Tax Court Nixes Theft Loss Deduction for Decline in Cash Value of Life Insurance Policies

(Parker Tax Publishing May 2024)

The Tax Court held that a married couple was not entitled to an $8.2 million theft loss deduction, and subsequent loss carrybacks, that resulted from a decline in the cash value of variable life insurance policies caught up in the Madoff Ponzi scheme. The court found that the couple did not own the assets at the time of the theft and thus did not qualify for the deduction. Pascucci v Comm'r, T.C. Memo. 2024-43.

Background

Bernard Madoff founded Bernard L. Madoff Investment Securities (BLMIS) in 1959. BLMIS promised investors a high rate of return using a special strategy. Madoff received billions of dollars from approximately 4,800 client accounts, including Christopher Pascucci. In 2001, Christopher began investing life insurance premiums in an entity called the Tremont Opportunity Fund III, LP (Tremont), which invested a portion of the premiums in an entity called Rye Broad Market Series (Rye Broad), which invested that portion in BLMIS.

Observation: Life insurance and annuities enjoy favorable tax treatment. Under Code Sec. 72, earnings that accrue to cash value and annuity policies - often referred to as the "inside buildup" - are not currently taxable to the policyholder (and in general are not taxable to the insurance company). The cash value of the policy thus grows more rapidly than the value of a taxable investment portfolio. The policyholder may access this value, often on a tax-free basis, by withdrawals and policy loans during the insured's lifetime. If the contract is held until the insured's death, then the insurance proceeds (the death benefit) generally are excluded from the beneficiary's income under Code Sec. 101(a).

On December 11, 2008, Madoff was arrested and charged with running one of the biggest Ponzi schemes in history through BLMIS. As of that date, Christopher owned, either directly or through trusts, 16 flexible premium variable life insurance policies (Policies). Seven of the Policies - which Christopher had owned since 1997 - were with Security Equity Life Insurance Co. (SELIC), and the other nine - owned by Christopher since 2001 - were with General American Life Insurance Co. (GenAm). Both GenAm and SELIC were acquired by Metropolitan Life Insurance Co. (MetLife) before the collapse of the Madoff Ponzi scheme. Under the express policy terms of both SELIC and GenAm, those companies owned the assets of the separate accounts during the 2008 tax year. Madoff eventually admitted that he used his clients' funds to operate the Ponzi scheme through BLMIS.

After the collapse of Madoff's Ponzi scheme, Rye Broad informed its clients that their investments were worthless. While the cash values of the Policies declined as a result of the collapse of Madoff's Ponzi scheme and the theft of Rye Broad Market Series' assets, Christopher still owned the insurance policies; GenAm and SELIC still owned (and held in the separate accounts) the limited partnership interests in Tremont; Tremont still owned the shares in Rye Broad; and Rye Broad still owned its shares in BLMIS - though the BLMIS shares and the Rye Broad shares were worthless.

The Department of Justice subsequently established The Madoff Victim Fund (MVF) to distribute more than $4 billion in assets forfeited from BLMIS and related persons to individuals who invested in, and suffered a loss resulting from the collapse of, BLMIS. The MVF program was "unique" in that it focused not on the feeder funds invested in BLMIS but on the "ultimate investor." Christopher applied for relief through the MVF and was eventually approved for an eligible loss amount of approximately $203,000 in 2018.

On their 2008 tax return, Christopher and his wife claimed a Code Sec. 165 theft loss deduction of $8.2 million and requested a refund after carrying the loss back to 2005, 2006, and 2007. They claimed that the theft loss resulted from the decline in cash value of separate accounts for the variable life insurance policies after the unraveling of Madoff's Ponzi scheme. The IRS disallowed the theft loss deduction and the NOL carrybacks.

In Webber v. Comm'r, 144 T.C. 324 (2015), the Tax Court held that while ownership of assets in the separate accounts of a variable life insurance policy is assumed to belong to the insurance company, a policyholder is considered the owner for tax purposes if his "incidents of ownership over those assets become sufficiently capacious and comprehensive." However, in Helvering v. Clifford, 309 U.S. 331 (1940), the Supreme Court held that if, after all facts and circumstances are considered, a policyholder is determined to be the owner of assets in separate accounts, then the hoped-for tax benefit to be enjoyed by the policyholder on the inside buildup is lost, and tax on the gain is not deferred. This principle is referred to as the "investor control doctrine," and it is a particular application of the general, long-held principle that tax liability attaches to ownership.

