The Serious Shortcomings Of The Guidance Issued On Tuesday By The IRS.
March 20, 2009
Re: The Serious Shortcomings Of The Guidance
Issued On Tuesday By The IRS.
Not being a tax lawyer, I am not sure that I understand all of the ins and outs of the revenue ruling and safe harbor procedure announced on Tuesday by Commissioner Shulman. (As an aside, my wife and I have known his parents since the period 1958-60, and he was nice enough to call me a few days ago to explain why he was not going to meet with me in response to a request I made. I appreciated his call.) But if, and to the extent, that I do understand things, I think the emotional exhilaration that greeted the IRS’ action is going to be replaced by disappointment and questions once there is an opportunity for sober analysis of the IRS’ action. And I am very afraid that I do understand things correctly, since, for vetting purposes, I sent this posting in advance to an accountant, three tax lawyers and a financial expert who is on the Steering Committee, with a request to notify me of any factual mistakes. Two of the five persons did notify me of errors, which I corrected, so I assume and fear that what I am saying is correct.
Many people are unhappy already since, it seems, the IRS has provided no help to those who invested through feeder funds, nor of course to non-taxpaying entities like charities, pension funds and IRAs. (Couldn’t some help have been provided to pensions and IRAs, with the help to become operative at the time people take out money from them and have to pay taxes on that money?(Or would have done this?)) But, if my analyses are right, I think that disgruntlement may spread upon reflection and sober analysis.
Let me start with an example that likely is reasonably typical -- not perfectly typical, but reasonably typical -- of many members of MadoffSurvivors and other investors in Madoff. For ease of comprehension, the example implicitly contains certain simplifying numerical assumptions to illustrate principles. For instance, the example ignores lost opportunity cost, and that tax rates used to be higher, both of which would make the situation even worse for victims. On the other side it ignores that sometimes people had an overall tax rate somewhat less than 35% because of certain kinds of non Madoff income. But I don’t think the simplifying assumptions invalidate the overall points I am trying to make.
So let’s assume that a person invested one million dollars in Madoff twenty years ago. On November 30th his account statement showed $2,500,000. Over the twenty years he paid $900,000 in taxes on his Madoff earnings. Because he could not afford to pay this tax from his non-Madoff income, he withdrew the $900,000 from Madoff to pay it.
Now, what has this investor actually lost? Forget tax argot. In American dollars and cents, in simple arithmetic, what has he lost? Well he obviously lost his one million dollars of initial investment. Under the well established principle of legitimate expectations -- which here serves as a substitute, as it were, for methods of computing lost opportunity cost that are used in finance and in litigation -- he has also lost the $1.5 million dollars of income and appreciation shown on his November 30th statement. And he has lost the $900,000 he withdrew from Madoff to pay his taxes, plus the “Madoff earnings” he would have made on that $750,000 had he not had to withdraw it to pay taxes (but for purposes of simplification I’m going to pretty much ignore those “earnings” except to note them where appropriate). So his total dollars and cents loss, his total arithmetic loss, is $3,400,000 (plus the earnings on $750,000 which I am ignoring): he has lost his initial investment of one million dollars, his appreciation of $1.5 million and the $900,000 he gave the IRS for taxes (plus, of course, the earnings on that $750,000, which I am ignoring).
So $3,400,000 is the investor’s dollars and cents loss. But what does Tuesday’s IRS guidance provide with regard to the loss? What can be taken as a theft loss deduction?
As I understand it, the initial investment of one million dollars is included in the theft loss deduction. So is the $1.5 million dollars of appreciation, because the investor paid tax on it. So now we’re up to a theft loss deduction of $2.5 million dollars. And as I and at least some others understand it, the $900,000 he withdrew to pay his taxes is also included, because he did pay tax on it. So now his theft loss is $3.4 million.
But from that $3.4 million dollars the investor must subtract his withdrawal of $900,000, which he used to pay his taxes. So his theft loss is now back to $2.5 million dollars. (The $900,000 became a wash because first it was added in calculating the theft loss and then it was subtracted. The results shown below for the investor would be worse if I am wrong in thinking that the $900,000 was included in one’s theft deduction before being subtracted. For that would mean that the theft loss is only $1.6 million - - $2.5 million minus $900,000, not $3.4 million minus $900,000).
This theft loss of $2.5 million can be taken in the 2008 tax year and can be carried back three years (not five, unless you are a small business) if it is not used up in 2008, and, if it is still not used up after the three year carryback, can be carried forward twenty years. But regardless of how many years it can be carried backwards or forward, it still is a theft loss deduction of $2,500,000, and a theft loss deduction of $2,500,000 will get you a total refund of roughly 35 percent of that amount, or $875,000. And the investor, whose real dollars and cents loss was $3,400,000, will get back only about 26 percent of his actual loss of that amount under the IRS’ guidance. ($875,000 is about 26 percent of $3.4 million.) (The percentage of recovery of one’s true loss would only be about 16 percent if you do not first add in the $900,000 when calculating the theft loss.)
