Bernie Madoff made news when he confessed to ripping off investors. When we first heard about it, the word was that at some point his investment vehicles became "ponzi schemes"--money coming in was being used to pay returns to other investors. As more information has become available, it appears that the fraudulent nature of the investment vehicles extended back quite a few years--it wasn't just that a few of the most recent investors were being robbed and those funds used to pay extra amounts to the real investors, but that there may not have been any real investments and real returns for quite a while.
The list of victims is long--people who thought they had invested wisely, one assumes, but who now are learning that their funds may never have been invested in solid assets. Some of the largest losses are highlighed in this list, including (i) investment entities like hedge funds, funds of funds, and other investment advisers, (ii) charities and foundations and universities (either directly, or through other investment vehicles), (iii) banks and insurance companies, and (iv) individual investors--John Malkovich, Zsa Zsa Gabor, Keven Bacon and Kyra Sedgwick (actors), Larry King (talk show host) Henry Kaufman (Salomon economist), Leonard Feinstein ( Bed Bath & Beyond cofounder), Jeffrey Katzenberg (film producer), Loeb family.
Many of these victims may have paid income tax on reported returns from those investments. Are those returns now to be treated as basis recovery so that the taxes paid on that "phantom" income would be refundable (if within the statute of limitations)? Various court decisions and IRS authority suggests that they should generally not be treated as basis recovery, though one court, at least, found otherwise in circumstances that might be more limited. Compare CCM 200305028, Dec. 27, 2002 (considering ponzi scheme investors' ability to claim return of capital for payments designated as a return on the investment, as well as theft loss issues, and citing Premji, T.C. Memo 1996-304, and other cases as treating purported payments of a return on capital as income, unless the taxpayer could establish that return of capital was uncertain when the payment was made) to Greenberg, T.C. Memo 1996-281 (in a penalty case, where new investor money was used to fund purported interest payments, court held that no penalty was due because the reported interest was actually return of capital). And even if the "returns" were treated instead as basis recovery, they may have amounted to much more than the original basis so that the excess should clearly be taxable income.
In addition to any refund that might be due for past taxes paid on purported "returns on investment" from the Madoff scheme, victims may be entitled to a loss for all or part of their original "investment" amount.
The CCA cited above suggests that ponzi scheme losses are theft losses. The issue is whether a loss in a Madoff-type Ponzi scheme would be a theft loss under section 165(c)(3)--essentially, this claims that there was no investment in the first place and that the loss is a theft of the funds that the victim thought were being invested, and is subject to various limitations on theft losses under section 165(h), including the disallowance of any net loss except to the extent it exceeds 10% of AGI--or a loss on a "transaction entered into for profit" , which is treated under section 165(c)(2) (and is not subject to the same limitations like the 10% of AGI provision).
Assuming there is an ordinary loss, it probably can't be claimed until any potential recovery claims are resolved. The year it is claimed, it might generate a net operating loss. Under the regular rules, net operating losses can be carried back three years and carried forward 20 years.
As Les Samuels at Cleary Gottlieb has noted, it's all a huge "mess", since circumstances will vary from investor to investor and it isn't clear how some of this should be treated. See Madoff Victims Go to IRS for Relief, Wall St. J., Feb. 18, 2009.
Should Congress provide any kind of bail out for Madoff investors? Two representatives in Congress have suggested that Congress should act to permit investors who now have learned that their "investment" was used by Madoff in the Ponzi scheme to get an extended carryback period for that loss. Kendrick Meek, Democrat from Florida, introduced H.R. 1159 on Feb. 24 (no co-sponsors) to provide a new subsection of section 165 providing for "treatment of investment losses in fraudulent Ponzi-type schemes". That legislation would benefit investors with losses in two ways. (Aside: It would also restore the unified credit and waive the limitation on contributions to charities that have losses, thus permitting taxpayers to make additional contributions, and get additional deductions for such contributions that zero out their tax liability for the year, to a private foundation that they administer.)
- First, it lets taxpayers take a loss for the full estimated amount--without regard to estimated recoveries--up front. If aggregate losses permitted exceed the aggregate actual losses because of a later recovery, then the excess is treated as income in that later year. That's a reversal of normal rules that do not permit taxpayers to take a deduction for losses that are uncertain. There seems to be no justification for that rule.
- Second, it would permit taxpayers to elect to carryback their losses from a ponzi scheme up to 10 years (limited, however, by the number of years taht the taxpayer had amounts invested in the scheme), rather than the ordinary 2-year carryback period. In his release, Meek states a particular concern for senior citizens who have lost money in ponzi-scheme investments and now face a more uncertain future in the midst of economic recession. (As seniors, they may not even live to fully recoup the loss under a 20 year carryforward, and they may be more vulnerable if the loss amounted to most of their assets on which they expected to live in retirement.)
