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- Client Commission Practices and Soft Dollars RIAs should always evaluate whether the products and services they receive from broker-dealers are appropriate. The SEC suggested that an RIAs failure to stay within the scope of the Section 28(e) safe harbor may violate the advisors fiduciary duty to clients, so RIAs must evaluate their soft dollar relationships on a regular basis to ensure they are disclosed properly and that they do not negatively impact the best execution of clients transactions.
- The New and Improved Form ADV Whether an RIA is describing its investment strategy in advertisements or in the new Form ADV Part 2, it is important the firm articulates material risks faced by advisory clients and avoids language that might be construed as a guarantee.
By now most of the globe knows something about Bernard L. Madoff, who made off with billions of dollars investor's funds. In spite of Madoff's admission of guilt, we are still short on verifiable data to know exactly how the fraud occurred, but a few simple facts have emerged. Let's review the scheme, identify the key financial factors that the investor needs to know, and then look at the tax recovery tools that are potentially available to the direct investor.
Part 1: The Scam Itself
The cornerstone of the scam was a plain vanilla brokerage firm called Bernard L. Madoff Investment Securities LLC (BLMI Securities). Sometime over the last two or three decades, Madoff started pretending to open brokerage accounts for individuals with at least $1 million to invest and often much more, although "family" groups could aggregate their investment to reach the threshold. For some this was their life savings. For others it was a small wager on a mysterious investment strategy that claimed to buy and then sell well-known common stocks such as Apple and ExxonMobil, or options on those stocks. The entire position was converted regularly to Treasury bills, generally monthly, and most of the time at year end.
The result, according to brokerage statements, was a 1% to 2% monthly profit year after year, frequently evidenced by a large Treasury bill and small cash balance. At the end of each year, BLMI Securities dutifully reported tens to hundreds of millions of dollars in securities sales and 10% to 20% account value growth for the typical investor with a $2 million to $20 million investment. The results were also reported to the IRS on Form 1099-B, along with modest dividend and interest income earned over the year. The investor's tax preparer then calculated the investment activity, usually substantial, fully taxable short-term capital gains, along with taxable interest and dividend income. Investors then paid the income tax on these earnings to the United States Treasury, and in most cases, to their state tax authorities.
But for decades, this was all an illusion. According to Madoff, he simply took the investors' money and deposited it into an account at Chase Manhattan Bank. This was, in effect, a slush fund for his fraud and private enjoyment. He sent investors cash from the account when they requested redemption to falsely demonstrate legitimacy and provided brokerage statements to everyone to cover his tracks.
The scam expanded to accounts for more sophisticated institutional investors such as banks and hedge funds. As long as he took in more cash than he used, the Madoff fraud prospered. The fraud came to an abrupt halt with the global financial crisis in 2008 when clients sought funds from liquid sources.
Part 2: First Steps on the Road Back
The Internal Revenue Code ("the Code," or IRC) provides tax relief when someone like Madoff steals your money or other property. Called "theft losses" in the Code, these losses are usually deductible in the year you discover the theft, so it is likely that they would be considered "discovered" in 2008. But how much did Madoff steal? Is it the cash invested, the net cash invested, or the "tax basis" of the assets reported in the approximately $65 billion of November 30, 2008 fictitious brokerage accounts ... all net of insurance recoveries and plus "clawback" obligations, if any? What about the taxes paid on the fictitious earnings reported to the IRS?
As a starting point, any investor must analyze the BLMI Securities brokerage statements from inception to get an accurate understanding of the tax claims that may be available. The investor will also need a series of crystal balls and a few fortune tellers to make a best guess as to whether there will be an insurance recovery or a clawback.
To analyze the activity in a BLMI Securities brokerage account, list carefully all deposits to and withdrawals from BLMI. The net of the two is the net cash invested into the account or removed from the account. The value of the account on November 30, 2008 should equal the sum of the net cash position, all the net income taxed for years prior to 2008, and the income that would have been taxed in 2008 if the whole arrangement was legitimate. A spreadsheet tying out the account balance to an investor's tax return data each year is essential in developing a strategy for recovery (see the chart "Getting Started: A Madoff Recovery Spreadsheet," below).
