Investors who directly maintained accounts with Bernard Madoff Investment Securities ("BMIS") and were victims of Bernard Madoff's ("Madoff") Ponzi scheme may be able to recoup a portion of their losses through federal income tax deductions. The Internal Revenue Code provides that taxpayers who had property stolen are entitled to a "theft loss deduction." This alert will provide a brief summary of the theft loss deduction available to such investors (the "Madoff Investors") with respect to their BMIS accounts.
Current Status of BMIS and SIPC Liquidation.
The full extent of the losses in BMIS as a result of Madoff's Ponzi scheme are not yet known. When Madoff was arrested on Dec. 11, 2008, he estimated that the losses from the scheme were at least $50 billion, and that he had only approximately $200-$300 million left. Madoff claimed that BMIS was insolvent and had been for years.
On Dec. 15, 2008, the U.S. District Court for the Southern District of New York appointed a trustee (the "SIPC Trustee") to liquidate BMIS (the "SIPC Liquidation") pursuant to the Securities Investor Protection Act. On Jan. 2, 2009, the SIPC Trustee mailed claim forms to Madoff Investors. In addition to any recovery that the Madoff Investors may receive from the SIPC Liquidation, each Madoff Investor may be reimbursed for up to $500,000 of losses from the Securities Investor Protection Corporation (the "SIPC Reimbursement").
Theft Loss Deduction for Madoff Investors.
Federal tax law provides that a taxpayer may take a deduction for losses suffered due to theft. The courts and the Internal Revenue Service (the "Service") have previously held that victims of Ponzi schemes are entitled to a theft loss deduction for their investment losses. Generally, Madoff Investors may take a theft loss deduction equal to all money invested with BMIS, increased by the amount of "income" earned in their BMIS account in which they paid tax ("Phantom Income"), and reduced by cash distributions from such an account and by their expected SIPC Reimbursement. However, the Service may challenge the amount of the theft loss deduction and assert that such a deduction does not include any Phantom Income earned in a BMIS account.
Since the Madoff Investors maintained BMIS accounts for investment purposes, the entire loss should be deductible (subject to certain limitations discussed below), and such a loss is not subject to the "personal casualty" loss limitations (personal casualty loss deductions are only permitted to the extent they exceed $100 and 10 percent of a taxpayer's adjusted gross income). Theft losses are also treated as ordinary losses and are not subject to the limitations on itemized deductions. In addition, theft losses are considered "net operating losses" and, as such, can be carried back three years to offset past income, and carried forward up to 20 years to offset future income.
Madoff Investors May Take Theft Loss Deduction In 2008.
A taxpayer is permitted to take a theft loss deduction in the year of the discovery of the theft only if they can establish that they have no reasonable prospect of recovering such a loss. If a taxpayer has a reasonable prospect of recovering some or all of a theft loss, then a taxpayer must delay taking a deduction for such a portion (the "Recoverable Loss"). A theft loss deduction for a Recoverable Loss may only be taken once the taxpayer can establish with substantial certainty that they will not recover such a loss.
Courts have found that a taxpayer has a reasonable prospect of recovering a theft loss when they have a bona-fide claim for recovery from third parties or otherwise, and there is a substantial possibility that such a claim will be decided in the taxpayer's favor. Claims for recovery whose prospect of success are remote or nebulous are to be disregarded. For example, a taxpayer will not have a reasonable prospect of recovery if the financial condition of the party against whom the recovery is sought is such that no recovery can be expected.
It is clear that the Madoff Investors first discovered the theft of their property in December 2008 when Madoff was arrested and the SIPC Liquidation proceeding began. Furthermore, given the purported staggering and unprecedented losses in BMIS, the seemingly insignificant funds that are remaining in BMIS, and the doubtful recovery by the SIPC Trustee of any meaningful amount funds from third parties, the Madoff Investors should not be considered to have any reasonable prospect of recovery of their losses, other than the SIPC Reimbursement. Therefore, Madoff Investors should have a reasonable position to take a theft loss deduction in 2008. In addition to taking such a deduction, Madoff Investors should also consider filing refund claims for the prior three years with respect to any tax paid on Phantom Income earned in their BMIS account. Such refund claims would result in a corresponding reduction in the amount of a theft loss deduction with respect to a BMIS account. Adequate disclosure of such a theft loss deduction on a tax return should protect a Madoff Investor from any penalties that could be imposed by the Service.
It is unclear at this time whether the Service will allow Madoff Investors to take a theft loss deduction in 2008 or to grant refunds of Phantom Income for the prior three years. The Service may take the position that such a loss is a Recoverable Loss in denying a theft loss deduction in 2008. Such a position would be consistent with how the Service has historically treated other victims of Ponzi schemes. If the Service were to take such a position, a theft loss deduction would likely not be allowed until the SIPC Trustee is able to reasonably estimate what funds can be recovered from Madoff, BMIS and other third parties which can be distributed to the Madoff Investors.
Many of the victims of Madoff's Ponzi scheme invested in funds ("Feeder Funds") that invested with BMIS. Generally, the Feeder Fund must determine whether it suffered a theft loss, and any such theft loss will pass through to the investors in such a fund. However, the Service may determine that Feeder Fund investors are able to recover their investment through lawsuits against Feeder Fund managers, and disallow any theft loss deduction from the Feeder Fund until such lawsuits are resolved.
The tax laws with respect to losses suffered by Madoff Investors are complex.