Many taxpayers have incurred huge losses in their IRAs because of the alleged or admitted fraud of Bernard L. Madoff, the Stanford Financial Group and the like.1

Taxpayers can mitigate this kind of damage — to some extent — by claiming deductions for IRA losses, reversing wasted tax payments on Roth conversions, avoiding tax on amounts recovered from the Securities Investor Protection Corporation (SIPC) or the bankruptcy estate, eliminating current tax on excess distributions and minimizing the value of the IRA in their estates.

While some of the tax issues involved in handling IRA losses due to fraud are fairly clear, additional guidance is needed on others. But as we wait for this guidance, let's look at what we do know might help clients.

Deducting the Loss

The Madoff fraud and similar disasters may create some, albeit limited, opportunities to claim losses on IRAs.

To determine the tax on IRA distributions, all of an individual's IRAs must be aggregated and treated as one IRA.2 As a result, a loss may be recognized only if all IRA accounts are distributed and the amounts received are less than the individual's unrecovered basis.3 Only non-deductible contributions create basis.

Some taxpayers will be out of luck. If a taxpayer has traditional IRAs and all contributions were deductible, that individual has a zero basis and no loss deduction is possible.4

But the result may be different if the taxpayer also made non-deductible contributions. For example: let's say Trisha has a traditional IRA funded with $100,000 in deductible contributions and $50,000 in non-deductible contributions. She's taken no distributions from the IRA. Due to Madoff losses, the value of the IRA drops to $30,000 and Trisha withdraws the entire balance. She recognizes a loss of $20,000 ($50,000 basis minus the amount withdrawn).

It's much more likely that taxpayers will be able to claim losses on Roth IRAs, because all contributions to a Roth IRA are non-deductible.5 With Roth IRAs, the amount of the loss is simply the amount contributed minus the value of the assets that are distributed to the IRA owner.

A loss on an IRA is claimed as a miscellaneous itemized deduction, subject to the 2 percent floor that applies to certain miscellaneous itemized deductions on Schedule A, Form 1040.6

But don't celebrate just yet. Any losses taken on an IRA are added back to taxable income for purposes of calculating the alternative minimum tax.7 This creates a real problem, in essence making a large loss valueless.

Even if you get past all these hurdles, consider that it may not be wise to distribute all IRA assets. While taxpayers may be able to recognize a current loss, they give up the ability to defer gain on the assets remaining in the trust. And future appreciation might be considerable, given how low stocks and other assets are valued now.

In deciding whether to claim the loss, consider:

  • the amount of the deduction compared to the amount remaining in the trust; if the Madoff loss represents the bulk of the IRA's assets, the benefit of the deduction probably would outweigh the loss of tax deferral.

  • the length of time before distributions from the IRA will begin; the longer the time horizon, the greater the benefit of tax-deferred growth; and

  • whether distributions could be received without penalty.8

Roth Recharacterizations

Madoff victims may be able to save money on Roth recharacterizations. If a person converted her traditional IRA to a Roth IRA and the Roth has since declined in value (in this case because of a Madoff investment, although loss due to fraud is not a required element), she may wish to re-characterize the Roth back to a traditional IRA.

For example: let's say that in March 2008, Trisha owned a traditional IRA with a value of $2 million. A substantial portion of the assets was invested with Madoff Securities. Trisha converted the traditional IRA to a Roth IRA, creating $2 million of taxable income. When the Madoff fraud was discovered later in 2008, the real value of the IRA turned out to be only $800,000. Thus, Trisha would pay tax on $2 million yet get only $800,000 of value into a Roth IRA. The tax paid on the remaining $1.2 million would be wasted. If, however, she recharacterizes her Roth IRA by Oct. 15, 2009, she can obtain a refund of the tax paid and return the funds to a traditional IRA.9

If the Oct. 15 deadline has passed, taxpayers should consider applying for a private letter ruling to allow for a late recharacterization. Treasury Regulations Section 301.9100-3 permits the Internal Revenue Service to grant an extension of time to make a regulatory election when such extension does not meet the requirements of an automatic extension. The IRS, in Announcement 99-57,10 ruled that a re-characterization constitutes a regulatory election.

