Tax Court Set to Decide If Estate Must Pay Tax on Worthless Madoff Account.
(Parker Tax Publishing June 10, 2014)

The Tax Court rejected the IRS's request for summary judgment, opening the door for a possible refund of estate taxes if the estate can prove that a hypothetical willing buyer of a Madoff-managed investment account could have reasonably known that Madoff was operating a Ponzi scheme at the time of the decedent's death. Est. of Kessel v. Comm'r, T.C. Memo. 2014-97 (5/21/14).

In Kessel, the essential issue was whether a defined benefit pension plan consisting of purported holdings from a Madoff Ponzi scheme account had taxable value on the date of the decedent's death for estate tax purposes. The Tax Court ruled against the IRS's summary judgment motions, finding that there were issues of material fact for determining the fair market value of the plan assets and whether, at the time Mr. Kessel died, a hypothetical buyer and seller would have reasonably known that Madoff was operating a Ponzi scheme.

The estate of decedent Bernard Kessel had as an asset a defined benefit pension plan. Upon Mr. Kessel's death, the beneficiaries of the plan were Mr. Kessel's wife, Iris Steel, and his son. After Mr. Kessel's death, Iris, as executrix, contacted Madoff Investment Securities, LLC for a valuation of the pension plan account in order to file the estate's tax return. Madoff Investments sent Iris a listing of the account's securities and their prices. After requesting a valid extension to file and pay, the estate timely filed its return and reported $4.8 million as the pension funds assets; the sum Madoff Investment Securities had appraised the account.

The estate paid approximately $1.9 million in tax. When the Ponzi scheme was discovered a year later, accompanied by the resulting prosecutions and eventual collapse of Madoff Investment Services, the estate attempted but failed to recover approximately $3.2 million of assets presumably owed to the estate by Madoff Investment Securities. The appointed trustee for Madoff's business denied the pension plan's claim. Over the years, the Kessels had withdrawn approximately $5.5 million from the investment account and this was about $2.8 million more than they had deposited. As a result, the trustee also filed suit to "clawback" some of the pension plan funds transferred to the family in order to reimburse other hurt Madoff investors. As a result, the estate filed a supplemental federal estate tax return claiming the pension fund held by Madoff Investments was valueless as a result of the Ponzi scheme and requesting a refund of the tax previously paid.

The IRS denied the refund request and found the estate had greater income than reported on the return. The estate filed a petition in Tax Court arguing that the fair market value of the Madoff account was zero, not the $4.8 million the estate had reported. The IRS moved for partial summary judgment on two grounds. First, the IRS asked the Tax Court to identify the Madoff account as opposed to the Madoff account's purported holdings as the property subject to federal estate tax. Second, the IRS took the position that the Madoff account had a fair market value of $4.8 million for estate tax purposes because the existence of the Madoff Ponzi scheme was unknown at the date of the decedent's death.

The Tax Court did not agree with the IRS and held that the estate's Madoff account could be a taxable and legal interest in personal property but, until both side presented more facts at trial, the court could not decide this issue.

As to the second argument, the Tax Court said it is unclear whether a hypothetical willing buyer and seller of the Madoff account could have reasonably known or foreseen that Madoff was operating a Ponzi scheme at the time of Mr. Kessel's death. The court considered Ithaca Trust Co. v. U.S., 279 U.S. 151 (1929), in which the Supreme Court held that subsequent events may not be considered to determine date of death value of a decedent's gross estate. The Tax Court focused on how to determine the fair market value of personal property subject to federal estate tax. The fair market value standard, the court explained, is defined by what a willing buyer would pay a willing seller, both having reasonable knowledge of the relevant facts.

The court made a distinction between later occurring events affecting the value of the property transferred from later occurring events that do not affect the value, the latter which may be relevant to the determination of fair market value regardless of their foreseeability at the time of the transfer. In this vein, the court noted the fact that some people had questioned the consistent success of the Madoff investments long before the Ponzi scheme become publically known, citing to congressional committee meetings and materials. Importantly, the court rejected the IRS's contention that the Ponzi scheme was not foreseeable or knowable until it was discovered and collapsed in December 2008. Thus, the court determined there continued to be facts in dispute regarding the hypothetical buyers and sellers and what information they would have had access to for determining the fair market value of assets in the Madoff account.

The Tax Court concluded that a trial is necessary to determine whether a buyer and seller would reasonably have known or foreseen there was a Ponzi scheme at play and what affect this information would have on the fair market value of the pension account. A final ruling from the Tax Court can provide helpful guidance for taxpayers similarly situated.

The case presents one of many issues that have arisen as a result of the Madoff Ponzi scheme. Not only did many investors lose their life savings, there are ancillary matters such as taxation which carry uncertain results. If the court holds that the Madoff account value was $4.8 million at the date of his death, and thus the estate is required to pay tax on that amount, taxpayers in like positions will face serious consequences. Moreover, such a decision should raise questions about the realization and recognition of gain and loss because the estate had not actually realized any gain. (Staff Editor Parker Tax Publishing)

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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