Gary Ackerman, Democrat from New York, wrote the IRS Commissioner urging that a theft loss be permitted for 2008 (there may not be sufficient proof to claim such a loss for that year under theft loss rules) and that investors be permitted to amend returns from at least 1995, giving a 13 year period for recouplment. See this press release. Note that the IRS doesn't have power, as the tax administrator, to extend the statutory NOL provision or revise the statutory statute of limitations on ability to claim refunds, which you would think that Ackerman would realize. The Bush tax administration tried something similar with the statutory section 382 provision, claiming that it had power under TARP, and got its overreaching hand slapped in the economic stimulus legislation.
Would legislation to permit this special extension of the loss carryback period as a bailout for ponzi-scheme sufferers be wise? I feel great sympathy for anyone who lost money in the Madoff and similar schemes. It is horrible to think you have invested wisely only to learn that someone ripped you off. And I recognize the special concern for senior citizens who have nothing other than the Madoff investment. Yet I am not convinced that such broad legislation as that proposed is wise. There are several reasons.
Under the rules, an investor who lost $20 million with Madoff and whose adjusted gross income was $10 million can claim a theft loss of about $19 million. To calculate the theft loss, investors must reduce the amount of the loss by 10 percent of their adjusted gross income plus $100, according to Robert Willens, an expert on tax and accounting issues for Wall Street clients. That theft loss would wipe out the $3.5 million in taxes that would otherwise be payable on the $10 million in income. The losses can be carried back for three years or carried forward for 20 years.If the losses wipe out current, past or future taxes, the end result is the same: The government loses money. "I think the $50 billion of Madoff's losses, if they really are that big and we're not sure, could cost the government $15 to $17 billion in lost tax revenues," Willens said. Madoff's Ponzi Scheme Could Cost IRS $17 Billion in Lost Tax Revenue, Huffington Post, Dec. 18, 2008 (scroll down).
3. Many victims apparently had investments with Madoff over decades, and consistently received stellar 10-12% "returns" even while other investments did not pay off at that kind of stead rate. Shouldn't they have been more responsible in considering whether this was some sort of Ponzi scheme? What about victims that put all of their investment with Madoff, rather than diversifying, which is recommended as essential to good investment? There thus appears to be a strong moral hazard issue in having the government (i.e., taxpayers generally) provide additional relief pinpointed to these losers rather than to other losers.
4. While there undoubtedly are victims that are particularly vulnerable and for whom some further government assistance may be advisable, see, e.g., Madoff Victim, 90, is Back in "The Market", CBS Evening News, Feb. 19, 2009, there are a number of cases that don't generate such concerns:
(i) many Madoff victims are better off than regular market investors, see, e.g., Was Madoff a Better Investment Than Your Mutual Fund?, Blog Maverick, Feb. 21, 2009;
(ii) most long-term investors who withdrew their "investment" before the scheme became public may have received considerable profits, depending on whether they have to "clawback" those profits because of the discovery of the scheme, see, e.g., Some Madoff 'Victims' Made Profits, Crossing Wall Street, Jan. 10, 2009 (discussing a "victim" who invested $1.8 million ten years ago and withdrew $3 million); Caruso, Madoff 'Victims' Who Profited left with Ethical Questions, AP, Jan. 8, 2009 (suggesting that "there are a lot of net winners");
(iii) investors may be counting money that Madoff reported they'd made, and that they treated as an additional investment, as though it were an actual "lost" investment; and/or
(iv) many of the investors, like the fund- of-funds professionals, should have known better--and they got lots of hefty fees while investing their clients' money, see, e.g., Forsyth, Funds of funds: Madoff's Victims or Enablers? Barron's, Dec. 15, 2008. At least one investment bank is offering shares to its private-banking clients (not institutional investors) for losses from its fund's investments on their behalf, see Santander's Offer to madoff Victims Puts pressure on Other Banks, Jan. 28, 2009. And of course, at least one of those investors was engaging in its own fraud, see, e.g., Stanford Group, a Madoff investor, accused in $8B fraud, Newsday, Feb. 18, 2009
(v) many Madoff victims are likely wealthy individuals who will still have significant other assets, even with the reduction in their assets caused by Madoff, see, e.g., Alleged Madoff Vitims Include 2,000 Long Island Accounts, Newsday, Feb. 5, 2009 (noting that some lost almost all, while for others the losses are relatively immaterial, such as real estate developor Scott Rechler's or retired comptroller Nat Finkelstein, who lost about half a million that he would have used "to treat his family to such things as trips overseas")
One might therefore consider that if such legislation is considered, it should at the least have some income and asset thresholds beyond which it would not apply, rather than applying generally to all victims of Ponzi schemes, to be sure that the benefit is going to vulnerable victims who lost a large portion of their assets and income. The federal government does not have limitless funds, especially given the deep deficits that this country will be running because of its economic stimulus actions and the bank "bailout" provisions (which I continue to think are being wrongheadedly handled to preserve shareholder value with taxpayer money, rather than to preserve bank value for the economy through nationalization). Accordingly, any such legislation should likely be targeted to taxpayers who are now within the bottom half of the income distribution for the taxable year of their first return that takes a Madoff-like Ponzi loss into account.
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