Experienced Tax
Accountant – IRS has announced special relief for victims of Bernard
Madoff's Ponzi scheme (and for investors in other similar fraudulent schemes).
Because Madoff's scheme continued for years, many investors are faced not only
with the loss of their original investments, but also with having paid taxes on
“phantom income,” based on fraudulent statements sent by Madoff's firm to
investors over a number of years.
The first question IRS answers—generally positively for
investors—is exactly how the loss from the investment will be treated for tax
purposes. If the loss was considered a capital loss, which is often the case
when a taxpayer loses money on an investment in stocks or securities,
individual taxpayers would be limited to offsetting the loss against their
capital gains, plus an additional $3,000 allowed as a deduction against
ordinary income. Although the excess loss can be carried forward indefinitely,
it would do little for losses of the magnitude incurred by the typical Madoff
investor. So it was good news for investors when IRS announced that investors
can take an ordinary loss deduction and the deduction isn't subject to the 2%
of adjusted gross income (AGI) limit on miscellaneous itemized deductions, the
income-based limitation on itemized deductions, or the 10% of AGI limitation on
the deduction for casualty losses.
When the deduction is taken. Taxpayers can deduct the loss
in the year the theft was discovered, which was 2008 for Madoff investors. This
deduction can be taken if the loss isn't covered by a claim for reimbursement
or other recovery that has a reasonable chance of occurring. If there is a
reasonable chance of recovery, the taxpayer must either reduce the deduction by
that amount or, alternatively, make a special election under a 2009 revenue
procedure, which is discussed farther below. If, after reducing the deduction,
the taxpayer actually recovers less than the reduction in a later year, he or
she can take an additional deduction in the year the recovery amount is
ascertained. And a taxpayer is required to include in income any amount
recovered greater than the amount anticipated at the time of taking the
deduction.
The amount of the deduction. According to IRS, the amount of
the theft loss is determined by adding to the amount of the initial investment
any additional investments and any amounts the taxpayer reported as income and
reinvested, minus any amounts withdrawn over the years and any reimbursements
or likely recovery.
Here's an example. Assume A invested $500,000 with Madoff's
scheme in 2002, reported $40,000 of income on the investment each year in 2003,
2004, 2005, 2006, and 2007, all of which ($200,000) he reinvested. A made no
withdrawals over the years, and has filed a claim for reimbursement with the
Securities Investor Protection Corporation (SIPC). A is likely to recover
$500,000, which is the most any investor can recover from SIPC (subject to a
$100,000 cash maximum). His ordinary loss deduction for 2008 is $200,000.
There is an alternative way to calculate the loss under an
elective provision, which is described below.
Net operating losses. Taxpayers with losses from Madoff's
fraud may have loss deductions in excess of their income for 2008. Under the
general rules for net operating losses (NOLs), the losses can be carried back
two years and forward 20 years. For casualty or theft losses, the carryback is
increased to three years. For 2008 and 2009 NOLs, most taxpayers could elect a
three-, four- or five-year carryback period (instead of two years). In
addition, a special increased carryback period election was available for small
businesses, but only for 2008 NOLs. The interaction of the NOL rules with the
rules for other deductions and credits is complex; if you had a potential NOL,
you needed tax advice before choosing a carryback period.
Safe-harbor relief. Some investors will qualify for elective
relief under Rev Proc 2009-20, 2009-14 IRB 735. The amount of the investment
that qualifies for relief under the revenue procedure is the same as it is
under the rules described above. But the amount to be deducted is 95% of the
qualified investment if the investor doesn't pursue any potential third party
recovery or 75% of the qualified investment if the investor is pursuing or
intends to pursue a third party recovery. These amounts must be reduced by any
actual recovery or potential SIPC recovery. The biggest advantage of this
method is that the deduction isn't further reduced by a potential direct or
third party recovery (although further deductions or income from losses or
recoveries occurring in later years are covered by the rules above). The safe
harbor can be elected only by investors who invested directly with Madoff (or
in a similar fraudulent scheme).
To qualify for relief under Rev Proc 2009-20, investors must
file Form 4684, Casualties and Thefts, marked “Revenue Procedure 2009-20,” with
the tax return for the year in which the theft was discovered. Appendix A of
Rev Proc 2009-20 contains a worksheet for calculating the amount of the theft
loss and a statement that must be signed by the investor and submitted with
Form 4684. We expect that this can be done on extension.
State tax treatment. Each state may treat these losses differently.
New York, for example, has announced that it will recognize the safe harbor
under Rev Proc 2009-20 for purposes of determining the amount of New York state
itemized deductions for the theft loss. However, itemized deductions in New
York are reduced for taxpayers with income in excess of certain thresholds
(that is also the case for federal income tax purposes, but the IRS has
explicitly excepted these losses from those reductions). And the NOL provisions
permitted for federal purposes aren't permitted for New York because the state
allows NOL deductions only for losses attributable to a business, trade,
profession, or occupation carried on in New York. The losses from a Ponzi-like
fraudulent investment arrangement generally won't qualify.
Please call me if you are interested in additional
information on these issues. I
look forward to hearing from you. Click this link to view our YouTube video http://youtu.be/EYJdQtbPZAI
Amare
Berhie
(651)
621-5777, (952) 583-9108, (612) 224-2476, (763) 269-5396
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