Relief will be granted when taxpayers provide evidence to establish to the IRS commissioner's satisfaction that they acted reasonably and in good faith, and that granting relief will not prejudice the government's interests.11

A taxpayer is deemed to have acted reasonably and in good faith if the individual:

  • requests relief under this section before the IRS discovers the failure to make the regulatory election;

  • failed to make the election because of intervening events beyond the taxpayer's control;

  • failed to make the election because, after exercising reasonable diligence (taking into account the taxpayer's experience and the complexity of the return or issue), the taxpayer was unaware of the necessity for the election;

  • reasonably relied on the IRS' written advice; or

  • reasonably relied on a qualified tax professional, including a tax professional employed by the taxpayer, and the tax professional failed to make, or advise the taxpayer to make, the election.12

Under Treasury Regulations Section 301.9100-3(c)(1)(i) the interests of the government are prejudiced:

  • if granting relief results in a taxpayer having a lower tax liability in the aggregate for all taxable years affected by the election than would have been if the election had been timely made (taking into account the time value of money);

  • if the election affects the tax consequences of more than one taxpayer and extending the time for making the election may result in the affected taxpayers, in the aggregate, having a lower tax liability than if the election had been timely made;

  • if a taxpayer had timely made the election to re-characterize, his tax liability would not have been more than if the late re-characterization is allowed under the ruling request; or

  • if the taxable year in which the regulatory election should have been made or any taxable years that would have been affected by the election had it been timely made are closed.13

The IRS will not deem a taxpayer to have acted reasonably or in good faith if the taxpayer uses hindsight in requesting relief. The IRS will not ordinarily grant relief if specific facts have changed since the due date for making the election that make the election advantageous to a taxpayer. If this is the case, the IRS will grant relief only when the taxpayer provides strong proof that hindsight was not involved in his decision to seek relief.14

It's difficult to say whether the IRS would allow taxpayers to make late re-characterizations under a Madoff scenario or whether the Service would consider the taxpayer to be acting in hindsight. If the dollar amount is large enough, it might be worthwhile to try to obtain a ruling to recapture the tax paid on the original Roth conversion. If a re-characterization cannot be made, a deduction for basis will be available, or even better, open years might be amended to revalue the original conversion to its true value. But this will be difficult, because the fraud was not discovered until 2008.

Rollovers

If taxpayers are able to recover some of the IRA losses from SIPC or the bankruptcy estate, it's likely they'll be able to obtain a PLR allowing the replacement of these monies into the IRA as a restorative payment.

Unfortunately, costly PLRs are necessary because, at press time, there is nothing with precedential value that specifically allows restorative payments to be disregarded when determining if the contribution limit has been reached for IRAs. We hope that the IRS will issue some guidance clearly allowing taxpayers to place these restorative payments in the IRA. But at least there are previous PLRs showing how the IRS is inclined to view these situations.

Restorative payments are payments made to replace losses to a plan that result from a fiduciary's actions when there is reasonable risk of liability for breach of a fiduciary duty under the Employee Retirement Income Security Act 15 or other applicable federal or state law. Similarly situated plan participants must be treated similarly with respect to the payments.16 Generally, payments to a defined contribution plan are restorative only if they're made to replace some or all of the plan's losses that occurred because of a fiduciary's action (or failure to act) in such a way that there's a reasonable risk of liability for breach of fiduciary duty (other than failure to remit contributions to the plan).17

In contrast, payments made to an IRA to make up for losses due to market fluctuations or poor investment returns generally are treated as contributions, not as restorative.

Past PLRs suggest the IRS will view as restorative those payments to an IRA to replace Madoff losses.

In PLRs 200738025 and 200705031, the IRS ruled that amounts received by the taxpayers — from a company to settle, at arm's length, a good faith claim of liability — constituted a restorative payment, rather than additional contributions.

In PLR 200738025, Taxpayers A and B owned IRAs maintained with Company N. Company N, through its broker, recommended the taxpayers invest their IRA accounts in three funds, later characterized as “high risk, aggressive, mutual funds.” As a result of following the broker's recommendations, Taxpayers A and B lost about two-thirds of their investments. They eventually joined with other investors in a class action against Company N and the broker. The lawsuit settled. PLR 200705031 involved similar facts.

