NO TAX REPRIEVE FOR MADOFFS' VICTIMS?
You know those poor souls paid taxes on non-existent profits, and for seasoned investors, over a long period of time. So suddenly, a $50 billion Ponzi may balloon a few bill. The SEC should, in my opinion pay back all these investors every dime they lost to this guy. If the SEC is the governing body to securities trading, my God there is no EMH.
A second wave of bad news is coming for victims of disgraced financier Bernard Madoff's purported $50 billion Ponzi scheme: personal tax troubles.
The victims have seen promised profits vanish and may see only pennies on each dollar of principal they invested.
Now add to that the specter of severe limits on their ability to recover taxes paid for years on those phantom earnings, and the added burden of having to wait to claim losses due to theft, according to tax lawyers.
Madoff investors who never touched the alleged profits reported on account statements most likely paid taxes on the purported gains for years. Not only did the profits never exist, but now the taxes paid will add to the pile of losses because the statute of limitations limits to three years their ability to claim refunds on overpaid taxes.
The investors, clients and friends who squirreled away money with Madoff face limits on the deductibility of their losses and may be barred from claiming refunds on overpaid taxes for any years prior to 2005, according to Jay Weill, a tax partner at Sideman & Bancroft in San Francisco and former tax division chief of the U.S. attorney's office there.
"They cannot expect the IRS to come to their rescue," he said.
Madoff told authorities in December that his investment firm had been a $50 billion Ponzi scheme that used money from late investors to repay earlier investors in what he told them were legitimate investments.
The tax consequences will fall unevenly, providing no benefits to tax-exempt charities and universities that get no breaks because they owed no tax, while giving limited help to investors with big losses because of legal limits on the ability to recoup all the tax losses, according to John Peterson, a corporate and international tax partner in Baker & McKenzie's Palo Alto, Calif., office.
For individual investors, the alleged capital gains, or profits on their original investment, are gone. Those cannot be claimed as losses on taxes because they existed only on paper and were never withdrawn, according to Weil.
Investors may claim refunds for taxes paid on the phony capital gains reported to them by Madoff, but they can only go back three tax years, to 2005, said Weill.
And if they actually pulled "profits" out of the account, then it is still taxed as income.
As for lost principal, representing the original cash investments in Madoff, claims of capital losses may be deducted to offset capital gains. That has limits, too. Deducting the losses that exceed gains is limited to $3,000 per year. For an investor who has lost millions, they may not live long enough to deduct all the losses, given the annual limit, according to Peterson.
And given the current economy, "most people already have a supply of capital losses," he said.
The silver lining in the tax picture will be the ability to claim the theft losses as a result of the Ponzi scheme, according to Weill, but that, too, has its limits.
Investors don't have to wait for the possibility that Madoff is convicted of a crime to show the IRS that a theft loss exists. "If someone rips you off, if there is no reasonable chance of getting it back you may claim the theft loss," Weill said.
In a 1996 tax case stemming from a Colorado Ponzi scheme, the judge said taxpayers cannot make the loss claim if "a reasonable prospect of recovery exists" when the taxpayer has a legitimate claim to recoup from third parties, such as insurers, banks and accountants. But the taxpayer is not "required to be an incorrigible optimist" waiting to make the theft claim, Premji v. Commissioner, No. T.C. 1996-304 (T.C.).
The theft loss deduction only kicks in for amounts that exceed 10% of an investor's adjusted gross income, he said. "There is an issue whether or not the 10% limit would be applicable in cases like this," he added.
Peterson agreed, saying he would bet the IRS will publish guidance to Madoff victims in the next six months spelling out some of these issues.
There is also an expectation on the part of the IRS that victims of thefts make insurance claims or other attempts to recover, according to Peterson. "I expect the IRS is going to look at whether people did that. It could very well take a while to play out before they figure out what is left," he said.
It makes sense to file amended tax returns for all the phantom income reported by investors, Peterson said. "One question could find its way into the courts: What about people who reported income five and 10 years ago? Does that give them a basis in court to claim a bigger loss now? There should be symmetry on taxes paid and what was paid off as gains later," he said.
"The reality is there was no income," he said.
