An influential voice in politics, former New York State Governor George Pataki, has asked IRS to issue pre-Apr. 15 guidance for victims of the Ponzi scheme alleged to have been perpetrated by dealer and advisor Bernard Madoff and his firm. Separately, members of the Senate Banking Committee will ask IRS to set up a special unit for Madoff victims.
Guidance sought in three areas. In a Jan. 12, 2009, letter to Eric Solomon, Assistant Secretary for Tax Policy, George E. Pataki, now a partner with Chadbourne & Parke, LLP, asked that IRS issue guidance before Apr. 15, 2009, on the following issues pertaining to Madoff victims:
- Nature of loss. Under Code Sec. 165(c)(2), an individual may deduct a loss incurred in a transaction entered into for profit, though not connected with a trade or business, and under Code Sec. 165(c)(3), a deduction may be claimed for losses of property not connected with a trade or business, or a transaction entered into for profit, if the losses arise from events such as storms, etc., casualties, or theft. Under Code Sec. 165(h)(1) and Code Sec. 165(h)(2), losses claimed under Code Sec. 165(c)(3) may be claimed only as itemized deductions, subject to reduction by 10% of AGI, and the $100 per occurrence floor (for 2008; $500 for 2009 only, returning to $100 after 2009). The letter takes the position that since all Madoff investments were transactions entered into for profit, Code Sec. 165(h)(2) (and not the less advantageous Code Sec. 165(c)(3)) should apply to Madoff-related theft losses. Nevertheless, the letter says that “internal guidance issued by the IRS Chief Counsel has stated that the “official position” of the IRS is that Code Section 165(c)(3) applies to theft losses.”
Observation: The letter may be referring to Chief Counsel Advice 200811016, dealing with investors’ losses on loans to a company engaged in writing sub-prime loans.
- Safe harbor for reasonable expectation of recovery. It’s well established that a theft loss may be claimed in the year it is discovered, but only to the extent that, at the end of such year, there’s no reasonable expectation of recovery. The letter points out that investors with direct accounts in the Madoff broker/dealer with no claims against third parties can reasonably expect to receive only a SIPC (Securities Investor Protection Corporation) payment, capped at $500,000, or if more, their pro rata shares of the assets in the Madoff estate ultimately available for distribution to investors. The letter asks IRS to issue guidance stating that Madoff investors with no claims at the end of 2008 other than a possible SIPC claim, and a claim against the Madoff estate, won’t be considered to have a reasonable expectation of recovery as of Dec. 31, 2008 in respect of Madoff-related losses in an amount greater than the higher of (a) $500,000 or (b) 10% of the investor’s “net investment” in the account (sum of all amounts of cash and FMV of all property transferred into the account, less total of cash and FMV of all property received as distributions from the account).
- Amount of theft loss. The letter asks IRS to rule that the amount of an investor’s Madoff-related theft loss for 2008 is equal to (a) his entire unrecovered tax cost basis in the account at December 31, 2008, including all amounts reported as income in years prior to 2008, less (b) his reasonable expectation of recovery as of December 31, 2008 (determined under the approach posited above.
Observation: Another issue to consider relates to whether investors can amend returns and claim refunds for tax paid on phantom earnings that were left to be “reinvested” in the account. Similarly, can an investor who received statements reporting, say, 10% income or gains, and withdrew and paid tax on the earnings, file amended returns treating the withdrawals as a nontaxable return of capital?
Senate Banking Committee will ask for special IRS unit. At a Jan. 27, 2009, hearing into the Madoff scandal, Sen. Menendez (D-NJ), a member of the Senate Committee on Banking, Housing and Urban Affairs, raised the issue of how Madoff victims should handle tax payments that they’ve made in previous years on phantom income. At the urging of Chairman Dodd (D-CT), he said he would draft a letter to IRS asking that it set up a special unit to handle tax matters relating to Madoff victims.