Theft Loss Deduction Allowed for Madoff Ponzi Scheme
In Estate of Heller,1 a case of first impression, the Tax Court held that an estate was allowed a theft loss deduction under Section 2054 for property it did not own directly, but owned indirectly through a limited liability company. The decedent owned an interest in an LLC, and the LLC owned an investment account that became worthless as a result of the Madoff Ponzi scheme.
James Heller died in January 2008. At the time of his death, he owned a 99% interest in James Heller Family, LLC. Mr. Heller's daughter and son each owned a 0.5% interest in the LLC. The only asset of the LLC was an investment account with Bernard L. Madoff Investment Securities, LLC. For estate tax purposes, Mr. Heller's interest in the LLC was valued at approximately $16.6 million. Between March and November 2008, approximately $11.5 million was withdrawn from the LLC and distributed among the three members of the LLC in accordance with their respective membership percentages in the LLC. The estate's share of the distributions, approximately $11.4 million, was used to pay estate taxes.
In December 2008, Mr. Madoff was arrested and charged with securities fraud resulting from a multibillion dollar Ponzi scheme involving his investment company, Bernard L. Madoff Investment Securities. As a result of the Ponzi scheme, the LLC's investment account in Bernard L. Madoff Investment Securities, and the estate's interest in the LLC, became worthless.
The estate filed an estate tax return and claimed a theft loss deduction of approximately $5.0 million which was equal to the difference between the estate tax value of the estate's interest in the LLC as of Mr. Heller's date of death and the estate's share of the amount withdrawn from the LLC. A notice of deficiency was issued based on the determination of the IRS that the estate was not entitled to the theft loss deduction because the estate itself did not incur a theft loss during the settlement of the estate.
The issue of whether an estate is entitled to a theft loss deduction relating to property owned not by the estate but rather owned indirectly by an LLC that was owned by the estate was an issue of first impression. Section 2054 permits a deduction from the value of the gross estate for losses incurred during the settlement of an estate arising from fires, storms, shipwrecks, or other casualties, or from theft, when such losses are not compensated for by insurance or otherwise. Neither the regulations nor the legislative history relating to Section 2054 or its predecessors addressed the issue of indirect ownership.
The IRS argued that the estate was not entitled to a theft loss deduction because the LLC, not the estate, incurred the loss. In support of its position, the IRS emphasized that pursuant to New York law the LLC, not the estate, was the theft victim.
The court disagreed with the position of the IRS and its narrow interpretation of the required direct nexus between the theft victim and the person entitled to the loss deduction. The court believed that the estate was entitled to a theft loss deduction because there existed a sufficient nexus between the theft loss and the estate's loss. The court stated that the nexus between the theft and the value of the estate's interest in the LLC was direct and indisputable. The court found that the loss suffered by the estate related directly to its interest in the LLC, and that the loss incurred by the LLC was a direct result of the theft. Therefore, the court held that the estate was entitled to a deduction pursuant to Section 2054 for the theft loss incurred by the LLC.
In addition, the court stated that its holding was in accordance with the purpose of the estate tax because estate tax deductions are designed to ensure that the tax is imposed on the net estate passing from the decedent to the beneficiaries. The court stated that in this case the theft loss incurred by the LLC diminished the value of the property available to the beneficiaries of the estate. Therefore, the court held that the estate's entitlement to the Section 2054 deduction is consistent with the overall statutory scheme of the estate tax.
The court's rejection of the IRS's attempted narrow interpretation of Section 2054 seems correct as it comports with the purpose of the estate tax to impose a tax, within certain limitations, on the value of the assets actually received by the beneficiaries of the estate. It is surprising that this was a case of first impression as one would have thought the issue presented would have been previously resolved. This case will provide helpful guidance to advisors dealing with analogous factual situations in the future.
1 147 TC No. 11 (2016)
Frank Baldino is an estate planning attorney who co-chairs Lerch, Early & Brewer’s Estate Planning & Probate group in Bethesda, Maryland. His focus is on protecting the assets his clients have accumulated and minimizing federal and state tax liability. These clients range from homeowners whose property has appreciated to people with significant investment, retirement, business, and real estate holdings. For more on theft loss deductions, contact Frank at (301) 657-0175 or firstname.lastname@example.org.
This article originally appeared in the February 2017 edition of Estate Planning, a monthly periodical directed to estate planning professionals that offers readers the newest and most innovative strategies for saving taxes, building wealth, and managing assets.