The Investor will also get back $25,000 less than the tax he paid to which the IRS never had a right in the first place. Concomitantly, the IRS is not hurting since it gets to keep some of the tax money it never had a right to in the first place -- often money it would not have gotten from Madoff “earnings” if another governmental agency, the SEC, had not sucked people into Madoff by announcing in 1992 that there was no fraud. And in the time period during which it had the investor’s hundreds of thousands of dollars in tax payments, it defacto received an interest free loan of said hundreds of thousands of dollars -- and it had some part of the interest free loan for many years, for nearly two decades. (Those who say the IRS would have gotten the tax money from other earnings neglect, among other omissions, the fact that one paid tax on Madoff earnings of 35%, that other investment vehicles where income was taxed at this rate (e.g., CDs or Treasuries) earned far less than Madoff and the amount of tax therefore would have been far less, and that income from investments that earned as much as Madoff (e.g., stocks, mutual funds) was usually subject to the far lower tax rate of 15 percent -- not 35 percent.)
And the investor, who previously had the yearly income from 2.5 million dollars on which to live, will now have the yearly income from only $875,000 on which to live. His annual income on which to live could easily be as low as $26,200 at 3 percent interest on safe treasuries or CDs (the 75 year old needs safety above all else now). Not exactly a high income for someone living in New York City, South Florida or in the Los Angeles area.
(You know, the situation faced by my hypothetical member of MadoffSurvivors is worlds different from that faced by the super wealthy. Take someone who lost 100 million or 200 million (or more) in Madoff. (There, of course, were such people.) Assume that such persons had put in half the amount lost, that the other half was phantom income, and that they paid their tax on Madoff income with money from non-Madoff sources, as is likely the case for the superrich. Someone who lost 200 million dollars would have paid 35 million on taxes on the Madoff income of 100 million dollars. His theft loss deduction will be the full 200 million still in his account, which will net him 70 million dollars in tax refunds carried backwards (with his deduction perhaps being for five years, not three, because he in effect is a small business) and carried forward for 20 years. Although he doesn’t need the money, he could live pretty well on 70 million dollars of refunds. Moreover, I imagine it is possible that, although Madoff income was shown as part of his gross income on his tax return, he may in reality have paid no or little tax on it because most or all of his taxes may have been wiped out in prior years by the deductions and tax credits which the superrich and their tax lawyers know about and the superrich get. Even so, the 70 million dollar theft loss deduction will be available to our 200 million dollar man to be used to lower his taxes in the future, for twenty years. Given all this it wouldn’t shock me if the superrich, with their super political access, lobbied in favor of some such result as is provided in the IRS’ guidance. In fact, based on snippets that I’ve heard here and there, I would speculate this could well be likely. It is, however, only a speculation at this point.)
But, you say, the hypothetical small investor who belongs to MadoffSurvivors will also get back refunds of the income tax of $900,000 that he paid. Nope. Sorry. Not so under the IRS’ guidance if the investor opts to use the safe harbor provisions. Though Commissioner Shulman said that last Tuesday’s guidance did not deal with the treatment of refunds of taxes paid in prior years, in fact, as he also said, the guidance does deal with this question if you use the safe harbor provisions. If you use the safe harbor, you must pledge -- must swear -- to give up claims for income tax refunds. If you have already filed for such refunds -- as so many people have because the smart money said to send in your claim for refunds as early as possible - - you have to withdraw the filing defacto. Nor can you use the claim of right doctrine. The IRS has said in its guidance that that doctrine is not applicable to Ponzi schemes because one doesn’t have to “restore” the income to avuncular Uncle Bernie, and there is somehow some inexplicable metaphysical difference, for purposes of the claim of right doctrine, between not restoring to Madoff the money which you never physically got from him and, for example, reversing an account if you are an accrual basis taxpayer who likewise never physically got the money on which you paid tax.
And, not satisfied to rely on this total lack of logic, if you want to use the IRS’ safe harbor provisions in order to avoid the terrible hassle of possible IRS inquiry into and rejection of your claimed theft loss, the IRS requires you to pledge, to swear, that you will not seek to use the claim of right doctrine against it.
You know, it is a harsh thing to say, but although the IRS says it put out its guidance to help out investors in Ponzi schemes, and though one doesn’t doubt its sincerity (and I certainly don’t doubt Doug Shulman’s personal sincerity), at this point the IRS’ guidance nevertheless begins to look a trifle extortionate, in result if not in intent. The investor only gets back 26 percent of what he lost, and the IRS keeps a part of the tax payments to which it never had any right in the first place, which it might not have gotten but for the SEC’s complicity, and which constitute an interest free loan to it for many years. And, if you try to claw back (how’s that for an unhappy phrase) the tax payments you should never have had to make in the first place, you cannot use the safe harbor provisions to avoid being hassled and possibly having your claim rejected by the IRS regardless of whether you are attempting to use amendments to prior tax returns or the claim of right doctrine as the vehicle for seeking the clawback (that dread word again).
