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.