Madoff’s Victims May Recover Some Losses Through U.S. Tax Code

By Ryan J. Donmoyer

Dec. 18 (Bloomberg) -- Individual investors who lost money in Bernard Madoff’s alleged $50 billion fraud may be able to recover some of their money by seeking tax refunds.

“The Madoff debacle will result in what amounts to another federal government bailout,” said Warren Kessler, an attorney at the Los Angeles law firm Kessler & Kessler. “It is likely that the Treasury will wind up refunding taxes,” at least on the loss of money individuals invested with Madoff, he said.

Capital-gains taxes paid by investors may be refundable for 2005 through 2007, lawyers said. In addition, they said investors probably can convince the Internal Revenue Service they are victims of theft, which would let them deduct losses from their income taxes dating back to 2006. Any unused theft losses could be used to reduce tax liabilities for the next 20 years.

Madoff, 70, is charged with bilking investors around the world even as he promised steady returns, including fictitious capital gains he may have falsely reported to the IRS. He was placed under house arrest yesterday as pressure mounted on the U.S. Securities and Exchange Commission to explain its failure to detect his actions for almost a decade.

Many of Madoff’s investors were charities and pension funds that were tax-exempt and wouldn’t be owed a refund. The extent of refunds to investors who paid taxes will depend on how much theft loss can be deducted by individuals and how much investment income was fraudulently reported to the IRS.

Theft Loss

John Barrie, a tax partner at the New York law firm Bryan Cave LLP, said investors will want to claim a theft loss rather than an investment loss. A theft loss can be used to reduce ordinary income, while an investment loss can only offset capital gains, which most people don’t have this year, he said.

To claim the more valuable deduction, Barrie said, the taxpayer must establish that a theft occurred, a threshold he said will likely be met by Madoff’s indictment. Taxpayers must also establish there is no likelihood of recovering the money, which he said they probably can do unless they get compensation from the government-sponsored Securities Investor Protection Corp.

Only individuals who invested directly with Madoff can deduct theft losses, Barrie said. Those who invested indirectly through a hedge fund or other entity must wait for the fund to report the theft loss on tax forms before they can claim any benefit.

The biggest area of “tension,” Barrie said, will be whether the IRS agrees that Madoff’s victims suffered theft losses rather than investment losses. While some other claims of theft loss resulting from stock transactions haven’t succeeded, he said that in the Madoff case the investors will be aided by the indictment.

Willens Report

Bruce Friedland, an IRS spokesman, said, “We’re aware of the situation, but beyond that we have no comment.” Treasury spokesman Andrew DeSouza declined to comment.

Robert Willens, who advises clients on how tax and accounting issues affect Wall Street investors, said in his newsletter “The Willens Report” this week that the tax code typically defines theft to include larceny, embezzlement and robbery.

“It seems likely, therefore, that investors in Bernard Madoff’s programs will be found, in the final analysis, to be the victims of a theft,” Willens concluded.

Willens said theft loss deductions are reduced when they exceed a person’s income earned in the year the theft was discovered.

Loss Calculation

The reduction is equal to 10 percent of income earned in that year plus $100. For example, if a loss totals $1 million in a year when the taxpayer earns $600,000, the person can claim a $939,900 theft loss -- or $1 million minus $60,100. The loss would wipe out taxes on $600,000 for this year, and the remaining $393,900 could be applied to the previous two years.

In addition to filing refunds for capital gains taxes, Kessler said investors may be able to get refunds on taxes paid on any interest and dividends falsely reported by Madoff.

“They will seek to eliminate any Madoff earnings reported on those returns and ask for a refund of taxes paid on such ‘phantom’ income,” Kessler said. In most cases, the amended returns should be filed before April 15, 2009, to be within the time limit, he said.

U.S. tax law allows people seeking refunds of capital gains paid on fictitious profits to amend their tax returns for the three most recent years. Theft losses generally can only be carried back two years.

Barrie said he expects some of Madoff’s investors may press the IRS and Congress to relax those limits because Madoff’s alleged fraud goes back at least a decade.

“Some families that are pretty much devastated will be asking the old and new administration what can be done to facilitate these claims,” he said.

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net