Madoff victims may recover more cash via new tax rules than from clawbacks

madoff-victims-may-recover-more-cash-via-new-tax-rules-than-from-clawbacksBernard Madoff's victims may recover more of their lost funds by filing tax claims than they could hope to get from trustee Irving Picard's recovery efforts. So far, he's recovered only about $1.5 billion in assets to be split among customers with estimated losses of $19.4 billion. Picard has also filed lawsuits to recover another $15 billion from some of the Madoff firm's institutional clients and individuals, but how much of that will be clawed back -- if any -- remains to be see.

While some investors have received insurance payouts of $500,000 each from the Securities Investor Protection Corporation, certain victims are finding that the fastest way to recover some of their losses is by filing for tax refunds. As victims of a Ponzi scheme, they can generally deduct nearly all their qualified loses, including any "phantom income" (income reported, but never taken out of the account) in the year the fraud was discovered. This speeds up the process because victims normally would have to wait for years to deduct their losses.
Under new IRS rules, Madoff investors can recover taxes paid in prior years by "carrying back" qualified losses for five years and applying any remaining losses against income going forward for as much as 20 years. Prior this new ruling, investors had to subtract $100 and 10% of their adjusted gross income from their loss deductions, and were only able to carry back those losses for three years or forward 20 years. One tax adviser told The Wall Street Journal that he expects people will be able recover about 40% of what they lost using the new tax ruling.

This tax benefit primarily will help the wealthy; unfortunately, it won't offer much assistance to those Madoff investors who are retirees and lack income-earning potential for tax offsets. Many of these retirees were building up their funds for 20 years or more and lost everything. Going back just five years won't help them much. Since they won't have much income going forward, they'll have little opportunity to recoup their losses.

Sen. Charles Schumer (D-N.Y.) filed a bill to help less wealthy victims of Madoff's Ponzi scheme, as well as victims who invested through feeder funds as opposed to those who directly invested with Madoff. His bill would allow victims to reclaim 100% of the taxes paid in four of the past five years, and 50% of the income taxes paid in the fifth, up to the full amount they lost by investing with Madoff. The bill would also allow investors with money in tax-sheltered retirement accounts to get tax relief and make penalty-free hardship withdrawals.

"The fact that Bernie Madoff swindled so many investors is outrageous, but the fact that so many of the smaller investors, who may not have even known they were investing with Madoff, are not receiving the same assistance as direct investors is simply unfair," Schumer said in a statement announcing the legislation. "This proposal would finally give those smaller investors, many of whom lost everything, the tax relief they need and deserve."

Madoff's Ponzi Winners Suing to Redefine 'Losses'

There's one lawsuit pending that could prevent Picard from collecting much more money from investors who profited by investing with Madoff. Currently, Picard is establishing claims based on "net equity" -- the difference between the cash a customer put in versus the cash that customer took out. The plaintiffs in the lawsuit want claims evaluated differently. They are asking for claims to be evaluated based on the statement balances as of November 2008 -- the month before Madoff fessed up.

The way Picard figures it, only $19.4 billion was lost, and only about half of Madoff's customers lost money. If the lawsuit is successful, then the total losses will be defined at $65 billion and most of his investors will be able to show losses. That would mean far less money classified as profit that could be clawed back from people who took out a lot of cash from their Madoff accounts over the years. Many people will get to keep their fictitious profits. But the problem with this $65 billion claim is that it has been proven that Madoff never made the trades and never grew the funds to that level, so I expect the courts won't buy the plaintiffs' argument.

Even if Picard can file clawback lawsuits to recover money from those who took out more cash then they put in, they may not have the money to pay back. Some will be forced to file bankruptcy to avoid the clawback.

So if you're a Madoff victim waiting for funds to be distributed by Picard, don't expect to get much money that way. But do contact your tax advisor and take advantage of the IRS's Ponzi scheme tax ruling. At least that way, you'll get some of your lost funds back quickly.

Lita Epstein has written more than 25 books, including The Complete Idiot's Guide to Tax Breaks and Deductions.
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