The Pascuccis appealed the IRS decision to the Tax Court, arguing that they were entitled to the theft loss deduction because they met the "sufficient nexus" standard set forth in Est. of Heller v. Comm'r, 147 T.C. 370 (2016) - in other words, Christopher had a sufficient nexus to the assets in the separate insurance policy accounts to claim a theft loss deduction. They also reasoned that they were entitled to a theft loss deduction because the Policies suffered a diminution in value because of Madoff's theft from BLMIS. The couple further relied on the Tax Court's decision in Jensen v. Comm'r, T.C. Memo. 1993-393, aff'd, 1995 PTC 528 (9th Cir. 1995), in claiming that Tremont and Rye Broad were merely middlemen through which they invested in BLMIS and thus losses associated with those investments were deductible.

While the Pascuccis initially affirmed in their briefs that Christopher lacked investor control over the assets in the separate accounts (an affirmation necessary to their avoiding taxation on the inside buildup), they subsequently argued that Christopher had sufficient "burdens and benefits" under the Policies to be considered an owner of the assets in the separate accounts.

Analysis

The Tax Court held that Christopher did not have investor control over the insurance policies and that lack of control fatally undermined his contention that he had an ownership interest sufficient to entitle him to deduct a theft loss.

With respect to the Pascuccis' argument that the court should apply the "sufficient nexus" standard set forth in Heller, the court found that Heller did not apply. The court noted that the issue in Heller was whether an estate could claim a deduction under Code Sec. 2054 (i.e., the estate tax version of the theft loss deduction) for the loss in value of an interest that the estate held in a limited liability company whose sole asset was an account with BLMIS that became worthless following the collapse of the Madoff Ponzi scheme. The applicable statute in the instant case, the court said, was Code Sec. 165(c)(3) which allows a deduction for "losses of property" while the text of Code Sec. 2054 allows a deduction for "losses incurred." According to the court, the text of Code Sec. 2054 is broad, and that text warranted a broad interpretation. On the other hand, the court said, Code Sec. 165(c)(3), which allows a deduction only for "losses of property," provides a narrower scope of loss that warrants an income tax deduction.

With respect to the Pascuccis' reliance on the Tax Court's decision in Jensen, the court noted that the taxpayers in Jensen invested in a Ponzi scheme through a broker and subsequently claimed a theft loss deduction once the Ponzi scheme collapsed. In that instance, the court said, the taxpayers were entitled to a theft loss deduction because the broker was acting as a middleman on behalf of the taxpayers. The court rejected the Pascuccis' argument that Tremont and Rye Broad were merely middlemen through which they invested in BLMIS. It would have been possible for the taxpayers in Jensen to invest in the Ponzi scheme directly without the broker, and the interposing of the middleman made no difference; that was not the case, the court said, with respect to the Pascuccis' investments in Tremont and Rye Broad.

Regarding the Pascuccis' argument that they were entitled to a theft loss deduction because the Policies suffered a diminution as a result of Madoff's theft from BLMIS, the court agreed that the Policies did indeed suffer a diminution of value as a result of Madoff's Ponzi scheme. However, the court agreed with the IRS that the multiple layers of investment in those Policies sufficiently separated Christopher from ownership of the BLMIS funds that Madoff stole.

Finally, the court noted that before the theft, the Pascuccis benefited from, and did not challenge, the fact that the assets contained in the separate accounts at issue were owned by MetLife and GenAm, and therefore, because the Pascuccis did not own those assets, they were not liable for any tax related to those assets. The Pascuccis, the court said, cannot have it both ways: They cannot simultaneously enjoy the tax deferral benefit of not owning assets in the separate accounts and also claim a tax deduction that is a benefit available only to someone who did own the assets.

For a discussion of the deductibility of losses from Ponzi-type schemes, see Parker Tax, ¶84,515.

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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