March 05, 2009
While investor losses from the Madoff fraud appear to be substantial and in some cases catastrophic, potential tax benefits should permit some recovery from the IRS. With thoughtful and timely planning, investors should have the opportunity to harvest their losses and obtain tax refunds. The favorable tax aspects include the following:
- While investment assets are typically capital assets, the theft of such assets gives rise to ordinary losses that may be taken as a deduction against ordinary income without limitation. Ordinary losses are more valuable because ordinary income is taxed at higher rates than long-term capital gains.
- Any unused theft losses are then treated as business losses that are carried back three years and forward for 20 years, which could result in substantial tax refunds to you for prior years.
- Investors may also seek refunds of taxes paid on phantom investment income in the prior three tax years (or earlier if you have open years under audit).
- Certain legal expenses also may be deducted as part of the theft loss.
Maximizing the tax recovery from the loss requires careful consideration of the investor’s particular situation and the available options. Informed decisions need to be made:
By December 31, 2008
Revisit year-end tax planning. The tax benefits from the loss will depend in part on your other income and deductions through December 31, 2008. Investors should revisit their year-end planning to determine whether it would be beneficial to make any changes to the timing of asset sales, charitable contributions, state estimated tax payments, or other items of income and deductions that are within their control.
FREE Accounting Training from Lorman
Lorman has over 37 years of professional training experience.
Join us for a special report and level up your Accounting knowledge!
Tax Aspects of Operating a Partnership-Taxed Organization
Presented by Langdon T. Owen Jr.
By April 15, 2009
File protective claims for refunds before statutes expire. Tax refund claims can be time-barred by statutes of limitation. Most investors have until at least April 15, 2009, to seek refunds for years as early as 2005 (or earlier if you have open years under audit). You should ascertain the applicable deadlines for your situation and file a protective claim for refund before the statute on any open year expires.
Estimate and pay 2008 tax. While you can extend your return filing date to October 15, 2009, you must still determine your 2008 taxable income and pay your tax by April 15, 2009, to avoid underpayment penalties and interest. If you receive Form 1099s reporting 2008 Madoff income to the IRS, you must decide how to best treat income you will likely never receive. Proper tax return reporting of this decision is important to avoid potential penalties.
Consider seeking a ruling or opinion on the tax benefits. A theft loss deduction is subject to several requirements and must be taken in the year in which the theft is discovered, which appears to be 2008. If an investor has a claim with a reasonable prospect of recovery, however, the deduction is deferred to the extent of the claim until it is resolved. There is inherent uncertainty in the proper timing and amount of a theft loss deduction, which is subject to challenge by the IRS. One avenue for obtaining certainty is to seek a private letter ruling from the IRS on the investor’s tax treatment, although the IRS may decide not to rule on this issue at this time. Alternatively, an investor may derive comfort and penalty avoidance from an analysis and opinion from counsel.
By October 15, 2009, the extended due date of the 2008 return
File 2008 return. A theft loss deduction must be based on the facts known at the time the return is filed, which requires investors to update the analysis and confirm the claim.
File carryback claims and elections. If an individual investor has any unused 2008 theft losses, such losses are carried back to the third year—2005—and then forward. Alternatively, if more beneficial, the investor can make an irrevocable election to relinquish the carryback period in favor of carrying the losses forward.
Special considerations—investment funds, private foundations, and state taxes
Investment funds should give special consideration to the tax consequences of how they report the loss from this fraud to their members. Private foundations faced with losses from this fraud will need to consider the impact on their annual minimum distribution requirement. The distribution requirement generally is computed on five percent of the value of the foundation’s investment assets, but where those assets have dropped precipitously in value—or never really existed—the distributable amount may need to be adjusted and the proper disclosures made on the foundation’s annual information return to the IRS. Finally, all investors should consider the impact of state and local tax rules, which differ from the federal rules in many respects.
Our highly-skilled tax attorneys have been advising investors on the tax implications and opportunities for tax losses and refunds that have resulted from this and similar frauds. We work with investors’ accountants to develop a holistic and customized approach in this uncommon situation to maximize tax relief for investors.
The foregoing has been prepared for the general information of clients and friends of the firm. It is not meant to provide legal advice with respect to any specific matter and should not be acted upon without professional counsel. If you have any questions or require any further information regarding these or other related matters, please contact your regular Nixon Peabody LLP representative. This material may be considered advertising under certain rules of professional conduct.