Many are surprised to learn that while it sometimes appears that the Internal Revenue Code reaches into every aspect of our lives, it lacks focus in addressing the complex tax consequences that face the unfortunate victims of Ponzi schemes.Of course, if the reports are true, there may have never before been a Ponzi scheme like Bernard Madoff's, so it is time to take a fresh look at things.

Most investors, directly or indirectly through investment partnerships/hedge funds, appear to have had brokerage accounts at Bernard L. Madoff Investment Securities LLC. Having received their Nov. 30, 2008, statements, most thought that the securities and cash balances reported in those accounts had been stolen when the alleged $50 billion fraud was first uncovered on Dec. 11, 2008. Based on this assumption, tax experts rushed to the loss rules in Code Section 165 to deal with this matter.

Covering everything from abandoned securities to shipwrecks and lost wallets, the loss provisions apply to both business losses (including transactions entered into for profit) and personal losses. Past Internal Revenue Service advice found some Ponzi schemes to be personal, not business, losses. Respected private tax authorities have convincingly declared those findings to be flawed. The business loss rules should apply to most of Madoff's investors, which is helpful since the deduction for personal losses must be reduced by 10 percent of adjusted gross income plus $100 for tax year 2008.

The specific deduction for thefts is a subset of the loss rules. While most losses are only deductible in the year of the loss, thefts have a special rule that allows a deduction in the year of discovery. All loss deductions must be reduced by insurance and other recoveries, such as SIPC claims, which can be estimated and trued-up later.

For individuals, business losses are fully deductible as itemized deductions for regular and Alternative Minimum Tax purposes. If the theft loss is greater than income in the year discovered, there is a special three-year (rather than two) net operating loss carryback and the normal 20-year carryforward. Although intended to be taxpayer-friendly, NOL carrybacks and carryforwards normally reduce the tax recovery potential for a deduction because they often are absorbed by income taxed in a lower bracket, while the original income was often taxed at the highest bracket.

Tax practitioners are well aware that a subsequent itemized deduction generally yields less federal (and state) income tax savings than the prior-year tax on the same amount of gross income. Taxes were paid by Madoff account holders on investment income reported to them and to the IRS for decades. In many cases, the income disappeared on December 11. They want to recover the tax paid. Somehow.

Here is an example of the problem. Imagine that a victim deposited $1 million with BLMI Securities in early 1998. No funds were withdrawn and taxes were paid from other sources. By the start of 2008, the account showed a portfolio of securities valued at $4.9 million, a 16 percent monthly compounded return. The trustee has indicated that no securities were ever traded or owned. Madoff simply issued false reports to everyone to cover his tracks. If the trades never existed, how can the account owner claim the securities purchased with $3.9 million of phantom income were stolen? How can he recover the $1.3 million or more of taxes paid?

Is the answer somewhere with Alice in Wonderland?

On the surface, taking a deduction for something you do not own sounds like tax fraud, but the statute provides relief. The loss rules allow a deduction equal to the tax basis of the stolen asset, so the $1 million used to open the account should have $4.9 million tax basis. This approach was designed to keep taxpayers from deducting untaxed appreciation or tax-deducted depreciation on losses; however, the rule provides a clear path to a full deduction in these circumstances.

While the theft loss deduction provides a recovery opportunity as an itemized deduction and likely net operating loss, there will always be some shrinkage. The tax recovered will be less than the tax paid. What else can be done?

* Can you file amended tax returns to exclude the Madoff income? Yes, but there are only three years open for most taxpayers. Amendments would reduce the tax basis and the theft loss by an equal amount. This extra work could increase the total overall tax recovery. If the initial investment was in 2005 or later, amending, rather than claiming, the theft loss deduction will normally produce the largest possible tax recovery. Move fast: The statute of limitations for 2005 tax returns expires on April 15, 2009, or a bit later if filed after the original due date.

* Does the mitigation/correction-of-an-error rule of Section 1311 apply? Designed to deal with rare, out-of-statute inequities that arise when the IRS or taxpayer take inconsistent positions in an open year as compared to closed years, there is little authority to apply these rules to the Madoff facts.

* How about the bad-debt deduction? It has been used in Ponzi schemes before. The bad-debt deduction in Code Section 166 does not seem to apply to the Madoff facts because no loans were involved. This provision would produce a short-term capital loss in 2008, great news for a few fortunate short-sellers in today's economy, but of little use to most taxpayers.

Anything else? Yes.

Although seldom used, Code Section 1341 was designed to provide tax relief when tax is paid on income that a taxpayer had an apparent right to that is unexpectedly returned in a later tax year.

Under these rules, a taxpayer may claim a deduction from gross income (rather than an itemized deduction), or a refundable credit for all prior-year tax paid on all income that is not retained. The tax paid is calculated by making a "with and without" calculation of tax for each previous year. The taxpayer can choose between a deduction and a credit. This almost always yields a larger recoupment than a theft loss deduction.

The major challenges in obtaining this relief are to show that the taxpayer had a right to the funds and they were repaid.

The right to claim the funds should not be hard to prove. Most investors made some withdrawals and others closed their accounts and received their cash ... apparently cash received from new investors to pay departing ones. But did the investors who had accounts with Madoff on December 11 "return" the funds? Or were the funds stolen? Or are we back in Wonderland?

Before you decide, think about the investor with $4.9 million according to his November 30 account statement, who withdraws all of the funds in good faith on Dec. 2, 2008, to purchase a new home. Assume that in June 2009 the investor learns that the bankruptcy trustee has a clawback claim and $3.9 million is returned. When the cash is repaid, surely the investor has met all the tests under Code Section 1341: He thought he was entitled to the income, paid tax on it year after year, received the cash and then, unexpectedly, wrote a check to pay back the income. This investor should be fully entitled to the benefits under the relief provisions for taxpayers that restore income, albeit in 2009 and not in 2008.

Whether the false return was simply lost or found and lost again, the investor has no cash. In one case, $1 million was paid and he received nothing. In the other, the investor paid his million, got $4.9 million and returned his $3.9 million of profits a few months later. Neither investor retained the $3.9 million of investment income. Is the $3.9 million of reported and taxed income a theft loss for some and restored income for others?

The fair answer is to give both types of taxpayers the right to claim-of-right-restoration treatment. Investors were comforted by the perception of government supervision of the brokerage industry and they obediently reported and paid tax on income as reported on Form 1099. Substance over form is a tax weapon of great power to right wrongs, and could be used in these unique circumstances.

Unless the IRS publishes guidance in agreement before a tax return is filed, taking a claim-of-right-restoration benefit could be dangerous; there is no direct authority to support or convincingly deny the position. It will be a long time before we know what really happened, and the IRS could be reluctant to rule until more facts are known. New facts could change any conclusion. Any tax position dealing with the Madoff travesty should be fully and properly disclosed to avoid penalties.

One can only hope that compassionate guidance will arrive that will respect the miserable circumstances that taxpayers and their advisors are facing.

David A. Lifson, CPA, is chair of the New York State Society of CPAs Committee on Tax Reform and a member of AICPA Council. He also is a partner with the firm of Hayes & Co./Crowe Horwath LLP. In January 2008, he was appointed to a three-year term on the IRS Advisory Council.

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