Victims of the alleged Ponzi scheme operated by Bernard Madoff may recoup some of their investment by claiming the fraud loss as an offset to ordinary income in the year of discovery and through amended returns in previous years. But with the Internal Revenue Service (IRS) not expected to issue guidance before April 15th of this year, and court rulings that are based often on individual circumstances, Madoff victims should not expect relief any time soon. And while Madoff investors could regain as much as 35 percent of their original investment by taking advantage of various deductions, depending on federal, state, and local taxes already paid, claiming a theft loss deduction is an incredibly technical and complicated process, says Michael Rozbruch, founder and CEO of Tax Resolution Services, Co. and filing amended returns will likely trigger an audit.
Investors don't have to wait for the possibility that Madoff is convicted of a crime to show the IRS that a theft loss exists, law.com says. "The IRS acknowledges Ponzi schemes as 'theft losses,' and there are several methods of tax recovery available," Richard Lehman, a tax attorney in Boca Raton, FL and former senior attorney for the IRS says. Lehman also emphasizes the complexity of claiming theft losses. "Each of these potential options of recovery has its limitations, restrictions, and strict requirements that must be met in order to take advantage of the maximum tax benefits from the alleged Bernard Madoff theft."
Most experts recommend taking at least the theft or fraud loss deduction for 2008 and earlier years and eliminating "phantom gains" reported on previous returns. The theft or fraud loss deduction for 2008 generally would be limited to the extent those losses exceeded 10 percent of adjusted gross income - after reducing each loss by $100. To the extent that any eligible losses exceed gross income, those losses can be carried back three years or forward 20 years. The taxpayer should keep in mind that any refund will be delayed because the IRS will not allow a deduction as long as there is any chance the money may be recovered through insurance claims or other means. The refund would be reduced by SIPC payments.
Income taxes paid by Ponzi investors on what turns out to be fake profits, or "phantom" income are recognized by the IRS as theft losses and taxes on this income may be recovered.
Since the IRS is not expected to comment on the Madoff scheme before April 15, investors should file for an extension for 2008 and file protective claims for all for all open tax years - 2005, 2006, and 2007 - in order to keep those years open before the three-year statute of limitations closes, says Timothy Mulcahy, chairman of the tax department at accounting firm Holtz Rubenstein Reminick LLP in Melville, NY, The Wall Street Journal reports.
What investors can expect from the IRS depends on individual circumstances and how the IRS views the Madoff scheme, says Neil H. Tipograph, tax partner at New York's Imowitz Koenig & Co., LLP, in an article submitted for inclusion in The CPA Journal and reviewed on the New York State Society of CPAs Web site. For the 2008 filing year, "There appears to be substantial authority to omit Madoff phantom income, he says … [and] a reasonable position to claim a theft loss deduction in 2008 for the Madoff phantom investment income on tax returns closed by statute."
In his interpretation of a number of IRS memos, rulings, and court cases concerning the treatment of losses in Ponzi schemes, however, Tipograph found inconsistencies in IRS positions, citing certain cases where "egregious" Ponzi schemes promised "outrageous" investment returns, where the IRS sided against the investor. In other cases with more sympathetic victims, the courts have sided with the taxpayer.
Tax professionals need to monitor announcements by the IRS concerning the tax treatment of the Madoff theft loss, Tipograph writes. They should also be aware that announcements by the Madoff trustee concerning the recovery of certain distributions may have significant impact on the income tax filings.