In both cases, the IRS ruled that the payments were eligible to be transferred into the IRAs and constituted valid transactions without regard to the limitations placed on IRA contributions. In these rulings, the IRS stated that a determination of whether settlement proceeds should be treated as a replacement payment, rather than an ordinary contribution, must be based on all the relevant facts and circumstances surrounding the payment of the settlement proceeds. It cited Revenue Ruling 2002-45,18 which applied a facts-and-circumstances test to determine whether a payment to a qualified plan is a restorative payment or a plan contribution. In both private letter rulings, the IRS found it was appropriate to apply the same reasoning to IRAs.

For example, let's say a man named John suffered $500,000 of losses in his IRA due to Madoff investments. More than 60 days after the loss, he recovered $50,000 of his losses through SIPC and $100,000 through the bankruptcy estate. If he obtained a favorable PLR, he could roll over the $150,000 to his IRA and not be subject to any income taxes or an excess contribution penalty. The IRS filing fee for such a ruling is $9,000.19

Any PLR request on this subject would ask that (1) the payments received be considered restorative payments and thus not subject to the IRA contribution limits; and (2) that the taxpayer be granted an extension of the 60-day rollover period to place such amounts into the IRA.

Reducing RMDs

Madoff-inflated IRA accounts led some people to take inflated required minimum distributions (RMDs). The question now is whether they can return the excess back to their IRAs.

When RMDs are taken from IRAs, the RMD amount is based on the Dec. 31 balance of the prior year.20 In other words, if an RMD was needed for 2008, the IRA owner used the IRA balance as of Dec. 31, 2007, to calculate the correct RMD. Of course, that means that if the IRA was invested in Madoff investments, it's likely the value used to take prior RMDs was significantly inflated. So, the taxpayer would have distributed unnecessarily high RMDs for an untold number of years (that is to say, the years that Madoff was over reporting the account balances).

So, can the excess be returned to the IRA?

Generally, any amount distributed from an IRA must be rolled over to an eligible retirement plan within 60 days to avoid income tax on the distribution.21 If 60 days have passed since the RMD was distributed, the only other alternative appears to be a waiver of the 60-day requirement under Internal Revenue Code Section 408(d)(3)(I). Under this section, the Secretary may waive the 60-day requirement if the failure to waive it would be against equity or good conscience, including situations when the delay resulted from casualty, disaster or other events beyond the individual's reasonable control subject to such requirement. Revenue Procedure 2003-1622 states that other events might include errors committed by a financial institution; inability to complete a rollover due to death, disability, hospitalization, incarceration, restrictions imposed by a foreign country or postal error; the use of the amount distributed; and the time elapsed since the distribution occurred.23

Rev. Proc. 2003-16 also provides guidance on applying to the IRS for a waiver of the 60-day rollover requirement in IRC Section 408(d)(3). Such a waiver is generally obtained through the PLR process.

But no PLR is required if a financial institution receives funds on behalf of a taxpayer before the expiration of the 60-day rollover period, the taxpayer followed all procedures required by the financial institution for depositing the funds into an eligible retirement plan within the 60-day period and, solely due to an error on the part of the financial institution, the funds were not deposited into an eligible retirement plan within the 60-day rollover period. This automatic approval is granted only if: (1) the funds are deposited into an eligible retirement plan within one year from the beginning of the 60-day rollover period; and (2) if the financial institution had deposited the funds as instructed, it would have been a valid rollover.24

The IRS filing fees for such rulings is $500 if the rollover amount is less than $50,000 and $1,500 if the rollover amount is between $50,000 and $99,999. It's $3,000 for rollover amounts equal to, or more than $100,000.25

Given the circumstances, it would seem the IRS could easily decide that relief should be granted for open years under the “errors committed by financial institution” argument and allow taxpayers to place the unnecessary RMDs back into an IRA.

IRA Value at DOD

The fair market value of property for estate tax purposes is the price at which the property would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.26 So, how are the Madoff IRA losses to be valued in taxpayers' estates? If a Madoff loss was discovered before the IRA owner died, the reduced value would be reflected in the date-of-death value of his IRA. If the loss was discovered after the IRA owner died but before the six-month alternate valuation date, the lower value could be reflected on the alternate valuation date — assuming alternate valuation is otherwise available.

