In December 2008, media outlets across the country broke the news of the largest investment fraud ever perpetrated by an individual. Bernard Madoff, former chairman of the NASDAQ (National Association of Securities Dealers Automated Quotations) had been arrested and was later charged with 11 federal crimes for swindling a combined $65 billion from individuals and investment firms. Recognizing that significant investment losses could be devastating during an economic recession, the Internal Revenue Service (IRS) in March of 2009 issued Revenue Rulings 2009-09 and 2009-20 to provide taxpayers who had investment losses from the Madoff fraud some measure of relief. This brief cites what California and similar states have done, or not done, to help victims of investment fraud.
Madoff's Ponzi Scheme
A Ponzi scheme, named after Charles Ponzi who was notorious for using this technique in the 1920's, refers to investment fraud in which investors are paid returns, not from any actual profit earned from investment, but from their own money or money paid by subsequent investors. The scheme usually lures investors by offering unusually high or consistent returns on investment.
According to federal prosecutors, Madoff's Ponzi scheme spanned almost two decades, and ensnared banks, investment firms, hedge funds, charities, universities, and individuals alike. In the end, when Madoff's scheme was exposed, individuals who invested directly with Madoff or through these firms were left holding the bag. It's estimated that investors lost as much as $65 billion1 (including $17 billion in principal). Thousands have reported losses, and some have lost their homes and life savings.
Federal law grants tax relief
In general, gains from investments are subject to capital gains taxes under both state and federal law, and loss from investments are normally treated as capital losses. For both state and federal tax purposes, taxpayers may generally only claim $3,000 of capital losses per year as an offset to income earned from other sources, known as a capital loss limitation. However, the feds subsequently changed this law.
In response to the magnitude of loss suffered by investors, the IRS issued Revenue Rulings 2009-09 and 2009-20 allowing taxpayers who directly invested with Madoff to recover some of the taxes that they paid on fictitious income. Specifically, the rulings converted Madoff investment losses from capital losses to business losses, and allowed taxpayers to apply them as net operating losses (NOLs). This conversion essentially allows taxpayers to apply investment losses as deductions against income realized in future taxable years, called a "carry forward," or as a deduction against past income, known as a "carry back", to obtain a refund of taxes. Additionally, these NOLs can generally be carried back 5 years and forward 20 years. The net effect of these changes is that Madoff victims would be able to obtain a refund on a portion of taxes paid on fictitious income, and use the remainder to offset future tax liabilities.
Other states offer similar relief
Since the rulings, states across the country with an NOL structure similar to the feds have either conformed to federal law or provided comparable relief. For example, Illinois treats Madoff losses as NOLs and has extended its carry-back and carry-forward period consistent with federal changes. Michigan, despite its budget turmoil and collapse of Detroit carmakers, provides its taxpayers a 3, 4, or 5 year carry-back and full 20-year carry-forward.
The more liberal "blue" states also have followed suit. New York fully conforms to federal law. Even Democrat-bent Massachusetts provides tax relief. Since it does not follow a fed-like NOL structure, it has chosen to refund to its citizens taxes that were paid on phantom income. Specifically, the Massachusetts Department of Revenue notice provides the following guidance "... in the case of an individual investor who paid tax in prior tax years on fictitious income from a criminally fraudulent Ponzi-type scheme, the taxpayer may submit a claim for refund from any tax paid in error by applying to the Commissioner for an abatement of the tax"2.
What about California taxpayers?
While state law allows Madoff losses to be treated as NOLs, it narrowly restricts the timeframe and the amount that can be deducted.
First, California law suspends all NOL deductions until January 1, 2013, for all taxpayers except those with adjusted gross incomes of less than $300,000, including small businesses that operate as sole proprietors or partnerships. Some may argue that suspension simply delays the time period for taking a deduction. However, without a NOL deduction during a downturn, small businesses which are critical to our economic recovery would have less money to retain or hire employees. Moreover, since California has suspended the NOL three times in the last ten years, it's conceivable that the NOL may be suspended again in 2013 or even reduced.
Second, when the suspension is lifted in 2013, NOLs may be carried back for only 2 years instead of 5. This severely limits deductions for taxpayers who had higher income in the past but, due to the recession or retirement, may not have enough income going forward to fully take the deduction. In these cases, any amount the taxpayer is unable to deduct is lost permanently.
Third, the amount of the NOL carry back is limited to 50 percent in 2013, and 75 percent in 2014. Taxpayers incur opportunity costs when carry backs are restricted, and they run the risk of losing deductions if they don't have sufficient offsetting income in the future.
Democrats thwart aid to Madoff victims
Introduced in 2011, Republican legislation (Senate Bill 157 - Anderson3) sought to give Madoff victims in California relief for taxes paid on non-existent income by: (1) conforming to federal law and providing victims similar relief; and (2) lifting the NOL suspension so that taxpayers are able to take a deduction now, during one of the worst recessions in the last two decades.
One would think that tax relief for fraud victims amid an economic recession would be a no-brainer. Not so in California. During its first committee hearing and needing 5 AYE votes to move forward, Democrats killed the bill on a 4-3 vote (3 Republicans and 1 Democrat voting AYE; 3 Democrats voting NO; and despite being present at the hearing, 2 Democrats opted to not even cast a vote, thus assisting in the defeat of the bill).
The very principle of income taxation is the imposition of taxes on income that is realized. In the Madoff case, Californians were paying taxes on fictitious and non-existent income. The victims never received income - they received a piece of paper that told them they had returns on their investments, and being law-abiding citizens, they paid taxes on those returns. Now it's discovered that the income never existed, California Democrats want to keep taxes that they were never supposed to receive in the first place.
Opponents tried to explain their NO vote citing the fiscal impact on the state and the potential for recovery of losses through the trustee appointed to liquidate Madoff's personal possessions. Essentially, they're saying it costs too much to refund the estimated $30 million4 dollars. They also claim it would be devastating to the budget. Yet the same committee just a few weeks earlier supported a number of costly bills which, apparently, they deemed more important. One required a study on the cultivation and transportation of medical marijuana. Another supported contributions for rare and endangered species. And another created a new state bureaucracy to oversee infrastructure planning. To top it off, the same Democrats who opposed refund of taxes to investment fraud victims just two weeks earlier gave public employee unions pay raises and retirement benefit increases that will cost taxpayers hundreds of millions of dollars in the long-term.
California taxpayers have suffered massive losses from Madoff's investment fraud. While other states, including Detroit's cash-strapped home state of Michigan and liberal Massachusetts, offer tax relief for Madoff victims, California adamantly refuses to give up money that rightly belongs to the taxpayers. Instead, it will use those funds to fatten public employee unions.
1 Reuters "US Prosecutors updated the size of Madoff's scheme from $50 billion to $64 billion", March 11, 2009
2 Massachusetts Department of Revenue "Notice - Individual Investors; Investments in Criminally Fraudulent Ponzi-type Schemes and Reporting of Fictitious Investment Income."
3 Authored by Senator Joel Anderson (representing El Cajon)
4 Franchise Tax Board's fiscal analysis of Senate Bill 157
For more information on this report or other Governance & Finance issues, contact Therese Twomey, Senate Republican Office of Policy at 916/651-1501.