The IRS has finally developed a strategy for dealing with the victims of Bernard Madoff’s Ponzi scheme. The plan is said to apply to all participants in Ponzi schemes, not just Madoff’s, but clearly would not have been put in place without recent events.
A Ponzi scheme operates like this: you put money into a pot along with everyone else’s money. Your return on your investment comes from your own money or other people’s money rather than actual profit earned. The lure of a Ponzi scheme – and exactly what happened in the Madoff situation – is the promise of an unusually high return on your investment. Ponzi schemes don’t work, of course, because it’s a shifting pool or money where earnings are usually lower than the promised returns. In the Madoff case, the Ponzi scheme involved more than $50 billion.
Here’s how the gang at Sesame Street describes it:
Most tax pros apparently (myself included) thought that the losses might fall under the existing casualty/theft loss rules. However, the IRS has noted that, “To have a theft loss, there needs to be some evidence of criminal theft.” This is not the case in all investment scams where some of the masterminds might not have pleaded or been found guilty (Madoff, by the way, pleaded guilty to all charges). So, the IRS has eased the rules for those losses.
For those affected by the plan, the IRS will allow investors to claim a loss equal to 95% of their investments minus any money received under the scheme or reimbursed as part of the fraud investigation. If there is any additional recovery expected, the IRS will allow a 75% deduction (in a traditional casualty/theft loss, you would deduct the total of the expected recovery).
Investors will be able to take a deduction against their total ordinary income on reported fictitious investment gains; taxes paid on those losses would not be included. Since these losses are characterized as theft losses rather than capital losses, most affected taxpayers will receive a bigger deduction. In addition, the so-called 10% rule won’t apply.
Those who invested through retirement accounts may not claim a loss of fictitious gains since no gains were actually reported under tax-deferred plans. Charities, similarly, may not deduct losses not previously claimed as income.
To qualify for the relaxed rules, losses must have occurred in 2008 and be reported on a 2008 return. If an affected taxpayer has already filed a 2008 return, he or she may file an amended return. If the deduction on the returns exceeds their 2008 income, taxpayers may be able to carry-back those losses for three or five years depending on their status. There is talk of extending the losses up to 13 years (the length of Madoff’s scheme) but that has not been approved.
The decision to modify the rules a bit was triggered by the “magnitude” of the victims, according to IRS. Doug Shulman, the IRS Commissioner has said: “The Madoff case is tragic as so many people were victims of this fraud.”
True. There were a lot of victims. But I have to say what I know many of my colleagues are thinking: why this investment plan? Why now? There have been many Ponzi schemes before – and many surely still to follow. There have been many folks cheated out of money, reporting fake income and having nothing to show but losses. Why are we just now ramping up the relief?
I can’t help but think that it’s because many of the investors were rich. It’s been estimated that Madoff defrauded 13,000 victims of about $50 billion. Yes, $50 billion is a staggering number and in pure numbers, ranks near the top of single person defrauding schemes (some sources indicate that Charles Ponzi’s take of millions per year would be much greater in today’s dollars). As is 13,000. But that works out to about $4 million per investor. Taxpayers who were involved in Madoff’s schemes included Elie Wiesel, Steven Spielberg and John Malkovich.
And yes, I understand that folks suffered massive losses. I’ve gotten emails from some of their relatives. And I can’t begin to surmise what it must be like to lose that kind of money.
I also can’t understand what it’s like to have lost my home in Hurricanes Katrina, Rita or Wilma or the flooding in the midwest. In most – but not all – cases of disasters, the relief afforded by the IRS has been restricted to extending deadlines and waiving penalties (Katrina victims were also spared the silly $100 and 10-percent limits). In fact, in most cases where folks lose property in a casualty or theft-related loss, there aren’t special exceptions and rules that apply. Bad things happen to good people. And the IRS doesn’t always fix it.
Here’s an example: there were 39,413 reported instances of burglary reported in Philadelphia in 2006, the last year for which crime statistics have been made available by the Philadelphia Police. That’s three times the total number of Madoff victims – in one year as opposed the thirteen year Madoff crime spree. And yet, there’s no special Philadelphia theft loss provisions in the tax code. Why is that?
Maybe my sympathies are a bit clouded here by the fact that this Madoff thing, while it’s terrible and horrible and criminal, was also avoidable. And there were some remedies already available under the Code – many investors had already amended returns to “unreport” the phantom income already reported. According to some sources, those taxpayers are now re-amending returns to take advantage of the relaxed carry back rules because it’s more tax favored.
And those losses? What about ordinary taxpayers that didn’t invest in a Ponzi scheme, but lost money through Merrill Lynch and Bank of America? Those still qualify as capital losses, which are less favorable, though in cases like AIG, it feels like theft – but maybe that’s just me.
And maybe I’m wrong on all of this. And maybe I’m not being fair.
But I just think it’s an awfully slippery slope to pass rules intended to protect just one class of taxpayers. It is, folks, why the Tax Code is so big. We can talk about simplifying until the cows come home. But we won’t actually do it. We won’t because there’s always something that needs fixing.
Before you go all nutty on me and think I have no sympathy for Madoff victims, please know that I do understand and feel badly for those folks – and anyone who has been taken advantage of by bad people. I’m just questioning our response to it.
It reminds of a story from my first year of law school. I had a friend who was extremely wealthy. Her father (gasp) took away her store-related credit cards and scaled back her other spending after she went over her limit (again). She was devastated. Like bawling her eyes out, “what am I going to do? type trauma. As someone who was supporting myself in a tiny studio apartment without a car or credit cards, I couldn’t muster up much sympathy for her. But then one of my colleagues told me something that I’ve always remembered: “the worst thing that’s happened to you is still the worst thing that’s happened to you.”
I guess, at the end of the day, I agree that our levels of pain are all relative. But the bigger question is whether the Tax Code should be…
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