“You
can’t cheat an honest man. He has to have larceny
in his heart in the first place.”
– W. C. Fields, 1939
Don’t cry (yet) for investors in Bernie
Madoff’s grand Ponzi scheme– or at least for
those of them who pay taxes. As bad as they may have done
in their calculated effort to beat the system by betting
with one of the stock exchange’s major market makers,
thanks to an odd feature of the US tax code they will probably
wind up losing less money than ordinary investors had by
buying shares in some of the largest companies on the New
York Stock Exchange. If an investor has a net loss in legitimate
investments, according to the tax code, it is considered
an investment capital loss, and the maximum amount he can
deduct from his other income is a piddling $3,000 annually.
So if he loses a million dollars, it will take him 334 years
to deduct it. If, on the other hand, an investor put his
million with Bernie Madoff, he could deduct the entire million
immediately from other taxes because, as far as the IRS
is concerned, it proceeded from a theft, not an investment
loss. If the investor was in a 50% bracket– with State
and local taxes– and he had other taxable income–
past or present, his bottom line loss from the million would
be only $500,000.
Consider, for example, if a prudent investor had bought
$1 million worth of shares a year ago in such blue chip
stocks as Citibank, Bank of America, AIG, Ambac, General
Motors or Barclays Bank, which fell between 81 and 90 percent
in value (as of January 19th), which, if he sold them, would
leave him with an after-tax loss of over $800,000, or, about
$300,000 more than he would have sustained if he had let
Bernie madoff swindle him out of the million.
Even better, to the extent that Madoff’s investors
paid taxes on falsified capital gains booked in their accounts
during the prior five years, they are owed tax refunds–
with interest. It also turns out that since virtually all
hedge fund partners are limited partners, the entity's theft
loss flows through to them, and they therefore can also
take advantage of the Madoff tax credit for their personal
tax returns. So as painful as it is to lose money in a Ponzi
scheme is, it is more painful to lose it in a legitimate
investments where the loss it is not tax deductible for
centuries.
The
US government stands to lose a vast amount of tax revenue
through the Madoff tax credit– as investors may deduct
billions of dollars worth of their loss against other income.
But there is also a silver lining for the government. According
to my knowledgeable source, Treasury department investigators
are now discovering that a great many of Madoff’s
investors funneled their money through off shore accounts
without reporting them. The IRS thus will be able to level
immense penalties on these tax-dodgers for hiding off shore
income–even if it was fictive income. But are tax-dodgers
really deserving of pity?
The
real victims are the tax-exempt players, especially the
legitimate philanthropies, that sunk their funds in Madoff’s
Ponzi scheme. Alas, they cannot recoup any of their losses.
The tragic flaw here was trust. Samuel Johnson adumbrated
that danger more than two centuries ago when he wrote about
the bankruptcy of merchants, that assumed the splendour
of wealth only to obtain the privilege of trading with the
stock of other men, and of contracting debts which nothing
but lucky casualties could enable them to pay; till after
having supported their appearance a while by tumultuary
magnificence of boundless traffic, they sink at once, and
drag down into poverty those whom their equipages had induced
to trust them."
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