Why Investors Might Want to Thank Bernie Madoff


Admittedly, it sounds quite odd. But victims of Ponzi schemes, embezzlement, and similar investment frauds might want to thank Bernie Madoff – his Ponzi scheme inspired the IRS to change their procedures with respect to how victims of fraud can claim losses on their taxes. 

Before 2009, victims of investment frauds had to rely solely on IRC Section 165.  

The government isn’t exactly thrilled about people claiming their losses – they are as greedy as thieves. As with all things related to the IRS, claiming losses under this section is needlessly complex and skewed in the government’s favor. 

Taxpayers must meet stringent requirements to claim losses under Section 165. The two most commonly contested requirements involve proving that the loss was caused by criminal theft and that in the year of discovery there was no reasonable prospect of recovery. 

Criminal Theft

You’d think that the IRS would clearly define “criminal theft” to help taxpayers claim their losses. But they refuse to do so only stating that theft is, “deemed to include, but shall not necessarily be limited to larceny, embezzlement, and robbery.” The IRS is reluctant to define theft because they want to frustrate taxpayers into giving up and not claiming their losses. 

The IRS thrusts taxpayers into the role of state prosecutor forcing them to prove that the impetuous of the claim fits the definition of theft under the state law without their resources and investigative powers.

Satisfying this requirement has proved difficult for many taxpayers. Several court cases and IRS decisions have fleshed out the technicalities in proving a theft and what kind of theft is allowed.

Year of Discovery & No Reasonable Prospect of Recovery

Under Section 165, victims of fraud are subject to strict rules as to when the loss can be claimed. 

A taxpayer must claim the loss in the year he discovers it. A second requirement stipulates that if in the year of discovery there exists a reasonable prospect of recovery, the amount that may be recovered can’t be deducted until it can be determined that there will be no recovery.  If recovery is “unknowable,” the entire deduction must be postponed until it can be determined with reasonable certainty whether or not reimbursement will occur.

Furthermore, taxpayers are subject to a three-year statute of limitation for filing amended returns when attempting to correct for the losses. 

Unsurprisingly, these requirements been hotly contested in the courts. Many taxpayers have been denied claimed losses because of the law’s squishy nature – “reasonable” expectation of recovery is rather subjective. 

Theft Loss Safe Harbor… Thank You Bernie Madoff!

Here is where Bernie Madoff comes into play. 

Reacting to the collapse of his Ponzi scheme, the IRS issued an official ruling and procedure to clarify the procedure around claiming investment theft losses and to create a safe harbor for “qualified investors.”’

This new method of filing claims allows qualifying taxpayers to immediately deduct 75% of their losses if they intend to pursue any potential for third party recovery, and 95% if they do not. The remaining losses are subject to the rules of Section 165.

Satisfy all safe-harbor requirements and the IRS will not challenge:

  • that the loss is a theft;
  • that the correct year was used regarding discovery, and
  • that the amount claimed was correct.

Considering the controversy and existing legal precedents established around losses claimed under Section 165, the safe harbor option is quite appealing.

Taxpayer Confusion

The safe harbor provision works but successful claims require the help of a skilled expert.

In 2011, the Treasury Inspector General for Tax Administration published a report claiming that 1,788 of 2,177, (82%), returns claiming investment theft losses in 2008 were erroneous. 

Far be it from the government accepted blame for anything. The confusing requirements aren’t to blame – taxpayers are. Make an erroneous claim and you can be hit with penalties and interest.

Perhaps the most troubling part of the report was the government’s response to the supposed lost revenue calling it possibly “substantial.”

Guess how much revenue they estimated to be lost in 2008 due to erroneous claims?

A whopping $41 million.

Don’t get me wrong, I’d love to wake up tomorrow with an extra $41 million in my bank account. But that’s chump change for an institution that, for the last decade, has expropriated $2 – $3.5 trillion from taxpayers per-year.

I hope you like some twisted humor – it’s estimated that from 2008 to 2013, more than 500 Ponzi schemes defrauded investors of more than $50 billion dollars. That’s $8.3+ billion a year – or, 20,143.9% more than the Treasury Department claimed to have lost in 2008 due to “erroneous” claims.

If the government wants to launch an investigation into anything it should be into their own failures.

Famously, forensic accountant Harry Markopolos warned the SEC and FBI with letters and in-person presentations about Madoff’s Ponzi scheme. As part of his case, Markopolos demonstrated that Madoff claimed to trade more of a certain financial instrument than were in existence. 

“Split-Strike” strategy by Bernie Madoff

Madoff famously used a “split-strike” strategy to hedge against massive losses. This strategy does not produce the gain claimed by Madoff. More importantly, Markopolos mathematically proved that Madoff would have needed to trade anywhere from $7 -$65 billion of options with maturity dates of less than a month given his assets under management when only about $1 billion existed. 

Government officials and regulators didn’t believe Markopolos or were too incompetent to follow his argument. 

Interestingly, Markopolos recently published a report claiming that GE is engaged in a $38 accounting fraud scheme. Unfortunately for investors, the IRS denies claims made by people that purchase stock on the open market even when induced by fraudulent and fictitious statements made by the company. 

One of my favorite complaints I often hear is that financial markets have been “deregulated.”

Venture a guess as to how many State and federal agencies are tasked with overseeing financial markets.

A dozen?

Two dozen? Maybe three?

Nope…more than 10 dozen. There are 115 agencies that regulate financial markets. 

Yes, you read that correctly – 115 agencies failed to catch Bernie Madoff and the 500+ other fraudsters that swindled $50 billion from investors in just a six-year span. 

Don’t hold your breath waiting for a report investigating the ineptitude of government regulators – they’d rather throw a hissy fit over $41 million. 

Never rely on the government for your protection.

Never assume the IRS will allow you to deduct your losses. 

If you find yourself in the unfortunate situation of needing to claim an investment theft loss, hire an expert that knows all of the weaselly tactics the government will use to deny your claim.

Contact us if you’re potentially eligible to claim an investment theft loss. 

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