The starting point to measure the loss is the net cash invested in the account, less estimated insurance recoveries and plus "clawback" obligations. The most difficult determination will be deciding how to handle the fictitious income that was fraudulently reported to the taxpayer and IRS.
Part 3: The Insurance Possibilities
The SIPC insures all brokerage firms for up to $500,000 per account. The details are complex, and there is some issue whether SIPC should pay based on account balances as of November 2008, or whether it will only pay based on a fraction of that amount only to the account holders with a net cash investment. Equity and protecting the integrity of the now seriously wounded U.S. brokerage system would indicate they should pay based on the reported cost basis of securities purchased in the account-- in other words, based on the balance in the account, even though it may be a total fraud. SIPC's intentions so far are to pay only to the extent there is a net cash investment in the account. Some homeowner or other general insurance policies may also reimburse for thefts. An investor should take these potential recoveries into account in measuring the loss.
There is also a prospect that the account holders will receive something from the bankruptcy process. Depending on how it is disbursed and the details of account balances, the $1 billion of recoveries located through mid-March plus clawbacks and further discoveries could result in distributions that some (including the IRS) have estimated to be up to 5% of the net cash balances lost by investors.
Part 4: The Clawback Risk
Learning about the clawback risk was, to some investors, even more shocking than learning that Madoff had stolen their money.
The concept of a "clawback" is that if you get your money out of a scheme that goes bad ahead of those folks who wait to read about it in the newspapers, you may have been unjustly enriched by luck, by insight, or through inside information. Various rules apply based on whether you got your money out within 90 days, a year, or even within six years or more of discovery.
The worst part is that this could apply to withdrawals without regard to deposits. The best part is that it is still unclear how and to whom the clawback will apply, so if the investor has a reasonable and unsuspicious pattern of deposits and withdrawals over a long period, it may be less likely that the clawback right will be claimed or enforced by the bankruptcy trustee. On the other hand, if the investor's account was liquidated in October 2008, there may be a real risk of clawback. Investors should consult a knowledgeable attorney in this area, since estimating your clawback exposure, if any, is an important step in estimating your theft loss.
Some long-term, modest investors will be surprised to learn they took net cash out of their account over the years. If an investor has net expected cash investment in a BLMI Securities brokerage account, it has likely been stolen. A net expected cash investment is the positive net of:
o cash deposited,
o less cash withdrawn,
o less any expected insurance or other recovery,
o plus any estimated clawback.
If this formula produces a negative amount, which means the investor expects to receive more cash than was put in to the Madoff account, the investor has a net cash return. I will refer to those with a net cash investment as the Cash Investors and the investors that received more than they put in as the Cash Receivers.
IRC Section 165 distinguishes between personal property theft losses and theft losses from property used in a business or an income-producing activity. Personal theft loss deductions are limited to roughly the loss less 10% of your income in that year, while both business and income-producing activity theft losses are fully deductible as itemized deductions. Some more exotic deduction theories could also apply to a Cash Investor, such as bad debt deductions, but their application is limited and not likely to apply or be useful to most individuals. The Cash Receivers have a different challenge in dealing with the net of their actual profits versus their reported profits, but obviously no cash was stolen from them.
Part 5: The Conundrum on Calculating Theft Loss
The conundrum faced by most investors and their tax advisors is how to account for the fraudulently reported income. Do you add the taxable income falsely reported by BLMI Securities to the investor's net positive or negative cash investment and treat the entire amount as a theft loss? That's where the IRS came out in its Madoff-inspired, comprehensive March 17, 2009 Revenue Ruling on criminal frauds, Rev. Rul. 2009-9, putting to rest some inconsistent and confusing positions from the sparse tax history of dealing with fraud and embezzlement.
