Tax Relief for Fraud Victims

(MoneyWatch) 

If any of your money disappeared down the rathole known as
Bernie Madoff — or any of the similar Ponzi operations that came to
light last year — the IRS offers some relief, if not much sympathy.
You may be able to get back some of the lost cash through tax write-offs on
your 2008 return. You might even be able to write off taxes on previous
returns, since you may have paid tax on fake gains for years. But
there's no agreed-upon way to claim these losses — even
though the IRS recently announced its recommendations for Madoff-fleeced
taxpayers. "The IRS has come up with an easy answer, but it is not
necessarily the best answer for everyone," says Robert A. Friedman, a
partner at the New York law firm Troutman Sanders. So if you were scammed by
Madoff, you'll need to do a little math to come up with the approach
that's best for you.

There are actually three ways to take losses. One has the
approval of the IRS but may not be best for you. The other two won't
make you any friends at the IRS but have had some success in the U.S. Tax
Court.

Option 1: Wait It Out

Bernie Madoff's fleeced investors can choose among three ways of claiming
their tax losses.(AP/Stuart Ramson)

The way the IRS likes to approach theft losses is to have
taxpayers claim a loss in the year the theft was discovered and when the amount
can be quantified. “It’s pretty clear that the loss was
discovered in December 2008, when Madoff confessed,” Friedman says.
But the size of each investor’s loss may not be clear yet, because
victims have legal claims against Madoff’s assets. Some investors
also have claims either against the intermediary who told them to invest with
Madoff or against an insurance company or guaranty fund.

Theoretically, you’re supposed to wait to claim
the loss until you can figure out how much, if anything, you’re due.
That typically takes years. On the bright side, any profits you paid tax on in
previous years would be added to your investment cost, increasing the value of
the loss when you finally do make the claim. In other words, if you invested
$100,000 and paid tax on $10,000 in annual gains for the past 10 years, your
loss would be $200,000.

However, the IRS just came out with special rules for Madoff
investors. If you’re not taking someone to court over your Madoff
mess, you will be allowed to claim 95 percent of your investment as a loss on
your ’08 tax return — after deducting any recovery you
might receive from the Securities Investor Protection Corporation. You can
write off 75 percent (minus potential SIPC recoveries) if you’re
pursuing legal claims. People following this approach must include with their
return a statement about their Ponzi losses.

Option 2: Fix Past Mistakes

Another approach is to amend previous tax returns to back
out Madoff-related profits, saying they were mischaracterized and were actually
a return of principal. After subtracting the return of principal,
you’d claim the remaining losses as theft losses. This approach has
the benefit of logic: Anyone who’s familiar with Ponzi schemes knows
that if you got money back, it was your (or someone else’s)
principal. It also lets you recover a portion of your tax overpayments fairly
quickly. Taxes remain open for three years following filing, so in the previous
example, you could claim $30,000 of overstated profits: $10,000 on your 2005
return, $10,000 for 2006, and $10,000 for 2007. Since Madoff’s
fiction was that he earned this money on short-swing trading, you probably paid
ordinary income tax rates on it. Assuming a 35 percent marginal tax bracket,
this claim would get you back about $10,500.

This approach creates a bookkeeping nightmare for the IRS,
though, and the agency has frowned on it in the past. But the Tax Court has
sometimes sided with taxpayers who chose this option. “I would advise
people to consider filing claims to back out the income for these open years
and then perhaps claim a theft loss on their 2008 return,” says
Philip J. Holthouse, a partner with Holthouse Carlin & Van Trigt, a tax
law and accounting firm based in Santa Monica, Calif. If you amend those
returns soon, you’ll preserve your legal right to claim
that’s how you ought to recover your Ponzi losses. If you wait, the
tax years will close and you’ll lose your chance.

Option 3: Claim It All Now

In this approach (the most immediately lucrative), you tell
the IRS that every dollar you invested with Madoff was lost, as were the fake
profits you paid tax on. In the unlikely event you recover any of these losses,
you’ll pay tax on them at that time.

This strategy would let you write off all of your Ponzi
losses on your 2008 return. “If the theft losses exceed your 2008
income, they become net operating losses,” Holthouse says. That means
they can be carried back three years to recapture taxes paid in the past. And
if you have still more losses, they can be carried forward 20 years.
“Some victims may never pay taxes again,” he says.