Tax Relief Proposed for Victims of Madoff-Style Fraud

Victims of Bernard Madoff’s massive Ponzi scheme and similar financial scams would be able to get tax relief under a bill recently introduced by Kendrick B. Meek, D-Fla., a member of the House Ways and Means Committee.

Enacting the measure would prove especially helpful to older Americans, who have less time to recoup retirement savings after being victimized by fraud, proponents say. The bill would permit fraud victims to go back as many as 10 years to identify and seek reimbursement for taxes paid on income that now appears to have been illusory.

Contrary to popular opinion, many victims of investor fraud like Madoff’s scheme are not wealthy. Significant numbers are middle-class workers who invested their entire savings in hopes of making their money last a lifetime. Many are widows unfamiliar with the world of finance who trusted the wrong person.

Last week on Long Island, for example, a grand jury indicted a New York financial adviser for allegedly bilking an estimated 6,000 investors, many of them blue-collar construction workers and financially unsophisticated homeowners. And in South Florida, thousands of Haitian Americans, many with modest incomes, were targeted in a $100 million Ponzi scheme, according to the Securities and Exchange Commission.

By amending Internal Revenue Service rules to let taxpayers review a decade’s worth of returns in order to offset their losses, the bill is especially designed with seniors in mind, Meek said. “While their initial investment cannot be saved,” Meek noted, “the taxes paid on that income can.”

According to his office, more than 2,000 victims of Madoff’s $50 billion fraud were Florida residents.

“These investors, many who are older Floridians from retirement communities living on a fixed income, were defrauded and now face an uncertain future,” Meek said. “They are liquidating assets, selling real estate and returning to work in the midst of an economic recession. This legislation provides some degree of relief, allowing them to recoup taxes paid on phantom income.”

Under IRS rules, fraud victims who aren’t suing to recover their losses can generally deduct up to 95 percent of their qualified losses—minus any potential recoveries from insurance or from the Securities Investor Protection Corp.—from their tax bill in the year the fraud is discovered. (The Securities Investor Protection Corp. is an industry-backed organization designed to help investors burned by failed brokerage firms.)

The IRS has advised that for 2008 returns, it will also allow victims to carry back net operating losses five years, rather than the normal three, to recover taxes paid on fraudulent investments, as long as an individual’s gross receipts are less than $15 million. Victims can also offset accumulated losses in future years.

But Meek and his cosponsors say that by extending to 10 years the “carry-back period” for net operating losses, older Americans will get a greater chance to recoup taxes paid on illusory income earned while they were in the prime of their working lives.

Suppose a fraud victim is now 65 and retired and deposited $10,000 into an investment fund she thought was legitimate. Each year for the past eight years she received $100 in income from the fund, and withdrew nothing. During that period, the victim properly paid taxes on the $800.

Suddenly, within the past year she discovers the entire $10,000 investment has been wiped out by a Ponzi scheme. The amount of reimbursement she can receive from the IRS under current guidance is limited to five years of net operating losses—and that could pose a major problem for this senior. While she was earning closer to $65,000 during her years as a full-time worker, her taxable income in retirement might only be $20,000.

Meek’s proposed measure, HR 1159, would allow her to go back up to 10 years—to when she was 55—to take the loss deduction against her periods of higher income. She would also able to go back a full decade to take a loss deduction for the taxes paid on the phantom income.

Older Americans near the end of their lives don’t have years to re-grow their investments, noted Cristina Martin Firvida, director of economic security for AARP. The proposed legislation, she said, “gives people a fighting chance to rebuild their nest eggs.

Michael Zielenziger writes about the economy for AARP Bulletin Today.