Estate Could Deduct Theft Loss Decedent's LLC Suffered in Madoff Ponzi Scheme

(Parker Tax Publishing October 2016)

The Tax Court, in an issue of first impression, held that an estate was entitled to a theft loss deduction for a loss the decedent's LLC incurred when its account with Madoff Investment Securities became worthless. The court pointed out that the estate lost value because its interest in the LLC had been reduced to zero as a result of the Madoff Ponzi scheme. Est. of Heller v. Comm'r, 147 T.C. No. 11 (2016).

Background

At the time of his death in January 2008, James Heller owned a 99 percent interest in James Heller Family, LLC (JHF). His daughter and son each held an equal share of the remaining interest in JHF. Harry Falk managed JHF, the only asset of which was an account (JHF Madoff account) with Bernard L. Madoff Investment Securities, LLC (Madoff Securities). Following Heller's death, his son, daughter, and Falk were appointed co-executors of his estate. Between March and November 2008, Falk withdrew $11,500,000 from the JHF Madoff account and distributed it according to JHF's ownership interests. The estate's share, $11,385,000, was used to pay its taxes and administrative expenses.

In December 2008, Bernard Madoff, the chairman of Madoff Securities, was arrested, and the Securities and Exchange Commission issued a press release to alert the public that it had charged him with securities fraud relating to a multibillion-dollar Ponzi scheme. In perpetuating the scheme, Madoff and his associates fabricated monthly and quarterly statements and sent them to Madoff Securities' clients. Madoff, in March 2009, admitted that he had perpetrated a Ponzi scheme through Madoff Securities and pled guilty to various federal crimes, including securities fraud, investment adviser fraud, money laundering, and perjury. As a result of the Ponzi scheme, JHF's interest in the JHF Madoff account and the estate's interest in JHF became worthless.

In April 2009, the estate filed its Form 706, United States Estate (and Generation-Skipping Transfer) Tax Return, reporting a $26,296,807 gross estate, which included the date-of-death value of Heller's interest in JHF ($16,560,990). The estate also claimed a $5,175,990 theft loss deduction relating to the Ponzi scheme, reflecting the difference between the estate's interest in JHF and its share of the amounts withdrawn from the JHF Madoff account in 2008. Following an audit, the IRS determined that the estate was not entitled to the theft loss deduction because it did not incur a theft loss during its settlement. According to the IRS, under state law, it was the LLC and not the estate that was the theft victim.

Analysis

Code Sec. 2054 provides that, in general, an estate is entitled to deductions relating to losses incurred during the settlement of the estate "arising" from theft.

The Tax Court noted that whether an estate is entitled to a Code Sec. 2054 theft loss deduction relating to property held by an LLC in which the estate has an interest was an issue of first impression. Because neither the regulations nor the legislative history relating to Code Sec. 2054 or its predecessors addressed the issue, the court stated that its analysis would begin and end with the statute.

The estate tax is imposed on the value of property transferred to beneficiaries and in that context, the court said, a loss refers to a reduction of the value of property held by an estate. The court pointed out that while JHF lost its sole asset as a result of the Ponzi scheme, the estate, during its settlement, also incurred a loss because the value of its interest in JHF decreased from $5,175,990 to zero.

The court disagreed with the IRS's argument that it was JHF and not the estate that suffered the theft loss. Code Sec. 2054, the court noted, allows for a broader nexus between the theft and the incurred loss than did the IRS's narrow interpretation. Citing the Merriam-Webster's Collegiate Dictionary, the court noted that "arise" is generally defined as "to originate from a source." Pursuant to the phrase "arising from" in Code Sec. 2054, the court said, the estate was entitled to a deduction if there was a sufficient nexus between the theft and the estate's loss. The court found the nexus between the theft and the value of the estate's JHF interest sufficient, noting that the loss suffered by the estate related directly to its JHF interest, the worthlessness of which arose from the theft.

The court stated that its conclusion was in accordance with, and buttressed by, the purpose of the estate tax. Estate tax deductions are designed to ensure that the estate tax is imposed on the net estate, which the court pointed out is the value of what passes from the decedent to the beneficiaries. The court noted that the theft extinguished the value of the estate's JHF interest, thereby diminishing the value of property available to Heller's heirs. Thus, the court determined that the estate's entitlement to a Code Sec. 2054 deduction was consistent with the overall statutory scheme of the estate tax.

For a discussion of deductions against the estate for losses, expenses, debts, and taxes, see Parker Tax ¶227,501.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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