Federal Income Tax Treatment of Investment Losses From L'Affaire Madoff

Investors in Bernard L. Madoff Investment Securities LLC (the “Madoff Firm”) are now addressing the federal income tax treatment of their losses from their investments in the Madoff Firm. Determination of the proper tax treatment depends on whether a person invested with the Madoff Firm directly (a “Direct Investor”), or through a hedge fund that invested that person’s capital contribution to the hedge fund in the Madoff Firm (a “Hedge Fund Investor”). Each Direct Investor and Hedge Fund Investor will need to evaluate the Investor’s entitlement to a theft loss deduction, the year in which to claim this deduction, and the ability to file amended returns for prior open years for phantom income reported from the Madoff Firm.

A theft loss incurred by a noncorporate taxpayer in an investment transaction, or by a corporate taxpayer in any transaction, is deductible against ordinary income. The deduction is generally allowed in the year in which the taxpayer discovers the loss. When the taxpayer has a reasonable prospect of recovery for all or part of the loss, the deduction for the amount of the loss that is potentially recoverable is deferred until that prospect no longer exists.

The theft loss deduction should not be subject to the limitations of Section 165(h) of the Internal Revenue Code of 1986, as amended (the “Code”). Code Section 165(h) provides that the loss must exceed $100 in taxable years prior to 2010, and $500 in 2010 and thereafter, and that the theft loss, when added to the other net casualty and theft losses incurred by the taxpayer in the taxable year, must exceed the sum of the taxpayer’s personal casualty gains and ten percent of the taxpayer’s adjusted gross income.

Furthermore, a theft loss deduction for individuals has significant tax advantages. The deduction is not a miscellaneous itemized deduction subject to the two percent floor on itemized deductions under Code Section 67. It is also excluded from the phase-out of itemized deductions under Code Section 68. When a theft loss deduction creates a net operating loss, the individual can carry back the loss for three years, and carry forward any unused loss for up to twenty years. Finally, a theft loss deduction does not create liability for alternative minimum tax.

For Direct Investors, it is the Direct Investor that determines the entitlement to the theft loss deduction. For Hedge Fund Investors, the hedge fund determines the entitlement to the theft loss deduction, and then allocates the deduction to its individual investors. 

To claim a theft loss deduction, a taxpayer must establish:

1. the loss was caused by theft;
2. the amount of the loss;
3. the year of the taxpayer’s discovery of the loss; and
4. the year in which there is no reasonable prospect of recovery of the loss.

Although the income of a tax-exempt private foundation is generally not subject to tax so that a theft loss deduction does not create a tax benefit, a private foundation still needs to address the tax issues of its investment losses from the Madoff Firm. The theft loss and the ability to file amended information returns will likely affect the foundation’s calculation of its required distributable amount, and its excise tax on investment income.

Definition of Theft

The definition of theft is well-established. In Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956), the court defined theft as follows:

[T]he word “theft” is . . . a word of general and broad connotation, intended to cover and covering any criminal appropriation of another’s property to the use of the taker, particularly including theft by swindling, false pretenses, and any other form of guile. . . . [I]t has been long and well established that whether a loss from theft occurs within the purview of [the predecessor of Code Section 165], depends upon the law of the jurisdiction where it was sustained and that the exact nature of the crime, whether larceny or embezzlement, of obtaining money under false pretenses, swindling or any other wrongful deprivations of the property of another, is of little importance so long as it amounts to theft. [232 F.2d at 110-111 (citations omitted)]

The IRS also requires that the taking be done with criminal intent. Revenue Ruling 72-112, 1972-1 C.B. 60. Accordingly, a taxpayer must determine the taxable year in which the taxpayer discovers or learns of sufficient facts that show that Madoff’s conduct comes within the definition of theft. In making this determination, the taxpayer must address the fact that Madoff individually was charged with, but not convicted of, one count of securities fraud in December 2008.

Amount of Deductible Loss

In the case of investment property, the amount of the deductible loss is the excess of (1) the adjusted basis of the property, over (2) the amount of any insurance reimbursements and any other compensation or recovery for the loss. The adjusted basis is generally equal to the amount of the money invested, plus any income recognized on the investment, and minus any distributions of cash from the investment.

Reasonable Prospect of Recovery

A reasonable prospect of recovery defers the deduction until the taxpayer no longer has this prospect. Treasury Regulation Section 1.165-1(d)(3). When the taxpayer knows who the wrongdoer is, and the wrongdoer may have assets to satisfy a judgment in whole or in part, the taxpayer must seek recovery, or face disallowance of the deduction for the amounts potentially recoverable.