The ruling confirmed that in Madoff-like situations, investors are generally entitled to business/investor theft loss treatment in the year the loss is discovered in an amount equal to the tax basis of the account less expected recoveries. The ruling does not discuss the clawback issue. It may be flawed in that it holds that the more favorable tax treatment for the restoration of an amount held under the claim of right provisions of the Code does not apply to these situations.
A companion Revenue Procedure (Rev Proc.2009-20) was released at the same time to help investors deal with their impending April 15 deadlines. In it, the IRS agreed to accept business/investor theft loss claims in situations like Madoff. Under the Revenue Procedure, losses equal to the net cash invested plus previously taxed income (called the "Qualified Investment") and less SIPC or other insurance recoveries would be partially deductible. For Madoff victims, the 2008 deduction is reduced by 5% of the Qualified Investment if the investor does not pursue any third party claims, and by 25% if third party claims are pursued. Any recoveries from the Trustee and differences between estimates and actual insurance recoveries are trued-up when they are known in future years.
Unfortunately, the safety offered through the Revenue Procedure involves shrinkage. Most taxpayers will receive a smaller total tax recovery than the taxes they paid.
BLMI Securities income was reported by the investors as fully taxable. Itemized deductions go through filters that limit their tax benefit in more ways than most realize. States often limit itemized deductions which also reduces the recovery opportunity. For example, for New York taxpayers, only half of the theft loss is deductible in calculating 2008 taxable income. Use of the "safe harbor" Revenue Procedure offers safety at a further cost to the taxpayer.
An alternate but seldom-used tax strategy always produces an equal or better recovery opportunity: it is called Restoration Claims due to the "claim of right" doctrine. Investors using the safe harbor Revenue Procedure must forgo the right to restoration relief, and while its availability is uncertain, its use should be considered.
Part 6: Claim of Right and Restoration Claims
The claim-of-right doctrine goes back nearly to the origins of the Code. A taxpayer may claim a refundable tax credit (or an above-the-line deduction) in the current tax year for tax paid on such income in a previous year. The tax paid is calculated by making a "with and without" calculation of tax for each previous year income was reported as earned but returned.
For example, if an investor has profits from securities sales credited to his brokerage account in both 1999 and 2006, and in 2008 it is determined that he had inside information relating to those trades and he is forced to repay the profits, the Code provides tax relief in 2008 when the profits are repaid. In 2008, regardless of statute of limitation issues, the investor generally has a choice between (1) taking a 2008 deduction for all repaid and previously reported profits, and the deduction is available in determining adjusted gross income (i.e. not a filtered, itemized deduction) or (2) a refundable credit for all the taxes paid in the previous year. These claims are sometimes referred to as "Restoration Claims." The same principle is also provided in most state income tax laws.
The only tax strategy for the Cash Investors to the extent of their investment is the Theft Loss, but Cash Investors may find greater relief with a Restoration Claim to the extent of their previously reported income, as opposed to a larger Theft Loss itemized deduction. Further, Cash Receivers should consider a Restoration Claim to the extent their previously reported income exceeds the net cash they expect to receive.
Will It Work?
Do the Madoff facts apply to the investor's entitlement to a Restoration Claim? Most commentators have expressed skepticism or simply ignore this tax strategy, preferring to focus on the Theft Loss deduction. I disagree with respect to the previously reported income in years prior to 2008, of course, unless it turns out that new facts are uncovered during the intense investigation that change the analytical landscape.
In order for this strategy to work, the IRS needs to agree with two key findings--the investor received the unfettered right to the income in previous years, and the investor restores the income.
In the Madoff case, proof of receipt (even though no trades took place) may be reasonably simple. Investors had evidence of their brokerage accounts and they deposited and withdrew money and securities for years up to December 2008. Investors surely thought they had a right, and in many cases they exercised that right, to all principal and income in their securities account.
