Clients Exposed to Madoff?
Tax Planning for Ponzi Scheme Victims
By Melissa Hoffmann Lajara
Posted on 1/29/09

NEW YORK -- It was fraud on a scale that would have made Charles Ponzi proud.

For years, people who invested large sums in Bernard L. Madoff Investment Securities LLC had something to smile about. It seemed that no matter what happened in the market, these investors always saw healthy returns.

Federal investigators are saying Bernard L. Madoff’s bulletproof strategy was actually an alleged Ponzi scheme, first popularized by its namesake at the turn of the 20th century, to bilk investors out of about $50 billion dollars. Like his predecessor and others who employ this method of fraud, Madoff allegedly paid returns to his initial victims out of money invested by his subsequent clients.

In the weeks after Madoff was charged and the breadth of the scam was revealed, investors began to work on recovering some of their losses and picking up the pieces of their financial lives. For some, including many charities, that proved impossible. Madoff’s massive theft shuttered businesses and cost many their life savings. At least one suicide was attributed to the scam.

And with so many affected -- at one recent NYSSCPA committee meeting, five out of 15 members present had clients exposed to Madoff -- speculation serves a purpose. To that end, several CPA firms have created task forces to discuss potential tax and audit considerations.

“Investors should realize that there is much uncertainty and that the Madoff scheme is unique in its magnitude and reach,” noted a bulletin from CPA firm Marcum & Kliegman LLP. “Short of waiting several years for all events to unfold, any tax strategy will have some element of inherent risk.”

All of the firms stress one point: It’s important to assemble all documents -- particularly financial records -- relating to Madoff investments and have them handy.

For those exposed to Madoff’s alleged scheme, there are more questions than answers. There is no definitive guidance from regulators or the IRS as to how losses from the Madoff affair should be treated. But at the same time, there are a vast number of individuals, corporations and organizations affected -- and they want answers from their financial advisors. The 2008 filing season is approaching. What is a CPA to do?

“Well, the first thing you should do is file protective claims for 2005, 2006 and 2007, so that you keep those years open under the statute of limitations,” said NYSSCPA member Timothy W. Mulcahy, who spoke at a town hall meeting arranged by Holtz Rubenstein Reminick LLP. “All of the facts aren’t out yet. If you filed an amended return right now, I don’t think they’d process it.”

And while many saw Madoff-related losses in 2008, the “year of discovery,” Mulcahy said “you’re probably going to put 2008 on extension and see if there’s further guidance.”

Paul E. Hammerschmidt, a member of the Society’s Tax Division Oversight Committee, pointed out that the trustee charged with liquidating Bernard L. Madoff Investment Securities is accepting claims that may be paid through the Securities Investor Protection Act of 1970. Although there is a chance that filing a claim could preclude you from certain tax treatments, Hammerschmidt said he would immediately file one.

“Don’t get lost in the tax side of things,” he said. “You want to be able to protect your financial interests.”

Using Precedent

On the tax side, little is known for sure. But in past Ponzi prosecution, there may be some precedent for planning purposes.

Neil H. Tipograph, a member of the Society’s Partnerships and LLCs and New York, Multistate and Local Taxation committees, authored an article submitted for inclusion in The CPA Journal that details some filing strategies based on “the interpretation of a number of IRS memos, rulings and court cases concerning the treatment of losses in Ponzi schemes.”

He noted some inconsistencies: In certain cases where “egregious” Ponzi schemes promised “outrageous” investment returns, the courts and the IRS tended to side against the victimized investor.

Likewise, Tipograph said that victims who received income payments from a scheme and then “intentionally omitted such income from their returns” were treated harshly. But in cases with more sympathetic victims, the courts have generally sided with the taxpayer or investor, he said.

Each case is unique, and each Madoff client has unique considerations that may sway the IRS or courts one way or the other. Tipograph recommends that prior to setting a course of action, a tax professional should compile the following information and organize it in a spreadsheet:

“The spreadsheet will help the tax professional with the filing of the 2008 return by identifying phantom income,” Tipograph noted, which is income that was either not paid or, if paid, was really a return of capital.

Theft Loss

For the 2008 filing year, “there appears to be susbstantial authority to omit Madoff phantom income … [and] a reasonable position to claim a theft loss deduction in 2008 for the Madoff phantom investment income on tax returns closed by statute,” Tipograph wrote.

However, Tipograph noted that both the Internal Revenue Code and the courts have determined that reimbursable theft losses should be postponed until the taxpayer is able to show there is no reasonable prospect for recovery.

But “the tax professional can serve an important role in assisting the client victimized by Madoff,” Tipograph wrote. “First, the tax professional can help the client (and the client’s attorney) accumulate information for the claim form to be submitted with the Madoff trustee. Second, the tax professional can prepare amended tax returns for all open years which, in effect, reverse the phantom income reported by Madoff during the open years. Third, the tax professional can prepare the 2008 tax return claiming a theft loss deduction for some portion of the phantom income reported on tax returns closed by statute.”

Tax professionals need to monitor announcements by the IRS concerning the tax treatment of the Madoff theft loss, Tipograph said. Likewise, announcements by the Madoff trustee concerning the recovery of certain distributions may have significant impact on the income tax filings.

Suing the Auditors

In spite of the fact that little information is available, lawsuits related to the Madoff scandal have already begun. “I think people are more focused on what due diligence was performed by the investment advisor and feeder funds,” said Robert N. Waxman, chair of the Auditing Standards Committee and a member of the Accounting and Auditing Oversight Committee.

“These feeder funds and their auditors are now subject to about a dozen … class-action complaints and to date, Ernst & Young and BDO Seidman have been named defendants in several of these suits,” he said.

Waxman said the alleged audit failures included funds’ excess reliance on Madoff and the risks inherent in that lack of diversity; the abnormally high and stable positive investment results achieved by Madoff; the discrepancies between publicly available information about Madoff’s firm and the amounts Madoff claimed to manage; and the fact that Bernard L. Madoff Investment Securities was audited by Friehling & Horowitz, a three-person accounting firm in Rockland County.

“What do investors want?” Waxman asked. “They want excess returns on their investment with little risk and at an acceptable low cost. It’s only when one or all of these objectives aren’t met do they get angry. And angrier still when they are the victim of a massive Ponzi scheme.”

Melissa Hoffmann Lajara is associate editor of The Trusted Professional. She can be reached at mlajara@nysscpa.org.