And international investors will have their own headaches. Foreign investors would not have U.S. taxes withheld until money was actually paid out to them, but whether they can deduct theft from their home-country taxes depends on the local tax law, he said.
"This sort of loss is peculiar, and there is no telling how it is treated from one country to another," he said.
A second wave of bad news is coming for victims of disgraced financier Bernard Madoff's purported $50 billion Ponzi scheme: personal tax troubles.
The victims have seen promised profits vanish and may see only pennies on each dollar of principal they invested.
Now add to that the specter of severe limits on their ability to recover taxes paid for years on those phantom earnings, and the added burden of having to wait to claim losses due to theft, according to tax lawyers.
Madoff investors who never touched the alleged profits reported on account statements most likely paid taxes on the purported gains for years. Not only did the profits never exist, but now the taxes paid will add to the pile of losses because the statute of limitations limits to three years their ability to claim refunds on overpaid taxes.
The investors, clients and friends who squirreled away money with Madoff face limits on the deductibility of their losses and may be barred from claiming refunds on overpaid taxes for any years prior to 2005, according to Jay Weill, a tax partner at Sideman & Bancroft in San Francisco and former tax division chief of the U.S. attorney's office there.
"They cannot expect the IRS to come to their rescue," he said.
Madoff told authorities in December that his investment firm had been a $50 billion Ponzi scheme that used money from late investors to repay earlier investors in what he told them were legitimate investments.
The tax consequences will fall unevenly, providing no benefits to tax-exempt charities and universities that get no breaks because they owed no tax, while giving limited help to investors with big losses because of legal limits on the ability to recoup all the tax losses, according to John Peterson, a corporate and international tax partner in Baker & McKenzie's Palo Alto, Calif., office.
For individual investors, the alleged capital gains, or profits on their original investment, are gone. Those cannot be claimed as losses on taxes because they existed only on paper and were never withdrawn, according to Weil.
Investors may claim refunds for taxes paid on the phony capital gains reported to them by Madoff, but they can only go back three tax years, to 2005, said Weill.
And if they actually pulled "profits" out of the account, then it is still taxed as income.
As for lost principal, representing the original cash investments in Madoff, claims of capital losses may be deducted to offset capital gains. That has limits, too. Deducting the losses that exceed gains is limited to $3,000 per year. For an investor who has lost millions, they may not live long enough to deduct all the losses, given the annual limit, according to Peterson.
And given the current economy, "most people already have a supply of capital losses," he said.
The silver lining in the tax picture will be the ability to claim the theft losses as a result of the Ponzi scheme, according to Weill, but that, too, has its limits.
Investors don't have to wait for the possibility that Madoff is convicted of a crime to show the IRS that a theft loss exists. "If someone rips you off, if there is no reasonable chance of getting it back you may claim the theft loss," Weill said.
In a 1996 tax case stemming from a Colorado Ponzi scheme, the judge said taxpayers cannot make the loss claim if "a reasonable prospect of recovery exists" when the taxpayer has a legitimate claim to recoup from third parties, such as insurers, banks and accountants. But the taxpayer is not "required to be an incorrigible optimist" waiting to make the theft claim, Premji v. Commissioner, No. T.C. 1996-304 (T.C.).
The theft loss deduction only kicks in for amounts that exceed 10% of an investor's adjusted gross income, he said. "There is an issue whether or not the 10% limit would be applicable in cases like this," he added.
Peterson agreed, saying he would bet the IRS will publish guidance to Madoff victims in the next six months spelling out some of these issues.
There is also an expectation on the part of the IRS that victims of thefts make insurance claims or other attempts to recover, according to Peterson. "I expect the IRS is going to look at whether people did that. It could very well take a while to play out before they figure out what is left," he said.
It makes sense to file amended tax returns for all the phantom income reported by investors, Peterson said. "One question could find its way into the courts: What about people who reported income five and 10 years ago? Does that give them a basis in court to claim a bigger loss now? There should be symmetry on taxes paid and what was paid off as gains later," he said.
"The reality is there was no income," he said.
And international investors will have their own headaches. Foreign investors would not have U.S. taxes withheld until money was actually paid out to them, but whether they can deduct theft from their home-country taxes depends on the local tax law, he said.
"This sort of loss is peculiar, and there is no telling how it is treated from one country to another," he said.
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