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Section Review

The Madoff Mess and the deductibility of investment theft losses

Introduction

The “Madoff Mess” will challenge you to help your clients determine the best way to recover their losses. Where there are few or no viable sources of recovery, one method may be to have the government help your client with a tax refund and/or a reduction of their future tax obligations. This can be accomplished by maximizing tax benefits under Internal Revenue Code (IRC) Section 165(c)(2), the theft loss provision.

Background

All financial frauds start with a story that is too good to be true. Madoff and his alleged consistent rates of return are simply the latest example of that. The problem is that many frauds may leave your client with no money and no viable alternative sources of recovery.

We know that there will be no shortage of legal actions. There will be bankruptcy proceedings, class actions and plenty of third party litigation. Lawsuits will be abundant. What may not be abundant is any money left for the investor. Accordingly, the investor’s best chance for recovery may be from the theft loss provisions of the Internal Revenue Code.

Technical requirements

The “theft loss” provision, IRC Section 165(c)(2)may allow for a reduction of ordinary income. It will do this by allowing the client to recoup previously paid taxes and minimize future tax obligations.

That section has numerous technical requirements and certain “legal” determinations that may make the tax preparer reluctant to take, or defend the IRS response to, this type of claim. Further, most tax software does not properly handle this situation and is usually geared toward preparing the more common IRC Section 1211 deduction with its $3,000 limitation.

The best course of action is for the tax preparer to take this to a tax attorney. An experienced attorney can help determine if the legal requirement of a “theft” has occurred. Whether a loss constitutes a “theft loss” is determined by examining the law of the state where the alleged theft occurred. Edwards v. Bromberg, 232 F.2d 107, 111 (5th Cir. 1956).

Further, the attorney can help determine whether there was actual fraud with the necessary element of “scienter” which is a criminal intent. Thus, to claim a theft loss, the taxpayer must prove that the “loss resulted from a taking of property that is illegal under the law of the state where it occurred and that the taking was done with criminal intent.” Rev. Rul. 72-112, 1972-1 C.B. 60.

The investor must have bought the investment directly from a seller that committed fraud under a local law. This leads to a requirement of “reliance” that the investor relied on the fraudulent information when parting with his property. This means that the investor dealt directly with the person committing the fraud, as opposed to purchasing the stock through his broker on the open market. The courts have consistently disallowed theft loss deductions relating to a decline in the value of the stock that was attributable to corporate officers misrepresenting the financial condition of the corporation, even when the officers were indicted for securities fraud or other criminal violations. Paine V. Commissioner, 63 T.C. 736, 523 F.2d 1053 (5th Cir. 1975).

The IRS in Notice 2004-27, 2004-1 C.B. 782 advised taxpayers that the IRS will disallow (and may impose penalties) for theft losses claimed by taxpayers for the decline in market value of their stock caused by disclosure of accounting fraud or other illegal misconduct of the officers or directors of the corporation that committed the fraud.

These legal elements often deter the tax preparer from advising the client to use the “theft loss” and its added benefits to the safer and less imposing IRC 1211, which is limited to $3,000 a year. Help your clients by dealing with a tax professional that will fight for your client’s best interests and the benefit that Congress intended they have.

The tax attorney can help the tax preparer and the client by using the IRC to possibly eliminate this year’s tax, but also by going back three years for refunds and forward for 20 years. This type of deduction can be used without triggering the Alternative Minimum Tax and is not subject to the 2 percent floor by IRC Section 67.

If there is no viable option for recovery, as there often aren’t in financial fraud matters, then IRC Section 165 may be the best alternative for the client.

Technical requirement and Madoff

It is clear that Madoff has been charged with “theft” and is likely to be convicted on those and/or related charges. Further. it is clear that he acted with the necessary element of “scienter” or evil intent, as is required by the IRS. The problem for many of Madoff victims is that there was no “reliance” as required. Remember that the reliance means that they dealt directly with Madoff or his company, Bernard L. Madoff Securities LLC.

