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Madoff Clients May Recoup More Losses Through Taxes Than Suits

Date: Thursday, January 22, 2009
Author: Bloomberg.com

Customers of Bernard Madoff, accused of bilking his clients in a $50 billion Ponzi scheme, may recover more of their investment losses through tax strategies than by suing Madoff or his bankrupt firm.

“If they invested a lot, then they could possibly recover 40 percent of everything” through U.S. and state tax laws, said Micah Bloomfield, a tax specialist at New York law firm Stroock & Stroock & Lavan LLP.

U.S. tax law allows Madoff’s customers to take income deductions for losses caused by theft if they prove their money was stolen, Bloomfield said. Madoff’s alleged estimate of the size of the fraud didn’t specify if it included principal or how much was lost by charities not subject to taxation.

Madoff, 70, was charged with securities fraud in New York on Dec. 11 after allegedly confessing the crime to federal investigators. So-called Ponzi schemes pay early investors with money from later participants. Madoff faces as much as 20 years in prison, a $5 million fine and forfeiture of his assets. He hasn’t formally responded to the charges or entered a plea.

Madoff lawyer Ira Sorkin declined to comment on the tax consequences of losses linked to his client.

“If an investor loses money to a Ponzi scheme, that can be claimed as a theft loss for tax purposes,” said Martin Shulkin, managing partner of law firm Duane Morris LLP’s Boston office. “The claim should be made for the year you discover the loss, and is subject to a reasonable expectation of recovery.”

Shulkin represents about 30 Madoff investors, most of whom invested directly with Madoff’s brokerage, Bernard L. Madoff Investment Securities LLC. The firm is being liquidated by the Securities Investor Protection Corp., a U.S. agency set up four decades ago to cover losses when brokerages fail.

SIPC Option

Direct customers of Madoff have the option of filing loss claims with SIPC, he said. If they have reasonably determined they are unlikely to recover their loss through a SIPC claim, they may opt to use a theft-loss deduction instead, Shulkin said.

Under the theft-loss provision, eligible victims who don’t file a SIPC claim would have their deductions lowered by the $500,000 cap on SIPC coverage for securities losses, said Bloomfield. Kevin McCue, a spokesman for Irving Picard, the lawyer hired by SIPC to oversee brokerage claims, declined to comment on the tax process.

The Internal Revenue Service has taken the position that the loss from a single occurrence has to exceed $100 and that the total loss has to be more than 10 percent of an individual’s adjusted gross income for the year the deduction is claimed, Bloomfield said.

IRS View

“Under disclosure rules, IRS can’t discuss any specific cases,” the agency said in statement e-mailed by spokeswoman Theresa Branscome.

In the IRS view, someone with an income of $500,000 wouldn’t be able to deduct the first $50,100 in losses. Bloomfield said he disagrees that the $100/10 percent limitation applies to a theft-loss deduction, given amendments to the tax code.

A so-called claim-of-right tax refund is another option for recovering losses in the Madoff scheme, according to Timothy Mulcahy, a tax consultant with accounting firm Holtz Rubenstein Reminick LLP in New York.

The doctrine may allow some Madoff investors to eliminate income tied to Madoff’s investment advisory business from previous tax returns and declare the income-tax paid on those amounts as tax payments for 2008.

The “rarely used” doctrine is more complicated and possibly more rewarding than theft-loss returns, Mulcahy said yesterday in New York at a town-hall style meeting about the alleged fraud.

Good Records

“Every case is going to be different,” Mulcahy said. “To recover as much money as possible, you need very good records” to take advantage of the claim-of-right option. “Hopefully by the end of the year, we’ll have advice from the IRS.”

The IRS may rule this year on whether theft-loss or claim- of-right returns are the proper route for Madoff victims to take, according to Mulcahy.

If the loss from theft is greater than the taxpayer’s income the year the fraud is discovered, it can be carried back three years and forward 20 years to reduce taxable income.

The theft-loss deduction is also an option for people who gave their money to so-called feeder funds, such as hedge fund Fairfield Greenwich Group, that invested with Madoff, Shulkin said.

“We believe it is unlikely that investors in Madoff feeder funds will be successful in recovering SIPC claims,” he said.

Taxpayers may also file amended returns going back as much as three years to adjust for income they didn’t actually earn.

‘Phantom’ Gains

“People have been filing income tax returns reporting gains and income that were phantom,” Stephanie Casteel, a tax partner at Atlanta law firm King & Spalding LLP, said in a phone interview.

Bloomfield said someone who gave, say, $1 million to Madoff to invest and then recorded gains of $3 million over the years, might have paid tax on that amount. A taxpayer might claim a $4 million theft-loss deduction, using the gain and the $1 million principal, he said.

If the IRS denies the deduction for the fake $3 million, the taxpayer could try for a refund claim. Refunds might be claimed on reported income going back further than the typical three year limit, he said.

Mortner Law Office PC in New York is running an ad on Google Inc.’s Web site that offers help to investors with getting money back from the IRS under the headline: “Madoff - Tax Refunds.” According to the Mortner Web site, “These are not simple claims.”

IRS a Beneficiary

The IRS has been a beneficiary of Madoff’s alleged scheme because it received taxes on what may have been billions of dollars in reported phony profits, said Brad Friedman, a securities litigator at Milberg LLP in New York.

“That’s where most of the money went,” he said.

Not everyone agrees the theft-loss tax route will be more fruitful than filing SIPC, bankruptcy claims or lawsuits.

“It’s going to depend on people’s individual situations, and whether legislation gets enacted that lets people restate their taxes for more than three years,” Friedman said.

“I think, through the claims process, if done properly, people will recover a lot more,” said Blair Fensterstock, a trial lawyer at Fensterstock & Partners LLP in New York who has been tracking the Madoff litigation and hasn’t filed any claims for clients. “I also think the government isn’t in any mood to give back money to taxpayers, especially wealthy taxpayers.”

The SIPC case is Securities Investor Protection Corp. v. Bernard L. Madoff Investment Securities LLC, 08-01789, U.S. Bankruptcy Court, Southern District of New York (Manhattan). The criminal case is U.S.A. v. Madoff, 1:08-mj-02735, and the SEC case is Securities and Exchange Commission v. Madoff, 1:08-cv- 10791, both U.S. District Court, Southern District of New York (Manhattan).

To contact the reporters on this story: Thom Weidlich in New York at tweidlich@bloomberg.net; Cynthia Cotts in New York at ccotts@bloomberg.net; Erik Larson in New York at elarson4@bloomberg.net.