Unfortunately, the concept of "restoration" is murky in this context, and untested by direct precedent. It is well settled law that restoration includes repayments. But what if the bank fails or the brokerage firm is a fraud? The Madoff case has been characterized as an old fashioned Ponzi scheme, but it was much more. It has regrettably stained our securities and governmental regulatory system, a different fact in this situation that should not be ignored. Is a theft a repayment? Surely, a theft is not always a repayment, but is it a repayment in this case? Ponzi schemes probably date back centuries, and were identified as such in the 1920s, not long after the income tax as we know it was first adopted in the U.S. Most of these frauds were structured as loans or simple investment schemes with incredible rates of return. They typically did not involve wealth accumulation through securities trading with regulated broker/dealers. Is Madoff distinguishable from previous Ponzi schemes? Some say yes and some are doubters.
Remember: the IRS Revenue Ruling concludes restoration does not apply, but the authority cited in the ruling is weak and not really on point. The cited cases focus on an investor's legal obligation to repay in one case and Alcoa Aluminum's "torturous" reading of the Code in an attempt to apply restoration relief to its environmental remediation obligation in the other. There is no settled law to interpret Madoff's actions. The law says that you are entitled to relief if "it appeared that the taxpayer had an unrestricted right" to the income and subsequently "the taxpayer did not have an unrestricted right to such item." Sounds like Madoff to me.
Investors and their investment advisors should carefully consult with knowledgeable tax advisors to protect themselves, since uncertain positions, no matter how innocent, can lead to the penalties enacted to protect the tax system from abusive tax shelters. Any position that contradicts the cited or any other Revenue Ruling should be prominently and properly disclosed.
Restoration Claims Should Be Allowed
Our government and the citizens that have created it rely on several core, commercial principles to prosper.
One key principle is the integrity of the financial system, including banks and brokerage firms. Protecting that integrity is important. It is noteworthy that during the 2008 meltdown of the global financial system, it was mostly the bank, brokerage, and insurance holding companies that showed legitimate distress, not the banks, regulated brokerage houses, or insurers. Part of the solution to the financial crisis we have accepted as helpful is more regulation of financial institutions.
A less obvious but vitally important principle is the integrity of tax information reporting. The IRS relies heavily on the presumption that Forms 1099, W-2, and other forms that report things the government needs to know about our income are accurate, so the IRS can effectively check on each taxpayer's reporting of the same income items through the self-assessment of tax. When a 1099 is wrong, a taxpayer must prove it is wrong, and the process is quite difficult. The IRS always presumes the payment reporter is right and the taxpayer is wrong, and only reverses that finding in the rarest of hard-won circumstances. It needs to be that way, or the entire "voluntary" self-assessment-based income tax system could seriously erode.
How do these principles influence the interpretation of the tax law in this case? When a bank or brokerage company says they owe you money, you need to believe it. So too, when they tell the IRS you have income, you generally need to believe that, too. If it is all a lie, has your money been stolen? To the extent they have your cash, probably. But to the extent they have caused you to report fictitious income, did they steal that? Or did you simply pay tax on it, dutifully thinking you earned it and had a claim of right to it, only to learn it was "repaid" through conversion, never to be seen again?
The is the crux: How could Madoff steal income that never existed? He could not. Similarly, taxpayers should not be prevented from recovering taxes paid on income that never existed. Restoration Claims should be allowed. The principle is simple. Taxpayers must include income when they think they earned it, and are entitled to special relief through Restoration Claims when they give the income back. To find otherwise would imbalance the responsibility to pay tax when you think it is earned and the systemic fairness imbued in the right to a corresponding tax benefit if you are wrong.
David A. Lifson, CPA, chair of the New York State Society of CPAs' Committee on Tax Reform, is a member of AICPA Council and is a partner with the New York CPA firm Hays & Company, LLP. He will be joining Crowe Horwath LLP with the others in his practice in June 2009. Lifson was appointed in January 2008 to a three-year term on the IRS Advisory Council (IRSAC). The views expressed herein are solely Mr. Lifson's, who can be reached at email@example.com.