Originally Published on forbes.com on November 23rd, 2011
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As Madoff investors go John and Cathy Dalton might count themselves lucky. They invested $655,500 in 2000 and $40,000 in January 2003. Between 2002 and 2008 they made 47 withdrawals totalling $572,900. In May 2009 they received $122,600 funded by the SIPC. Being even in the last decade was actually pretty good performance. Still there were tax issues. Every year they received detailed statements showing the gains and loss and interest and dividends from the fictitious investments that Mr. Madoff was pretending to make for them. They dutifully reported these amounts on their federal and state tax returns and paid the appropriate taxes.
When the whole thing came crashing down in 2008, tax people were scratching their heads about how to clean up the mess. It was like trying to unscramble an egg. One of my earliest blog posts noted the relief that the IRS granted in Revenue Ruling 2009-9. The ruling allowed taxpayers to take a theft loss in 2008. Conceptually the ruling was a little disturbing in that it was piling one fiction on top of another. We made believe that Madoff stole the money that he made believe he had made for you. On the other hand it was emotionally satisfying to accountants since it was at least a balanced entry. As I noted in my post it was not such a great deal for Massachusetts taxpayers, since Massachusetts does not allow theft losses. Neither does New Jersey, where the Daltons lived. Even though the Daltons took the federal safe harbor treament they determined that they would do better on the New Jersey Gross Income Tax (GIT), if they backed out the fictitious income. So they amended their New Jersey returns for the open years:
Plaintiffs timely filed amended GIT returns for 2005, 2006 and 2007. The amended returns excluded the dividend and gains income previously reported, recalculated the tax due, and claimed refunds in the amount of $1,332 for 2005, $2,886 for 2006, and $818 for 2007.
The refunds were not allowed:
According to the Director, the only relief available to victims of the Madoff fraud was to report a capital loss pursuant to N.J.S.A. 54A:5-1(c) for tax year 2008, the year in which the fraud was discovered. The latter position is consistent with the April 15, 2010 notice issued by the Division. That notice specifically took note of the Madoff Ponzi scheme and Madoff’s March 12, 2009 guilty plea. In pertinent part, the notice states:
The New Jersey Income Tax Act requires taxpayers to claim losses in accordance with their Federal method of accounting, including federal basis rules. Therefore, taxpayers must report and claim their Madoff investmentlosses for New Jersey Gross Income Tax purposes in tax year 2008. The investment loss deduction is calculated as follows, in accordance with IRS Bulletin 2009-14 and Revenue procedure 2009-20 (see Appendix A): the original investment plus income reported in prior years minus distributions received in prior years. The New Jersey Gross Income Tax Act does not follow federal law regarding carry-forward and carry-back losses and the loss on the 2008 New Jersey individual income tax return can only be netted against gains or income reported in the category Net gains or income from disposition of property.
The New Jersey argument is a little strange. It is that during the years of the fraud the taxpayers were in constructive receipt of the fictious income, because they would have gotten it if they asked for it. The Tax Court of New Jersey went with the taxapayers:
There is no way for the Director to determine which investors would have received income had they demanded it, and which investors would not have received the income. Given the substantial limitations and restrictions on the ability of plaintiffs to actually demand and receive the dividend andcapital gains income that BLMIS reported they had earned, the court concludes that plaintiffs did not and could not constructively receive the money that plaintiffs had reported as income on their GIT returns. Accordingly, the very definition of constructive receipt relied upon by the Director fails in this case.
There was never any sale, exchange or other disposition of property at all, except for the theft of some of plaintiffs’ capital investment. The gains income reported by plaintiffs and on which they paid tax was not stolen — it never existed.
