Advisers: Recovering taxes for Madoff victims is tough

Few options exist for retrieving money that clients paid the IRS, but did not owe

Mar 1, 2009 @ 12:01 am

By Sara Hansard

Advisers, accountants and attorneys who represent victims of the alleged Madoff Ponzi scheme are struggling to recover taxes investors paid on "phantom profits." A major issue is how clients of Bernard L. Madoff Securities LLC of New York can get the taxes they paid on earnings they reported before 2005 returned to them, said Robert Keebler, a certified public accountant and partner with Virchow Krause & Co. LLP in Madison, Wis. He is heading a group at his firm that works with clients who invested in the scheme. Under the Internal Revenue Service rules, tax returns can't be amended after three years. Clients who invested with the Madoff firm in 2005 or afterward can amend their tax returns to get their taxes back, but the returns must be filed by April 15. "If you got in the deal in 2000, you've paid income tax on those phantom earnings for this entire period," Mr. Keebler said. "Arguably, they shouldn't have paid anything, because what they were getting back was their own money." Investment advisers have referred to Mr. Keebler 10 clients who were investors in the fund.

Mr. Madoff and the firm, of which he was principal, were charged in December with securities fraud by the Securities and Ex-change Commission. It isn't yet known how much investor money was lost in the alleged scheme, which is thought to have been carried out for several years.

Mr. Madoff told family members that the losses amounted to $50 billion, making it the largest Ponzi scheme in history.

To be sure, many investors face the prospect of returning money they received from their accounts, because they were paid more money than they put into the funds.

In addition, others are seeking the return of back taxes they paid on profits that turned out to be money that they and other investors had put into the fund.

Mr. Keebler and others working with Madoff clients are hoping the IRS will issue guidance on how to deal with tax issues stemming from the case. But the IRS so far has been unwilling to provide such guidance. The IRS declined to comment for this story, because it cannot discuss specific cases, Dean Patterson, a spokesman, wrote in an e-mail.

Last week, Rep. Gary Ackerman, D-N.Y., sent a letter to IRS commissioner Douglas Shulman asking him to issue guidance "immediately" that would allow victims of the Madoff scheme to claim losses for theft on their 2008 tax returns and to amend their returns going back to at least 1995.

The trustee for Madoff Securities, Irving Picard, a New York-based partner in Baker & Hostetler LLP of Cleveland, said there is no evidence that securities were purchased for accounts over the past 13 years.

POSSIBLE STRATEGIES

One approach is to claim losses due to theft, an option that may offer the best solution for long-term investors, according to some advisers.

That strategy would allow long-term investors to claim losses due to theft for the original capital that was invested in the fund, plus taxes paid on the phantom profits, said Ian Weinberg, a certified financial planner and chief executive of Family Wealth and Pension Management LLC in Woodbury, N.Y., a family office that manages about $150 million. He has two clients who invested in the Madoff fund before they became Mr. Weinberg's clients.

Those losses could be spread over the last three tax years and over the next 15 years, Mr. Weinberg said. But "it's not a guarantee that you'll be able to get the IRS' blessing and call it a fraudulent-theft loss," he added.

Even if the IRS does allow the bilked investors to take losses for theft, people who make such claims could end up offsetting income taxed at lower tax rates than they paid, such as capital gains rates, said Neil Tipograph, an accountant and tax partner with Imowitz Koenig & Co. LLP, an accounting firm in New York.

Income that Madoff Securities reported was taxed at ordinary income tax rates, Mr. Tipograph said. "It's possible when you do carry-backs and carry-forwards, they're offsetting capital gains income. That's just how the rules work. That's why the theft loss is not a perfect solution," Mr. Tipograph said.

Another method for handling the tax claims would be to use a "claim of right credit" on 2008 tax returns, a rarely used provision in the tax code which would be equal to all taxes paid on the phantom income for all prior years, he said. "That really is the perfect solution," Mr. Tipograph said.

The fraud hits individual retirement accounts the hardest, said Jeff Baskies, a partner with Katz Baskies LLC, a law firm in Boca Raton, Fla., who represents five investors.

"A typical Madoff account was believed to be very actively traded," generating substantial short-term gains, he said. "So a lot of people chose to put IRA money into the Madoff accounts to avoid that significant annual income tax liability," Mr. Baskies said. Those clients probably will not be able to get tax deductions for their losses, because the money went in on a tax-deferred basis, he said.

E-mail Sara Hansard at shansard@investmentnews.com.

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