Tax planning for feeder fund losses

Just when we thought we had heard all the bad financial news there was, a new major money scandal is being played out. Everyone wants to know what happened to the Bernie Madoff money.
JAN 13, 2009
By  Bloomberg
Situation: Just when we thought we had heard all the bad financial news there was, a new major money scandal is being played out. Everyone wants to know what happened to the Bernie Madoff money. If you have clients that were victimized, you can be sure that they know they have little chance of getting their money back. So now they want to know whether they can handle the loss as such on their tax return. The question has not been ruled on by the Internal Revenue Service, but there is precedent in treating the loss of investments due to fraud as a theft loss. Most investments made through Bernard L. Madoff Investment Securities LLC of New York seem to have been feeder funds, which for tax purposes, are usually partnerships. The partners invested their money in the partnership, which subsequently invested with the Madoff firm. Some individuals had been investing this way for decades. Income was reported year by year as profits. As in all partnerships, IRS Schedule K-1 was issued to every partner and each partner was then responsible for including the income on their tax returns. A reconciliation of each partner’s investment account is on Schedule K-1 (Form 1065, Partner’s Shares of Income, Deductions, Credits, etc.). Solution: Let’s examine how to handle feeder fund losses for tax purposes. Your client invested $500,000 in a Madoff feeder fund 10 years ago. After making some withdrawals during the years, his account value is $1 million. If the entire amount is treated as a theft loss, the loss would be deducted in full in the year discovered — namely 2008. Unlike a capital loss, which is only deductible against capital gains with any excess subject to a $3,000 limit, the entire $1 million is deductible in 2008. Obviously, all of the client’s income would be eliminated and they would not owe any taxes for 2008. Furthermore, because the feeder fund losses are a casualty loss they can be carried back three years. Amended returns can be filed and refunds obtained for 2005, 2006 and 2007. It should be noted that the partnership must take the theft loss and report the loss on Schedule K-1. If the losses are not entirely used in 2005, 2006, 2007 and 2008 then the balance can carried forward for 20 years. The Department of the Treasury ends up paying for some of the lost feeder fund investments via a refund of taxes previously paid. It will be interesting to see whether Treasury will issue any special rules to address this specific situation.

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