Direct Investors should evaluate the prospects for a recovery from the Securities Investor Protection Corporation (“SIPC”), and also the prospects for a recovery beyond SIPC coverage. Prospects for a recovery beyond SIPC coverage turn on the amount of assets of the Madoff Firm and Madoff individually that creditors can reach, and the amount that the SIPC trustee recovers on clawback claims against investors who received payments of cash and securities from the Madoff Firm in prior years. The loss that exceeds the amount recoverable from SIPC and beyond SIPC coverage is deductible in the year of discovery of sufficient facts showing that Madoff’s conduct comes within the definition of theft.

The Securities Investor Protection Act provides that customers of a failed brokerage firm receive all nonnegotiable securities already registered in their names or in the process of being registered. Funds from the SIPC reserve are available to satisfy the remaining claims of each customer for theft up to a maximum of $500,000, which includes a maximum of $100,000 on claims for cash.

For Hedge Fund Investors, the hedge fund, rather than the individual investor in the hedge fund, will need to determine the prospects of recovery from SIPC, the Madoff Firm, and Madoff individually. Once the hedge fund makes this determination, and the proper year for claiming the theft loss deduction, the hedge fund will allocate the deduction to its individual investors.

Furthermore, individual investors in the hedge fund may have claims against the hedge fund’s general partner and investment manager for failure to diversify investments, and for failure to conduct the appropriate due diligence in making and monitoring the investment in the Madoff Firm. The IRS may take the position that as long as there is a reasonable prospect of recovery on these claims, the taxpayer cannot deduct the amount potentially recoverable as a theft loss.

In addition, if an individual investor in the hedge fund claims a theft loss deduction prior to resolution of the claims against the general partner and investment manager, the general partner and investment manager can argue that claiming the deduction is an implied admission by the individual investor that any exculpatory provisions in the hedge fund’s partnership agreement and investment management agreement exonerate the general partner and investment manager.

Amended Returns for Open Years

Direct Investors and Hedge Fund Investors should determine whether to file amended returns for prior open years for phantom income reported from the Madoff Firm. By filing amended returns, the taxpayer makes a claim for refund for tax paid on the income erroneously reported.

If a taxpayer reported income associated with the receipt of payments of cash, the IRS has taken the position that the taxpayer cannot file amended returns for prior open years. Chief Counsel Advice 200451030. If a taxpayer reported income that did not exist and did not receive payments of cash, the taxpayer should be able to file amended returns for prior open years. The amended returns will show a reduction in the amount of income previously reported from the Madoff Firm.

Prior to filing amended returns, a taxpayer should evaluate whether the IRS can successfully argue that the taxpayer was in constructive receipt of the income credited to its account with the Madoff Firm but that the taxpayer did not withdraw. If the Madoff Firm timely honored a taxpayer’s requests for withdrawals when the taxpayer made these requests, the IRS can take the position that the taxpayer was in constructive receipt and cannot file amended returns. If the IRS takes this position, the amount of the income credited to the taxpayer’s account in the Madoff Firm increases the taxpayer’s adjusted basis, which in turn increases the overall amount of the theft loss deduction.

For most taxpayers, the current open years are 2005, 2006, and 2007. A taxpayer will need to file an amended return for 2005 by April 15, 2009 if the taxpayer filed the 2005 return on or before April 15, 2006. If a taxpayer obtained an extension for filing until October 15, 2006, the taxpayer will have three years from the date of filing in 2006 to file the amended return.

By filing an amended return, the taxpayer implicitly reduces its adjusted basis by the amount of the reduction in reported income. This reduction will also reduce the overall amount of the theft loss deduction.

Clawback Claims

Finally, Direct Investors and Hedge Fund Investors will need to consider the tax treatment of the payment of clawback claims to the SIPC trustee. If a Direct Investor or Hedge Fund Investor received payments of cash or securities from the Madoff Firm in prior years, the SIPC trustee may seek to recover the payments under state fraudulent conveyance laws. The SIPC trustee and defendants in clawback claims will vigorously litigate which state’s fraudulent conveyance law applies. In the bankruptcy case of In re Bayou Group, LLC, Case No. 06 B 22306 (ASH), Judge Adlai S. Hardin, Jr. of the Bankruptcy Court for the Southern District of New York recently allowed a six year clawback period under New York law. If a Direct Investor or Hedge Fund Investor pays a clawback claim in whole or in part to the SIPC trustee, the Direct Investor and Hedge Fund Investor should evaluate its entitlement to a deduction under Code Section 1341 for the repayment of amounts previously received under a claim of right.