Madoff IRS Issues

March 8, 2009 10:48 AM

Could a soft (no more investigating) Madoff plea deal protect the IRS from claims by victims? Didn't they pay real taxes on fake income?

Also: If the government demands that people who actually did pull out a profit pay that money back, shouldn't the IRS also pay back the money paid in taxes on that profit? I guess I'm just worried that Madoff's wife, kids and friends will be allowed to keep 'their' assets. Also: can Madoff's victims sue Mrs. Madoff in civil courts? What a mess, eh?

posted by Pennyblack to law & government (4 comments total)

I'm not sure why you think the IRS would be subject to liability here.

These types of investment vehicle (i.e. one that doesn't pay interest or dividends) only trigger income realization events when you withdraw money. An increase in stock price is not an income event, only selling that stock would be. Thus people involved in Madoff's scheme would only have triggered an income realization event when they withdrew their funds. If you paid your money into the scheme, saw that radically "increase" in "value," and then saw the whole thing disappear, you wouldn't have paid any taxes. Quite the contrary, when the scheme collapsed, that would itself be an income realization event, and the losses recorded could be used to offset income elsewhere. They've paid no taxes, so there aren't any taxes on "fake" income, rather there is a recorded loss.

As to the people who got their money out and pad taxes as a result, I'm not sure under what circumstances the government could demand that they refund the money. Under what legal theory could they do this? Assuming such investors are not guilty of any wrongdoing, why should they be penalized? Yeah, it sucks that other people didn't get out as early as they did, but as far as I know while it's illegal to operate a pyramid scheme, it isn't actually illegal to participate in one.

But Madoff's attempt to shield his ill-gotten assets by giving them to his wife and kids is not likely to be effective. It should be pretty easy to demonstrate that Madoff's relatives knew what was going on and they themselves will probably be liable for receiving the proceeds of a fraud.
posted by valkyryn at 11:48 AM on March 8

>As to the people who got their money out and pad taxes as a result, I'm not sure under what circumstances the government could demand that they refund the money.

It's known as a clawback. The idea is that all of the gains were illusory, and thus that any "gains" that were paid out need to be repaid in order to preserve the pool of money available so that all vicitims can ultimately participate in dividing up what is left. With this scheme, given its breadth and the length of time it has gone on, how far back the government and the courts are going to go is going to be an interesting question.

See Law.com, a blog, FT, NYT.
posted by yclipse at 12:23 PM on March 8

Yeah, the fallout from this is going to be messy. It will probably end up generating new case law.

No, I don't think it's a crime to get your money from a pyramid scheme but you may not be entitled to keep the money.

Certainly from a tax standpoint the way it would work is (roughly):
1998: Deposit money with Madoff
2008: Withdraw money from Madoff, file taxes on phony gains
2008-2018: Have use of money, effectively a loan from other investor-victims, pay taxes on interest/dividends/capital gains
2018: Return money in whole or part as a result of lawsuit and judgement

Basically, these people [who withdrew funds] did have use of the money, so the tax isn't illegitimate. But they'll eventually have to give it back. I don't think there's anything in the law saying they're entitled to get their taxes back.
posted by dhartung at 3:10 PM on March 8

My guess, and its only a guess, is that individuals, as cash-basis taxpayers, will have to recognize the money as income when they received it and pay taxes on it then. They may be able to claim a loss in the year when it is clawed-back. It will be a more complicated question for corporate investors, who pay taxes on a accrual-basis, i.e., pay taxes on income when they are legally entitled to it. They may be able to amend their old returns arguing that they were never really entitled to the money in the first place.
posted by rtimmel at 11:58 AM on March 9