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The Tax Views Of Deadeye, The SEC's Customary Action, And Losses of Non Madoff Investors.

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Headlined to H3 3/24/09

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March 24, 2009

 Re:  The Tax Views of Deadeye, The SEC’s Customary Action, And Losses Of Non Madoff Investors.   

            Last Friday I received a phone call from a friend of 45 years standing.  I’ll call him Deadeye.  Deadeye is a brilliant fellow.  He is a crackerjack bridge player, finished first in his class in a significant eastern law school, and has spent 47 years as a tax lawyer.  Most important of all, in our youth Deadeye had one of the three best “sandlot” jump shots I ever saw.  The form was beautiful, the shot was true, he made a tremendous percentage.  Hence, Deadeye.

 

            Before he went elsewhere for law school, Deadeye and I had been in college at the same time in Ann Arbor, in different Jewish fraternities which had a real sports rivalry going. So we have actually known each other for about 53 years though we have been good friends for only 45 years, starting with the time we both practiced tax law together in the Department of Justice in Washington, D.C.  (I lasted only about four months in tax law, before giving it up for antitrust.)  So, not having spoken for about a year, when he called, Deadeye and I engaged in some of the reminiscences and banter in which we find such pleasure, everything from people we knew, to touch football games on the mall in the mid 1960s, to all the guys and their wives from the old days whom he, luckily, unlike me, manages to see frequently even now, decades and decades later. 

 

But reminiscences were not the reason he called.  Deadeye wanted to talk about an aspect of my recent post on the guidance the IRS presented last week for victims of Ponzi schemes.

 

            Deadeye’s point was tax-profound, albeit simple -- so many great ideas are really very simple, yet are great because, simple though they are, they have long managed to go unrecognized.

 

            I had used the following example in the post.  An investor puts one million dollars into Madoff 20 years ago, had paid $900,000 in tax on phantom income, and on November 30th received a statement showing $2.5 million in his account.  I had worked through what the investor lost in real economic terms, in arithmetic terms, and how much he “recouped” under the IRS’ guidance ($875,000).  But, said Deadeye the tax lawyer, shouldn’t the matter be viewed as follows?  The investor’s actual investment was one million dollars.  His actual amount of taxes paid was $900,000.  In a just world, he would receive back $900,000 in tax paid on phantom income, and $350,000 from a theft deduction on the one million dollars of stolen principal.  His total restitution via taxation would therefore be $1,250,000 -- whereas under the IRS’ safe harbor provisions it is only, as said, $875,000.

 

            I said to Deadeye that, putting aside the crucial idea that under the principle of legitimate expectations the theft deduction should be for the full two million dollars in the account on November 30th, I agreed with him.  One million dollars of actually invested principal was stolen and should qualify for a theft deduction.  Nine hundred thousand dollars of taxes was paid on income that never existed and should be returned. Simple. True. The way it should have been if one does not use the legitimate expectations principle. Deadeye is still shooting dead-on.

 

            Which leaves a question.  Why didn’t the IRS use these simple ideas when giving guidance, instead of creating the cockamamie Rube Goldberg contraption it called guidance.  Here one can only speculate.  The answer surely cannot be that the people in the IRS were not aware of the simple, true propositions put forth by Deadeye. 

 

            If I had to make a guess -- and I suppose I do -- it is because using Deadeye’s dead-on ideas would require the IRS to allow refunds of taxes paid on phantom income -- on non-income which the IRS has no constitutional right to tax -- all the way back to the beginning of the time when the investor began paying the unconstitutional tax on non income.  Judging by the IRS’ outright rejection in the guidance of use of the claim of right doctrine and its condition requiring that to use the safe harbor provisions one must give up all right to use the claim of right doctrine or the doctrine of equitable recoupment to recover prior taxes paid on the non income, and judging as well by the IRS’ additional demand that one also must give up all right to claim a refund even for the three year period currently allowed by statute, a desire not to have to give up the tax it collected over the years on the phantom income, on the non income which it had no right to tax, coupled with a desire to do at least something to help the Ponzi victims, almost surely has to be the motivating force behind the IRS’ Rube Goldberg scheme. 

 

This is only the more true when one recognizes that the underlying motivation, both legislatively and judicially, for these rights the IRS is forcing investors to give up in order to use the safe harbor rule -- as also of the tax benefit rule which, in reverse, requires taxpayers to pay tax when something happens that makes a deduction taken in a prior year improper -- is to correct the situation so that it will reflect what the tax should have been rather than what it mistakenly was.  It seems to me that the IRS is terrified that, whatever technical objections it might be able to throw up in court in order to argue that investors should not be allowed to use rules like the claim of right doctrine or equitable recoupment, the courts might allow those rules to be used because it has now been revealed to have been so wholly wrong in the end for the IRS to have collected an income tax -- an income tax on what turned out to be non income, an income tax on non earnings that never would have existed were it not for a fellow government body, the SEC. 

 

You know, maybe it was neither ignorance nor oversight that caused the IRS, in its guidance, to not even mention a rule that I learned of only a day ago and would bet even most tax lawyers don’t know (just as they knew very little on December 10th about what is beginning to be revealed to be a raft of tax rules that are extant but rarely used).  There is a doctrine called the equitable tolling doctrine, which essentially means that, if serious consideration of justice and equity require it, the statute of limitations on seeking refunds will not apply.  That doctrine would certainly seem to fit the Madoff matter, and would enable people to sue for refunds back to the beginning of their investment.

 

            The IRS simply does not want to “open up” prior tax years back to the early 2000s, the 1990s or, for some people, even earlier, and this is true even though it had no constitutional right to collect the tax in the first place.  If the prior years were opened, it would simply have to give up too much money that it had no right to collect, and whose collection was co-caused, co-enabled, by a fellow government agency.  It has thus created a Rube Goldberg scheme to force people to give up their rights in return for at least some tax relief, particularly people who cannot afford to hold out and, perhaps, at the opposite pole, people so rich that they are willing to call it a day in return for scores of millions of dollars they will get back under the guidance, either immediately or in tax carry-forwards.

 

            That, anyway would be my guess. 

 

* * * * *

 

            Now let me turn to the SEC’s public statement in 1992 that “Right now, there is no evidence of fraud,” a statement which sucked in thousands of people and billions of dollars to Madoff, a statement the SEC never retracted, not even after it began receiving extensive evidence of fraud.

 

            I have wondered for a long time whether such statements by the SEC were as rare as I thought them to be.  Somewhat neglectfully, I fear, I failed to inquire into the answer to this question. But now some of us have found out the answer in conversations with, or emails from, securities lawyers.  Such statements are never made, the professionals tell us.  Never.  Oh, on rare occasions, when a party tells it that public knowledge (via leakage?) that he is being investigated is threatening to ruin his reputation, the SEC will give a no action letter to an investigated person and let him use it as he pleases. But that is as far as the SEC goes, and is itself rare.  Usually the SEC simply closes its investigation.

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Lawrence R. Velvel is a cofounder and the Dean of the Massachusetts School of Law, and is the founder of the American College of History and Legal Studies.
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