Bernie Madoff Fraud Fallout
A Valuation Perspective
In this article, three U.S. Tax Court cases are discussed. Each case stems from the fallout which occurred after the discovery of the Madoff Ponzi scheme amounted to more than just lost investments for each of the investors. The end-effect is much more far-reaching and complex, as many investors have been forced to pay hefty legal bills in a battle to reduce their estate tax liability on monies that did not actually exist. To confound the fight, the battles are complex, and sometimes a matter of first impression for the Tax Court.
Madoff pled guilty in 2009 to federal felony charges connected to the orchestration of what is believed to be the largest Ponzi scheme in United States (U.S.) history, a $65 billion fraud that lasted for years.¬† Below are summaries of a series of cases that have been before the U.S. Tax Court since Madoff‚Äôs 2009 conviction.
At the time of his death on January 31, 2008, James Heller (the Decedent), held a 99.0 percent non-voting membership interest in the James Heller Family, LLC (JHF).¬† At the time of the Decedent‚Äôs death, the sole asset of JHF was an account in Bernard L. Madoff Securities, LLC (the Madoff Investment).
At the time of the Decedent‚Äôs death, the Decedent‚Äôs daughter, Barbara H. Freitag, and his son, Steven, P. Heller, each held a 0.5 percent interest in JHF.¬† JHF was managed by Harry H. Falk.
On December 11, 2008, Bernard Madoff, the chairman of Madoff Securities, was arrested, and the Securities and Exchange Commission issued a press release to alert the public that it had charged him with securities fraud relating to a multibillion-dollar Ponzi scheme.¬† As a result of the Ponzi scheme, JHF‚Äôs interest in the JHF Madoff account and the estate‚Äôs interest in JHF became worthless.
On April 1, 2009, the estate tamely filed a Form 706 U.S. Estate (and Generation-Skipping Transfer) Tax return on which the estate reported a $26,296,807 gross estate, including the value of the Decedent‚Äôs 99.0 percent interest in JHF (i.e., $16,560,990).¬† The estate also claimed a $5,174,990 theft loss deduction relating to the Ponzi scheme, the amount of which reflects the difference between the value of the estate‚Äôs interest in JHF reported on the estate tax return and the estate‚Äôs share in the amounts withdrawn from the JHF Madoff account.¬† Respondent on February 9, 2012, issued the estate a notice of deficiency in which respondent determined that the estate was not entitled to the $5,175,990 theft loss deduction because the estate did not incur the theft loss during its settlement.
IRC Section 2054 entitles the estate to deductions relating to ‚Äúlosses incurred during the settlement of the estate arising from theft.‚ÄĚ¬† Whether the estate is entitled to a Section 2054 theft loss deduction relating to property held by an LLC was a matter of first impression for the U.S. Tax Court (hereinafter, the Tax Court).¬† Neither regulations nor legislative history relating to Section 2054 or its predecessors address this issue.¬† Thus, the Tax Court‚Äôs analysis begins and ends with the statute.¬† While JHF lost its sole asset as a result of the Ponzi scheme, the estate, during its settlement, also incurred a loss because the value of its interest in JHF decreased from $5,175,990 to zero.
The IRS concedes that Madoff Securities defrauded JHF, but contends that the estate is not entitled to a Section 2054 deduction because JHF incurred the loss.¬† In support of this contention, respondent emphasizes that pursuant to New York law, JHF, not the estate, was the victim.¬† Section 2054, however, allows for a broader nexus (i.e., between the theft and the incurred loss) than does respondent‚Äôs narrow interpretation.¬† ‚ÄúArise‚ÄĚ is generally defined as to ‚Äúoriginate from a source.‚ÄĚ¬† Pursuant to the phrase ‚Äúarising from Section 2054, the estate is entitled to a deduction if there is a sufficient nexus between the theft and the estate‚Äôs loss.¬† See White v. Commissioner, 48 T.C. 430, 435 (1967) (finding similarity between losses caused by direct and proximate damage of a section 165(c)(3) ‚Äúother casualty‚ÄĚ and those arising from the specifically enumerated section 165(c)(3) causes).¬† It is sufficient indeed.¬† The nexus between the theft and the value of the estate‚Äôs JHF interest is direct and indisputable.¬† The loss suffered by the estate relates directly to its JFH interest, the worthlessness of which arose from the theft.¬† Thus, the Tax Court ruled that the estate was entitled to the Section 2054 deduction relating to its JHF interest.
This was the second case, at the date of this article‚Äôs writing, to reach the Tax Court concerning the huge Madoff Ponzi scheme.¬† The first case was Estate of Kessel v. Commissioner, T.C. Memo 2014-97.¬† The Kessel case was not a full Tax Court case, but rather a motion for summary judgment brought by the IRS.¬† The Kessel case also did not concern IRC Section 2054, but rather reasonably foreseeable future events, namely as they relate to the fair market value standard of value.
At the date of Decedent‚Äôs death, on July 16, 2006, he held a 4.8 million investment account with Bernie Madoff.¬† The estate timely filed their Form 706 and paid all related taxes.¬† Upon a later discovery that the Madoff investments were in fact a Ponzi scheme, the estate filed an amended Form 706 claiming a refund on estate tax paid (for the estate tax related to the Madoff investment account).¬† The Amended 706 reported a value of zero for the Madoff investments.
