News Gets a Bit Better for Victims of Madoff

Date: Wednesday, December 9, 2009
Author: Jane J. Kim, The Wall Street Journal

For some Madoff investors, the financial damage likely won't be as bad as originally feared.

Nearly a year after the massive fraud was exposed, sweetened tax breaks, payouts from the Securities Investor Protection Corp. and signs of success by the court-appointed trustee in charge of liquidating Bernard L. Madoff's firm are offering some of his investors hope for at least a partial recovery of their losses.

Irving Picard, the trustee, has recovered about $1.5 billion in assets that will go toward covering an estimated $19.4 billion in customer losses. He also has filed lawsuits to wrestle away $15 billion from some of the Madoff firm's institutional clients or individuals Mr. Picard says profited at the expense of other clients. Mr. Madoff was arrested Dec. 11, 2008, for orchestrating a Ponzi scheme.

For some Madoff investors, taxes are proving to be a saving grace. In March, the Internal Revenue Service said victims of Ponzi schemes could generally deduct nearly all of their qualified losses, including any "phantom income," in the year the fraud was discovered. In the past, such victims would typically have had to wait years to deduct their losses and could generally deduct only their principal.

Under the recently issued rules, investors who had taxable accounts with Mr. Madoff's firm can recover taxes paid in prior years by "carrying back" qualified losses for five years and applying any remaining losses against income going forward for as much as 20 years. Under prior rules, many investors had to subtract $100 and 10% of their adjusted gross income from their loss deductions, and could carry back losses only three years or forward 20 years.

"No matter how successful [Mr. Picard] is in recovering assets, it's clear that the bulk of the recompense here will be from taxes," says Robert Willens, a New York tax adviser. "It's not nearly as dire as we all feared. At the end of the day, you could recover a good 40% of your losses."

Generally, wealthier investors who paid a substantial amount of taxes in recent years and are likely to have income in the future will get the most benefit, says Barry Nagler, an accountant and attorney in Melville, N.Y. One of the firm's clients who lost between $8 million and $9 million got a refund of more than $2.3 million, Mr. Nagler says.

Separately, SIPC, which steps in to cover losses of as much as $500,000 from theft and proven unauthorized trading when a brokerage firm fails, has agreed to advance more than $500 million to Madoff victims. Some investors who held several accounts at Madoff's firm have gotten multiple SIPC checks.

David Selznick, a tax attorney in Armonk, N.Y., says he expects one client who had roughly $20 million invested with Mr. Madoff to get back about $6 million in federal and state tax refunds. The client also got a SIPC $500,000 advance, he says.

The future is murkier for many other Madoff investors, including retirees without much income-earning potential for tax offsets, and others.

Larry Leif, a retired toy and sporting-goods manufacturer in San Antonio, estimates he paid about $3 million in taxes that is mostly unrecoverable, mainly because he can't recover taxes paid earlier than five years ago. In addition, half his money with Mr. Madoff was in a retirement account and so isn't eligible for the tax deductions. "I paid taxes on my Madoff taxable account for 25 years, and the IRS is only allowing us to go back five years," says Mr. Leif. An IRS spokesman declined to comment.

Many investors who invested through so-called feeder funds, or funds that invested client money with Mr. Madoff, could also get some expanded tax benefits.

On Monday, Sen. Charles Schumer (D., N.Y.) proposed a bill that seeks to further expand the carry-back period up to six years for direct and indirect investors. The bill would, among other things, also allow investors in tax-sheltered retirement accounts to get tax relief and penalty-free hardship withdrawals.

Another issue that could affect how much Madoff victims ultimately recoup hinges on Mr. Picard's methodology for paying claims. Currently, Mr. Picard is paying claims on a "net equity" basis, or the difference between the cash customers put in and the cash they took out.

Some former Madoff customers say their claims should be based on what was shown on November 2008 account statements, which reflected balances of nearly $65 billion before the fraud collapsed. A court date is set for early February on the issue.

If Mr. Picard is forced to evaluate claims based on statement balances, "it will probably sharply reduce the residual bankruptcy estate distribution" for each claimant, says Stephen Breitstone, a Mineola, N.Y., lawyer. "Not only does it increase the number of people entitled to the share of the estate, but it also reduces, possibly to zero," the number of people whose assets can be "clawed back." If "net equity" was calculated to include fictitious profits, he says, there would probably be no "net winners," meaning people who withdrew more than their investment.

Another wild card: Mr. Picard has another year to file all his claw-back suits, and many court decisions are likely to be appealed. That means it could be years before Mr. Madoff's victims know how much they are entitled to get back.

"Some of these people will clearly be forced to file for bankruptcy, which will stop the [clawback] proceedings in their tracks," says Steven Caruso, a New York attorney. "This will still get uglier before it gets any better."

Write to Jane J. Kim at jane.kim@wsj.com