One potential problem will be that many of the victims came to Madoff through one of the several dozen “feeder funds,” which were intermediary companies that stay in between the victim and Madoff and could end their ability to use the theft tax loss because the victim relied on their fund manager rather than Madoff personally. Further review by competent counsel should be arranged to determine the viability of all such claims.

When do you write off the loss?

The timing of the Section 165 loss can at first appear black and white. The IRC at 26 CFR 1.165-1 (d) (1) says “[a] loss shall be allowed as a deduction under section 165 (a) only for the taxable year in which the loss is sustained.”

However, the Code Section itself states at Section 165 (a) “there shall be allowed as a deduction any loss sustained during the taxable year and not compensated for by insurance or otherwise.

So what does “compensated by insurance or otherwise” mean?

The issue of insurance is a question of fact for the bankruptcy trustee in the Madoff Mess.

And what is meant by “otherwise”? One could interpret that to mean litigation against the principal and other possible defendants who could be liable. Any litigation has a life of its own and could go on for a substantial period of time. So the question arises, does this preclude the taxpayer from writing off his losses while participating in the ongoing litigation?

This issue is further compounded by IRC Section 6511, which acts as a statute of limitations on these claims whereby the taxpayer must file within three years from the date that the return was required to be filed or two years from the time the tax was paid, whichever was later.

An extraodinary case

How do you reconcile these two positions? What is the rule for taking “theft losses”?

A recent U.S. Tax Court case was fueled by an extraordinary set of facts that will help shed light on how the U.S. Tax Court interpreted the timing of the claim.

The case of Johnson and Johnson v. The United States, US-CL-CT, 2008 -1 USTC 50, 142 (January 24, 2008), demonstrates how this court analyzed and ruled on the timing issue.

The Johnsons sold their Detroit-based television station for more than $175 million in 1997. They then purchased $83.5 million of jewelry from a well known Palm Beach jeweler named Jack Hasson. Late in 1997, the Johnsons discovered that the gems were worth only $5.4 million. The result was that the Johnsons lost $78,160,409 in this fraudulent scheme.

In 1998, the Johnsons took a deduction of $58 million on their federal income tax return. The Johnson’s had the assistance of their accountants and lawyers in estimating that there would be an approximate $20 million recovery. Subsequently, Hasson was convicted of fraud in 2001.

To begin the analysis, the Johnsons met the three requirements of the IRS for Section 165 — theft loss to apply as they had already established: (1) Theft, as Hasson was indicted and later convicted under Florida state law; (2) Privity or Reliance — the Johnsons had bought the jewels directly from Hasson so that there was privity of contract; and (3) Scienter — Hasson had the necessary “intent to deceive” as he knew at the time of the sale that he was deceiving and defrauding the Johnsons, who had relied on him about the value of the stones he sold them.

Armed with the three needed requirements, the Johnsons filed for their theft loss in 1998. The IRS objected to the deduction and off to court they went. It was not until January of 2008 that the matter was fully resolved as noted above in the case of Johnson and Johnson v. The United States, US-CL-CT, 2008 -1 USTC 50, 142 (January 24, 2008).

How do you write off Johnson’s $78 million?
The Johnsons’ position

As previously mentioned, the plaintiffs initially sought the theft loss in 1998 with the loss carry back to 1997. The plaintiffs tried to rely on IRC at 26 CFR 1.165-1 (d) (1) which provides that “[a] loss shall be allowed as a deduction under section 165 (a) only for the taxable year in which the loss is sustained.”

In a revised complaint, the plaintiffs filed for the loss in 1998 and in the alternative, for the loss deduction in 1999, 2000 and/or 2001. The plaintiffs relied on the “year of discovery” rule for the timing of their deduction. The plaintiffs had established their damages based upon an estimate made by their lawyer’s and accountant’s experience using the “reasonable prospect of recovery standard.

