How much is a fictitious brokerage account worth, and what happens when it loses value? The IRS and the Tax Court have struggled with issues arising from the Bernie Madoff scandal. The answer may depend on when (and how) you ask the question.
In Estate of Bernard Kessel, TC Memo 2014-97, the court denied summary judgment for the IRS when the estate requested a refund of $1.5 million of estate tax on $4.8 million of appraised account value after the Madoff trustee denied its claim to recover the account balance. The trustee took the position that investors with negative equity would be made whole before investors with positive equity received anything. Decedent died in 2006. The estate paid the tax in 2007. Decedent and his heirs had already withdrawn more than the amount deposited.
Madoff was exposed in December 2008. So the question is how much was the account worth on the date of death? The estate claimed the account had no value beyond the amount already withdrawn. The IRS argued that the account was worth the reported amount because a willing buyer and willing seller would not have reasonably know or foreseen that Madoff was operating a Ponzi scheme when Decedent died. The court found there were disputed material facts on whether Decedent had a property interest in the account and its value.
We still don’t know the estate tax value of the account. It must have been worth something if the heirs were able to withdraw $2.5 million after death. But this doesn’t necessarily mean Decedent had a transferable property interest in the account. There were no securities. Perhaps this was taxable income to the heirs but not an asset of the estate. The heirs also may have to return some of the money to pay off investors with negative equity. What then?
In Estate of James Heller (2016) 147 TC No. 11, the estate and the IRS took a different tack. Heller died in January 2008. Madoff was exposed after the estate withdrew $11.5 million from the account but before the estate filed the return. The estate claimed a $5 million theft loss deduction for the difference between the reported account value and the amount withdrawn. The IRS denied the deduction on the ground that the loss didn’t occur during the administration. See IRC §2054 (estate is entitled to deductions relating to “losses incurred during the settlement of [the estate] arising . . . from theft”). The court concluded there was a sufficient nexus between the theft and the estate’s loss.
The Heller decision seems right, but several questions remain unanswered. What happens if the heirs have to pay back some of the money? Does this reduce the estate tax value of the account, or do the heirs just get a loss deduction on their income tax returns? What happens if the heirs get money back from the Madoff trustee? Heller’s heirs have zero basis in the worthless account, so anything they get should be fully taxable. By contrast, the heirs in Kessel should have a basis in any recovery if Decedent’s interest in the account had a positive estate tax value.
In unusual situations, it’s not always clear how to report.
For more on losses and related estate tax deductions, check out CEB’s California Trust Administration §12.44 and California Estate Planning §10.54. For more on valuing property interests, see Drafting California Irrevocable Trusts §§2.20–2.24.
And to keep up with all of the recent developments, don’t miss CEB’s Estate Planning and Administration: 2016 Year in Review live in various locations and Livecast starting January 20, 2017.
Other CEBblog™ posts you may find interesting:
- No-Contest Clauses May Not Be the Deterrent You Think
- How to Amend a Trust
- Protecting Digital Assets: 6 Steps to Take on Death or Incapacity
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