(Bloomberg) Bernard Madoff’s fraud might have been detected with enough due diligence in mid-2006, more than two years before the Ponzi scheme collapsed, a U.S. Tax Court judge ruled.

That means it’s possible, Judge Diane Kroupa said, that the estate of a New York man who died that year is entitled to a $1.9 million refund for death taxes paid on his $4.8 million Madoff account—an account revealed to be worthless after the fraud was uncovered.

Kroupa, in a decision May 21, didn’t assess the likelihood that Bernard Kessel’s estate can prove its case. She did say, though, that it can try to do so at a Tax Court trial where lawyers may iron out a new wrinkle in the financial mess created by Madoff’s crimes. Other challenges to estate taxes on Madoff accounts are under administrative appeal at the IRS, Stephen Krass, a New York attorney representing the estate.

“I know there are others. How many, I don’t know,” he said, adding that the Kessel case has advanced the furthest.

The Internal Revenue Service, which rejected the estate’s bid for a refund, contended that when Kessel died in July 2006 his Madoff account was worth the $4.8 million that was reported at the time and subject to federal estate tax. A Ponzi scheme by nature remains hidden until it’s discovered or collapses, the agency argued.

The estate of Kessel, who became a customer of Bernard L. Madoff Investment Securities LLC in 1992 through a pension plan set up by a company he owned, took a different view. The value of the account was established through an appraisal. Had the estate used the more rigorous standard of fair-market value, a hypothetical buyer might have conducted due diligence that uncovered the fraud, Krass said.

Stock Certificates
Such steps might include trying to examine stock certificates for securities only to find they didn’t exist, Krass said.

Kroupa said Krass’s argument raised “disputed material facts” that merited a trial.

While the IRS said prospective buyers of Kessel’s account wouldn’t “reasonably know or foresee” that Madoff was operating a Ponzi scheme, making the account worthless, Kroupa said that wasn’t necessarily so.

“Some people had suspected years before Mr. Madoff’s arrest that Madoff Investments’ record of consistently high returns was simply too good to be true,” she wrote.

Dean Patterson, a spokesman for the IRS, didn’t respond to an e-mail seeking comment on the decision.

Even if the estate wins a Tax Court trial on the refund, it faces continuing efforts by Madoff bankruptcy trustee Irving Picard to recover payments of fictitious profits to compensate people who invested more than they took out.

Deposits and Withdrawals
Deposits into the Kessel Madoff account totaled $2.8 million while withdrawals totaled $5.52 million, a $2.72 million difference, making the estate a “net winner” among Madoff investors.

As a result, the estate is targeted in one of about 800 clawback suits by Picard.

The Picard suit, filed in federal bankruptcy court in New York, seeks recovery of $2.9 million from the estate.

“This is a sad situation,” Krass said. “You’re getting hit from the left and the right.”

Madoff, 76, who hatched his $20 billion fraud scheme in the 1970s, targeted thousands of wealthy investors, Jewish charities, celebrities and retirees. The scam unraveled in 2008 when the economic crisis led to more withdrawals than he could afford to pay. Madoff pleaded guilty to fraud in 2009 and is serving a 150-year sentence at a federal prison in North Carolina.

At least seven other people have pleaded guilty to roles in the scheme, including his brother Peter Madoff, who is serving a 10-year term. A federal jury in Manhattan in March found five former employees of Madoff’s firm guilty of aiding the fraud.

The case is Estate of Bernard Kessel v. IRS, 028602-10, U.S. Tax Court, District of Columbia (Washington).

—With assistance from Linda Sandler in New York.

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