The Internal Revenue Service (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 the 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, “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 to the thirteen year Madoff crime spree. And yet, there are 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 “un-report” 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 bad 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…
I think you’re right. People do get ripped off or lose to bad investments all the time and the tax code is not amended to help them, nor should it be. As a society, we seem to be in emotional overload, overreacting to every new outrage without taking a close look at the facts. We have become Southpark.
Bad things do happen and the tax code is a pretty inefficient means of leveling the pain. The more that we complicate the code in order to favor some group or special interest, the “less fair” it becomes.
Thanks for saying it.
I really don’t have much sympathy for Madoff victims at all — with returns come risks, and with such high returns there’s got to be the risk of some kind of fraud in there. I read some story with an anonymous Madoff investor saying, in effect, yeah, I knew there had to be something hinky going on there, but I didn’t want to pry.
I don’t see how it’s the tax code’s job to compensate for people burned by the inevitable risk that comes with unrealistic rates of return.
I sympathize with “victims” of investment scams and loss of value in their investments. At the end of the day though, all people must be responsible for their own “Choices” and bear the burden of due diligence, taking responsibility for themselves. Yes, it is sad that greed seems to have prevailed over blind faith. Scarpy is right, it is not the IRS job to compensate for investment risk… and its blatently wrong to offer compensation to selected classes of loss. Further,instead of bailing out banks with toxic assets and hoping that will free them up to make home loans that are later sold to Fannie Mae and Freddie Mac, the Federal Government should create a new investment entity, such as a “Linda Lou” (backed by the the Treasury… with a “clean slate”…or HUD, since they are already in the Home business so to speak and “oh so familiar with fair housing” ) to immediately begin lending to “Qualified Homebuyers,” with a more generous than $8,000.00 credit for first time buyers, AND/OR buyers of “foreclosed propertis.” This plan would reduce the home inventory, prop up home values, and allow move up buyers the opportunity to sell and possible come out ahead,; and save the taxpayers the risk on the Obama’s plan to suppoert 85% of the investment of buying toxic assets, only to have the banks regain their composure…. with NO ASSURANCES they wil make loans again.
Hobbes
Your friend in law school reminds me of my Dad’s anecdote about overhearing a conversation in a dining hall at Harvard (he was Class of ’50), between a couple of his well-to-do classmates — one of them complained that his father had cut his spending money down to $150 a week. The other one said that’s nothing, my dad cut me down to *$90* a week. Those are 1948 dollars. Oh, the humanity!
Urb
An almost identical Ponzi scheme was pulled off in the Muslim community in the US about 4-6 months before the Madoff scheme came to light, I want to say. Investor took money, doled out huge returns, and went down his list of donors, taking more money, doling out more returns, and then finally took in another batch, so to speak, and simply absconded with it. People lost several million dollars each, and there wasn’t a mention of it anywhere. So while I feel badly for Madoff investors and anyone who had a similar experience, I agree. I’m glad you said it out loud – that the reason we’re seeing this kind of massive reform and relief is because the investors themselves were wealthy (although, cough cough, such was not the case for the Muslim investors who were ALSO incredibly wealthy) – because if you hadn’t, I probably would have. And then I’d have ended up on some FBI watchlist. đŸ˜›
My big beef in all this is the absurd $3,000 annual limitation on allowable net capital losses. If the IRS cheerfully taxes you on all your gains, it should allow you to deducy all your losses. Okay, if the long-term gain rate is only 15% then, maybe, the long-term loss rate should be the same, but that’s a detail.
This one “fix” would take care of almost everybody, including, especially, the large number of “middle Americans” whose direct investment portfolios have been devastated in the last year. Tax-wise, nothing at all has been done for them. And “they” are US — not a relative few wealthy people.
I agree re the capital losses. I’m not sure that I believe that you should be able to deduct ALL of them – but the $3k limit is really silly in today’s economy.
The problem with a rule like this is that it affects incentives. The payoff for investigating a potential Ponzi scheme is now a little less (because of the tax cushion), so in the future, this will lead to Ponzi schemes being a little more common. It was well-meaning, but you can’t compensate people for an avoidable error without making that error cheaper to commit.
“The worst thing that’s happened to you is still the worst thing that’s happened to you” Haha, that’s very true. As for the Madoff victims, well, there’s a legal system to deal with frauds and I don’t think the government should be compensating for this.
I think this is like people arguing that the bail-out is a bad thing, because that’s going to be removing the risk and indirectly encourage recklessly risky investments. There’s something in common there.
When I first started reading this article I thought you were describing social security. Social Security is the exact definition of a Ponzi scheme. Too bad I am a gen x-er and not a baby boomer. The gen x-ers will be too late and the money will be all gone. Who will they throw in jail though?
I do agree that it is crazy to write specific tax code for every ill that pops up like the AIG bonuses. It is no different than the targeted tax cuts that always seem to come after you no longer qualify. It is a form a discrimination. Not that different than a progressive income tax code which charges higher and higher percentages based on your income.
From what I have read and heard, it is unconstitutional to target tax payers after the fact. I have heard the term: bills of attainder? Not sure what that is but apparently the new tax on AIG bonuses falls within that category or is at least unconstitutional.
We have a government that can’t cut spending and doesn’t really care what the constitution says. Not a good combination.
Being able to deduct your losses only helps if you have income to deduct it from. If are retired, lost your life savings and are trying to live on social security you will never recoup your losses. Once again it is a case of the rich get richer and the poor get poorer.
Yep, Ponzi schemes are terrible – wonder if the tax code will give a break to the folks who are currently investing in the ultimate ponzi scheme (social security) when it finally goes broke.
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