But if an executor elects the alternate valuation date under IRC Section 2032, any estate tax deduction for administration expenses under IRC Section 2053(b) or for theft or casualty losses under IRC Section 2054 is disallowed to the extent the item in question is, in effect, taken into account by using the alternate valuation method.27 In other words, estate tax deductions are disallowed to the extent they already are reflected in the alternate date valuation.

Guidance Needed

On March 17, 2009, the IRS issued Revenue Ruling 2009-928 and Revenue Procedure 2009-20.29 Both are designed to assist taxpayers with the income tax issues associated with the Madoff and other Ponzi schemes and investment theft losses. Similar guidance on IRAs would be welcome.

The key issues still to be resolved include:

  1. Which taxpayers can treat recovered losses as restorative payments and can these taxpayers automatically place those funds in an IRA without regard to the 60-day rollover rule?
  2. Can taxpayers make a late re-characterization of their Roth IRAs to traditional IRAs if the Roth suffered losses due to Madoff investments?

Usually it takes a while for the IRS to formulate and issue responses to questions. But the financial crisis has hit suddenly and hard, forcing surprising revelations of wrongdoing. So, we respectfully ask the IRS to move as quickly as possible. For even in the economic realm, justice delayed is often justice denied.

Endnotes

  1. Versions of this article were originally printed in Steve Leimberg's LISI Estate Planning Newsletter (Feb. 4, 2009) and (Feb. 18, 2009); www.leimbergservices.com.

  2. Internal Revenue Code Section 408(d)(2)(A). Note that traditional IRAs and Roth IRAs are treated separately. There is no need to distribute amounts in all Roth IRAs to recognize a loss on the traditional IRAs and vice versa. (IRC Section 408A(d)(4)).

  3. Internal Revenue Service Notice 89-25, 1989-1 CB 662. The reason that taxpayers must aggregate all IRAs to claim a loss is presumably to prevent them from gaining a timing advantage. Without the rule, taxpayers could cash in IRAs with losses now while deferring gain recognition on other IRAs until a later tax year.

  4. IRS Publication 590 (2008), p. 41.

  5. IRS Pub. 590 (2008), p. 42.

  6. Ibid.

  7. IRC Section 56; IRS Pub. 590 (2008), p. 42 example.

  8. IRC Section 72(t) imposes a 10 percent penalty on withdrawals before age 59 1/2.

  9. IRC Section 408A(d)(6), Treasury Regulations Section 1.408A-5.

  10. Announcement 99-57, 1999-2 CB 692.

  11. Treas. Regs. Section 301.9100-3(a).

  12. Treas. Regs. Section 301.9100-3(b).

  13. Treas. Regs. Section 301.9100-3(c)(1)(ii).

  14. Treas. Regs. Section 301.9100-3(b)(3).

  15. Employee Retirement Income Security Act of 1974 (88 Stat. 829), Public Law 93-406.

  16. Treas. Regs. Section 1.415(c)-1(b)(2)(ii)(C); regarding limitations for defined contribution plans.

  17. Ibid.

  18. Revenue Ruling 2002-45, 2002-2 CB 116.

  19. Revenue Procedure 2009-8, 2009-1 IRC 229.

  20. Treas. Regs. Section 1.401(a)(9)-5, Q&A 3.

  21. IRC Section 408(d)(3).

  22. Rev. Proc. 2003-16, 2003-1 CB 359.

  23. Rev. Proc. 2003-16, 2003-1 CB 123.

  24. Rev. Proc. 2003-16.

  25. Supra note 19.

  26. Treas. Regs. Section 20.2031-1(b).

  27. Treas. Regs. Section 20.2032-1(g).

  28. Rev. Rul. 2009-9, 2009-14 IRB.

  29. Rev. Proc. 2009-20, 2009-14 IRB.


Robert S. Keebler, far left, is a partner and chair of the Financial & Estate Planning Team and Michelle Ward is a senior consultant, both in the Appleton, Wis., office of Virchow Krause & Company, LLP. Peter Melcher is a senior manager at the firm and is based in its Milwaukee office.