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.
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.
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
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
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
However, the Code Section itself states at Section 165
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”
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
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
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
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
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 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.
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.
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.