The IRS filed a motion for summary judgment taking the position that, under the fair market value standard, the hypothetical willing buyer and willing seller ‚Äúwould not reasonably know or foresee that Mr. Madoff was operating a Ponzi scheme at the time Decedent died.‚ÄĚ
The Tax Court denied the IRS‚Äô motion for summary judgment, stating that some in the investment community had suspected Madoff‚Äôs investments and their consistently high returns.¬† The Tax Court further stated, ‚ÄúWhether a hypothetical willing buyer and willing seller would have access to this information and to what degree this information would affect the fair market value of the Madoff account or the assets purportedly held in the Madoff account on the date Decedent died are disputed material facts.‚ÄĚ
It should be noted that the Madoff Bankruptcy Trustee classifies the estate as a ‚Äúnet winner,‚ÄĚ as they withdrew a total of over $5.5 million, while only depositing approximately $2.8 million in the Madoff investment account.¬† Further, the Trustee had brought an adversarial proceeding against the estate seeking to recover ‚Äúfictitious profits.‚ÄĚ
The final case of issue is Gladys C. Luria, deceased, and Richard C. Yeskoo as administrator v. Commissioner of Internal Revenue, which is a case pending decision.
The estate was administered by convicted fraudster, Bernard Madoff.¬† The estate‚Äôs position is that the IRS should allow a $7.4 million refund, because the taxes were originally paid on nonexistent accounts in Madoff‚Äôs Ponzi scheme.¬† The estate of Gladys Luria, a New York woman who died in 2005, said that Bernard Madoff, through Bernard L. Madoff Investment Securities, LLC, falsified documents about two investment accounts worth more than $18 million that were actually worthless at the date of the Decedent‚Äôs death.
Madoff and his brother, Peter Madoff, were made executors of the estate, which had accounts with their company that ‚Äúin fact had no value at the time of death‚ÄĚ according to court documents.¬† The estate said that the Madoff‚Äôs filed false returns in 2006 to hide the Ponzi scheme, which eventually came to light in 2008.
‚ÄúBernard Madoff breached his fiduciary duty to the estate and his legal duty under the Tax Code to file an accurate return and instead knowingly filed a false return to cover up his criminal Ponzi scheme,‚ÄĚ the suit said.
The estate field for a $7.4 million refund on taxes paid in 2009 based on the ‚Äúworthless‚ÄĚ accounts, before it received a 2013 IRS notice disallowing the refund, saying that Madoff knowingly made the certifications.¬† Originally, the estate paid $12.5 million at the time of the Decedent‚Äôs death, but after accounting for the alleged fraud, the estate said that the tax due went down to $5.1 million in 2009.
Shortly after the scheme was revealed, Bernard Madoff resigned as an executor, and Peter filed for the refund in 2009, according to court documents.¬† A new executor, Richard Yeskoo, was appointed after Peter‚Äôs resignation in 2013.¬† After accounting for the fraud, the estate said that its total value of $32.7 million was a severe overestimate, and it should be allowed the refund.
The estate noted that even aside from the fact the Madoff‚Äôs controlled the accounts and knew they were empty, a reasonable investor would have seen ‚Äúred flags‚ÄĚ such as too-consistent returns, a paper confirmation system, family members in key positions and lack of audits, and suspect the truth.
‚ÄúA willing buyer, conducting due diligence, would discover that securities in the accounts did not in fact exist,‚ÄĚ the complaint said.
The IRS did not agree with the taxpayer‚Äôs position.¬† The IRS formally disagreed in a July 2013 letter, saying the estate would not get the $7.4 million refund.
‚ÄúIt is determined that the claim for refund had no merit and is therefore fully disallowed,‚ÄĚ the IRS letter said. ¬†‚ÄúOur decision is based on the provisions of the Internal Revenue laws and regulations.‚ÄĚ
As noted above, the case has not been decided by the U.S. Tax Court.¬† The IRS has not provided comment on the case.¬† Further, the IRS noted they will not provide comment, in keeping with their policy of not providing comment on pending cases.
As evidenced by the three cases discussed above, the fallout which occurred after the discovery of the Madoff Ponzi scheme amounted to more than just lost investments for each of the investors.¬† The end-effect is much more far-reaching and complex, as many investors have been forced to pay hefty legal bills in a battle to reduce their tax liability on monies that did not actually exist.¬† To confound the fight, the battles are complex, and sometimes a matter of first impression for the Tax Court.¬† As time goes by, we will see more cases stemming from the Madoff fraud.
Peter H. Agrapides, MBA, CVA, is with the Salt Lake City, Utah, and Las Vegas, Nevada, offices of Western Valuation Advisors. Mr. Agrapides‚Äô practice focuses primarily on valuations for gift and estate tax reporting. Mr. Agrapides has experience valuing companies in a diverse array of industries. These engagements have ranged from small, family owned businesses to companies over $1 billion.
Mr. Agrapides can be reached at (801) 273-1000 ext. 2, or by e-mail to firstname.lastname@example.org.