Edward Mendlowitz, a partner at accounting firm WithumSmith+Brown, outlined a series of tax strategies that could help offset the staggering losses incurred from investments with Bernard Madoff’s scandal-scarred securities firm.
Madoff, who admitted to running a giant Ponzi scheme that cost his clients $50 billion, is currently under house arrest. A number of tax experts have suggested that some of his clients could claim theft losses as a result of the scheme.
Mendlowitz noted that theft and embezzlement losses fall into the category of casualty losses that are deductible to the extent that they exceed 10 percent of adjusted gross income plus $100. There is an exception for transactions entered into for profit, such as investing transactions with an investment manager or with a hedge fund. In those situations, they are deductible in full without the 10 percent plus $100 limitations.
Casualty losses are deducted on Schedule A of the individual tax return, but are not limited by the 2 percent of AGI threshold or the itemized deduction phaseout, or affected by the alternative minimum tax. Losses not deducted can be carried back as a net operating loss deduction, but they can be carried back three years (not the two years for NOLs), and can be carried forward for up to 20 years.
Theft losses are deductible in the year that the loss is discovered, or the year that it is finally determined that it won’t be recovered. Notification that a loss might have occurred constitutes a discovery, but the tabulation of the actual amounts of the loss could take quite a long time, and then the recovery process takes more time.
If there is a chance of recovery, the IRS will not permit a deduction. If a loss is known but a final calculation is not made for many years and the client is in danger of exceeding the normal three-year statute of limitations (for tax year 2005, the statute expires on April 15, 2009, for timely filed returns and a maximum of Oct. 15, 2009, for extended returns), then the client may want to consider filing a protective claim for refund to keep the statute open.
An issue to consider is whether part of the loss was from fraudulently recorded income in a prior year that has been taxed and added to the investment balance, Mendlowitz added. In those situations, it might be appropriate to file amended returns for the prior years, reducing those amounts from income since those amounts weren’t actually income. Generally tax years 2005, 2006 and 2007 are still open for amended returns.
Grantor trusts that have interests in Madoff investments can distribute the investments to the beneficiaries who will assume the basis of the trust. This will enable the beneficiary to be able to claim the loss, rather than the grantor.
