund. All affected investors are urged to seek tax counsel.