The IRS position

The IRS argued that the plaintiffs were not entitled to a theft loss deduction in any amount neither in 1998, nor 2001 but instead only in the year in which all of the claims for reimbursement were resolved. The government asserted that the plaintiffs were not entitled to a theft loss deduction until, at the earliest 2005, when the plaintiffs’ last recovery efforts were concluded. The IRS used Treas. Reg. Section 1.165-1(d)(2)(i) to support its “reasonable certainty standard whereby it states that “whether or not such reimbursement will be received may be ascertained with reasonable certainty, for example, by a settlement of the claim, or by an adjudication of the claim, or by an abandonment of the claim”

The verdict

The court held for both the plaintiffs and the IRS in a split decision as follows.

The judge ruled against the plaintiffs for a theft loss in 1998 as he stated that the plaintiffs did nothing more than anticipate the recovery in the pending litigation against Hasson and his associates. He further stated that the plaintiffs’ reliance on the “reasonable prospect of recovery standard was misplaced, as it only applies in the year a taxpayer discovers a theft loss. The court agreed with the IRS on the use and application of the “reasonable certainty standard. The judge wrote “the requirement that a taxpayer ‘ascertain with reasonable certainty’ means that a taxpayer must obtain a verifiable determination of the amount she will receive based on a resolution of the reimbursement claim before taking a theft loss deduction.” Accordingly, the plaintiffs were not entitled to a theft loss deduction in 1998 for any portion of their loss.

However, the court ruled against the IRS’ position that no deduction could be taken until 2005. The government had argued that Treas. Reg. Section 1.165-(d)(2) states that “no portion of the loss with respect to which reimbursement may be received is sustained … until it can be ascertained with reasonable certainty whether or not such reimbursement will be received … [t]he government interprets the phrase ‘no portion of the loss’ to mean the regulation requires that a taxpayer refrain from taking any portion of a theft loss deduction until the taxpayer determines exactly how much of the entire loss the taxpayer will recover … [h]owever contrary to the government’s position the Court held that ‘the regulation and the examples given therefore confirm the plaintiff’s contention that once a portion of the recovery was established, they were entitled to take a theft loss deduction for that “portion” that they were reasonably certain they would never recover.” Accordingly, the court held that as of 2001, the plaintiffs had established with reasonable certainty that they had no prospect of recovering $37,216,383 of the estimated $78,160,409 loss.

Therefore, the court found that theft losses can be calculated as the loss becomes reasonably certain; and second, that those losses can be incurred over several years and not held back until the total of the loss is determined.

When do you write off the Madoff Mess?

This will be the hardest decision for you and your client/investor. The year of discovery is clear, however, is there insurance? Are there viable sources of recovery? Will SIPC pay for your client’s losses? We do not know the answers to these questions.

What we do know is that there will be: (1) litigation, lots of it; (2) class actions; and (3) bankruptcy proceedings. And, even with all of the above actions, there could be nothing.

If it appears that there will be nothing left, should your client just go for the theft tax loss now?

This is just one of the many issues that the victims of the Madoff Mess will have to consider. There should be an analysis of the viable options but one viable option might be to forego the years of participation in litigation that could lead to less than what might be available now under the theft loss provisions of the IRC.

Conclusion

Section 165(c)(2)Theft Loss of the Internal Revenue Code – is one of the best kept secrets of the IRS. The tax preparer has a duty to apply it to any client situation that meets the requirements, especially the victims of the Madoff Mess. Further, the use of the section of the code with the application of the above recent Tax Court case provides a new found flexibility for the tax practitioner to help his client recover theft losses from the only source remaining, Uncle Sam.

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Kevin Diamond is an attorney licensed in Massachusetts and a fellow of the Massachusetts Society of CPAs. He has previously been a federal investigator for the FDIC and fraud investigator for the Massachusetts Securities Division. His practice is in Holliston and can be found at [e-mail Kevin] for comments.

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