Before It's Too Late: Reconsidering The IRS Relief For Madoff Losses

Previously published by Tax Analysts, February 2012.

In early 2009, just months after the disclosure of Bernard Madoff's Ponzi scheme, the IRS issued Rev. Proc. 2009-20,1 which offers generous and simplified tax relief to a defrauded Ponzi investor in the form of a safe harbor theft loss deduction for the tax year in which the fraud was discovered, irrespective of whether the taxpayer had a reasonable prospect in that year of recovering any portion of the loss. The theft loss allowed under the safe harbor includes fictitious phantom income reported to the investor (and to the IRS) by the Ponzi operator in years before discovery, provided the phantom income had been reported as gross income. For the Madoff scheme, which is the focus of this article, the safe harbor relief enabled investors to claim theft loss deductions for the 2008 tax year for up to 95 percent of their investments, including previously reported phantom income, less any withdrawals and potential recoveries from the Securities Investor Protection Corp. Because the IRS recognized that theft losses from profit-seeking investments are fully allowable to individuals as itemized deductions and are treated as business expenses for purposes of computing net operating losses, the safe harbor theft loss deductions available under Rev. Proc. 2009-20 provided substantial tax benefits to most Madoff investors.

However, for other Madoff investors, those theft loss deductions had limited value,2 and in particular, the portion of their theft loss deductions attributable to previously reported phantom income may have resulted in substantially less tax reduction than the tax previously paid on the phantom income. By contrast, if section 1341 were applicable to the previously reported phantom income, it would give those taxpayers refundable payment credits equal to the income tax previously paid on the phantom income, while still allowing them theft loss deductions for the portion of their net investments (exclusive of previously reported phantom income) for which they have no reasonable prospect of recovery. Depending on individual circumstances, the combination of these two forms of tax relief could substantially exceed the value of the safe harbor theft loss deductions available to Madoff investors under Rev. Proc. 2009-20,3 even though the tax benefits would likely be realized in a later tax year or years.

Concurrent with Rev. Proc. 2009-20, the IRS issued Rev. Rul. 2009-9,4 which sets forth the Service's general (non-safe-harbor) position on the income tax treatment of losses from Ponzi schemes, including its view that section 1341 is inapplicable to a taxpayer's lost claim to previously reported phantom income and that such amount is properly treated as a theft loss. The IRS's rationale for denying the applicability of section 1341 is not defensible, not even close, and its willingness to treat a lost claim to fictitious income as a theft does not mean taxpayers must abide by that characterization. At least for the Madoff fraud, it is indisputable that such income was fraudulently misrepresented, not misappropriated, which was the ''get real'' basis of court decisions in the Madoff bankruptcy that rejected some investors' claims to phantom income. Because Madoff investors who claimed safe harbor theft loss deductions under Rev. Proc. 2009-20 did not enter into closing agreements or otherwise irrevocably commit themselves to the safe harbor relief, those who claimed safe harbor theft loss deductions may wish to reevaluate their reporting position, with particular focus on section 1341, before it is too late to amend their 2008 tax returns.5

Overview of Section 1341

Section 1341 was added to the code in 1954 to lessen the inequity of income inclusions under the claim of right doctrine when a taxpayer loses the right to that income in a subsequent tax year.6 Recognizing that a later-year deduction was often insufficient to compensate for the tax cost of claim of right income under an annual tax accounting system,7 Congress provided for a payment credit for the taxes previously paid on the claim of right income when that amount is greater than the tax reduction resulting from a current deduction (including refunds from any loss carryback) for the lost income.8

For section 1341 to apply, an item must have been included in gross income in a prior tax year ''because it appeared that the taxpayer had an unrestricted right to such item'' (section 1341(a)(1)), and a deduction must be allowable in a later tax year ''because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item or to a portion of such item'' (section 1341(a)(2)).9 For purposes of section 1341, it makes no difference whether a taxpayer's allowable deduction would otherwise be limited as a miscellaneous itemized deduction.10 The regulations use the term ''restoration'' to describe the deduction event in section 1341(a)(2),11 but, as explained below, section 1341(a)(2) is not confined to allowable deductions involving a taxpayer's obligation to repay income that was reported in an earlier year.

Because section 1341 is confined to previously reported income, its applicability to Ponzi investors would not affect (or be affected by) their right to claim theft loss deductions for the portion of their actual investments that were misappropriated and for which they have no reasonable prospect of recovery. In other words, if section 1341 applies, their tax relief would be split between the lost claim to phantom income and the loss of their invested capital. Section 1341 would apply to the former in the year when a deduction was allowable because the investor ceased to have a claim to the previously reported phantom income; the latter would be deductible as a theft loss in the year when the extent of the investor's recovery prospects was determined.12 Contrary to the impression of some, section 1341 is not an elective provision that taxpayers may waive or choose to ignore. When applicable, a taxpayer's income tax liability for the tax year in which a deduction is otherwise allowable must be determined under section 1341.13

The IRS has a well-known history of antipathy to section 1341,14 having advanced a series of limiting interpretations, some of which have been repeatedly rejected by the courts. It has contended that section 1341 does not apply when the taxpayer had an ''actual'' or ''unchallengeable'' as distinguished from a merely ''apparent'' right to the income reported in the earlier year,15 when the loss of the right to the income was attributable to subsequent events that did not exist in the year the income was reported,16 when the taxpayer did not have a rightful claim to the income because he procured it through wrongdoing,17 when the deduction allowable in the later year did not involve the same circumstances or have a sufficient nexus to the previously reported income,18 and when the taxpayer voluntarily relinquished the previously reported income and thus failed to show that it was ''established'' that the taxpayer had no right to the income.19 Notably...