In addition to the safe harbor provisions requiring you to give up your claim for refunds if you want to avoid the horrible hassle of a potential IRS challenge and rejection, the provisions also have another requirement that is, to put it mildly, very onerous. You must deduct from your theft loss any potential SIPC recovery (which will of course increase the amount of ill gotten tax money the IRS will be able to keep). Well, right now many Madoff investors, maybe even most of them, cannot know whether they will get a SIPC recovery nor how much it would be. The position now occupied by so many Madoff investors is that they will get a greatly diminished or no SIPC recovery if the SIPC Trustee continues to follow his (illegal, I think) cash in/cash out basis of determining net equity, but will get a full SIPC recovery if the Trustee is ultimately required by litigation or legislation to follow the governing legal principle of “legitimate expectations,” under which investors’ net equity is calculated on the basis of the amounts shown on their November 30th statements. (This is discussed in a prior blog.)
And then there is this to cap off the onerous aspects of the IRS’ guidance - - guidance which provides the typical MadoffSurvivors investor with recovery of a relatively small percent of his losses, allows the IRS to keep some of its ill-gotten tax gains that were an interest free loan and are often attributable to the SEC’s complicity, and that imposes adverse requirements on the investor if he wishes to use the safe harbor provisions to avoid possible hassling and rejection by the IRS: Tax day is less than a month away. The investor therefore has less than a month to decide what to do -- to decide whether to use the onerous guidance -- unless he gets an extension for filing. Why do I think there could well be a lot of requests for extensions? -- at least there could be a lot of requests for extensions unless, as one tax expert has warned me, such a request will cut off one year of your carryback.
As said, I dearly hope to be wrong about lots or all of what has been written here. And what the hey, I read the materials closely, and wrote this, between two and six in the morning, thereby dramatically increasing the possibility of being mistaken. But my fear is that I’m not factually mistaken, especially since five tax experts were asked to tell me if they found errors, and I equally fear that the IRS’ guidance is really a sort of wolf in sheep’s clothing for the small man. And unless I am really, really wrong about some of what has been written here, the need for enactment of a bill like Congressman Ackerman’s, a bill allowing refunds of taxes paid on phantom income going back many years, preferably at least back to 1992 when the SEC became an aider and abettor of Madoff’s Ponzi scheme, is now more essential than ever, since the small man obtains only modest help, and suffers extensive adverse consequences, from the IRS’ supposedly helpful “guidance.”
Before I end this posting, let me make one additional comment, with regard to whether one should be allowed to recover income tax paid on phantom income. The comment is based on a thought which occurred to me at 1:30 a.m. on the night after I wrote everything preceding this.
When I was in my second year of law school in Ann Arbor in 1961-62, we had an unforgettable tax professor named L. Hart Wright (the father of the famous journalist Robin Wright.) Elhart (which is what the students called him among themselves then and now, 47 years later) had a remarkable teaching style. So I can still hear him, in response to students’ inadequate answers to some hypotheticals, boomingly quoting the 16th Amendment, which allows Congress to levy an income tax. An income tax, he would plangently say, can be levied on “all ‘incomes, from whatever source derived.’”
Think about that for a moment. The 16th Amendment to the Constitution gives Congress power to levy an income tax on all “incomes, from whatever source derived.” (Emphasis added.) It turns out that, to the extent that people did not physically withdraw appreciation in their accounts from Madoff, they never had any income from him. That is why the appreciation in one’s account is called phantom income. By not honoring claims for refunds of taxes paid on phantom income that turns out to never have existed, the government is continuing to levy a tax on non income rather than on income. The 16th Amendment does not allow this; it allows only a tax on income, not a tax on non income. To disallow refunds of taxes paid on non income is to violate the Constitution. (Thus, at least back in the day when I was teaching and was expert in constitutional law, in the 1960s and 1970s, the IRS’ demand that one give up the right to seek refunds of taxes paid on such non income as the price of using its safe harbor provisions would have been called an “unconstitutional condition.”)
Yes, there is a constitutional argument here, and I, at least, think it correct. So, nearly forty-eight years later I offer a belated thanks to Elhart -- who, ironically, did a lot of work for the IRS -- for plangently and therefore indelibly impressing on our feeble minds that an income tax lies only on “all ‘incomes, from whatever source derived.’” (Emphasis added.)*
* This posting represents the personal views of Lawrence R. Velvel. If you wish to comment on the post, on the general topic of the post, or on the comments of others, you can, if you wish, post your comment on my website, VelvelOnNationalAffairs.com. All comments, of course, represent the views of their writers, not the views of Lawrence R. Velvel or of the Massachusetts School of Law. If you wish your comment to remain private, you can email me at Velvel@VelvelOnNationalAffairs.com.
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