Does Federal Estate Tax Apply on the Nothingness of a Ponzi Scheme Account?

Posted by Kathy Bazoian Phelps

     In a case arising out of the Bernard Madoff Ponzi scheme, the United States Tax Court recently considered whether federal estate tax must be paid on the amount identified on the Madoff account statement at the time of the death of the decedent account holder, or whether no tax is owed because the account really had nothing in it. Kessel v. Commissioner of Internal Revenue, 2014 Tax. Ct. Memo LEXIS 98 (May 21, 2014).

     Although no definitive answers were provided because the court simply denied the IRS’s motion for summary judgment, the opinion is thought-provoking nonetheless. The facts are that Bernard Kessel, the decedent, had an account with Madoff that was valued at $4.8 million at the time of his death in 2006. We now know that the account was actually worthless at that time because Madoff never actually invested in any securities. Kessel’s estate paid about $1.9 million in federal estate tax, but then sought a refund after the Madoff fraud was revealed in 2008.

     The executrix of Kessel’s estate had had the Madoff account appraised by an appraisal service and, based upon that report, the estate paid the tax owing. Following the demise of the Madoff scheme in 2008, however, the estate sought to recover the assets in the Madoff account. The Madoff trustee denied payment because Madoff had not actually purchased securities for the account and because about $2.7 million more than was originally invested had been withdrawn from the account, making Kessel a net winner.

     The IRS filed a motion for summary judgment, asking the court to find that the Madoff account was subject to the federal estate tax and that a hypothetical willing buyer and willing seller of the Madoff account would not reasonably know or foresee that Madoff was operating a Ponzi scheme at the time that the decedent died. The court declined to make either finding, noting that there were disputed material facts.

     On the first disputed issue, the court observed that the Court of Appeals for the State of New York “has held that the eventual discovery of Mr. Madoff’s Ponzi scheme did not dissolve a Madoff Investments account before Mr. Madoff’s Ponzi scheme began to unravel,” citing Simkin v. Blank, 968 N.E. 2d 459, 464 (N.Y. 2012). However, the court disagreed that “the Madoff account must be the property valued for Federal estate tax purposes” and reserved the issue for trial.

     On the second disputed issue, the court noted that “the value of the property to be taxed must be determined as of the time the property was transferred.” The court defined “value” as “fair market value--what a willing buyer would pay to a willing seller, both having reasonable knowledge of the relevant facts.” But the court recognized that “later occurring events affecting the value of the property transferred” might be relevant to a determination of fair market value “if they were reasonably foreseeable at the time of transfer.” However, “later occurring events not affecting value may be relevant to the determination of fair market value regardless of their foreseeability at the time of transfer.” The court reserved the issue of whether the Madoff Ponzi scheme was reasonably knowable or foreseeable before its collapse in 2008 for trial.

     The final rub in this case is that, while Kessel’s estate is fighting for a refund of the estate tax paid, it must also contend with the Madoff trustee’s fraudulent transfer claim to recover the net winnings of about $2.7 million paid to Kessel. To have paid tax on something that didn’t exist and then to get sued for more than that amount to return profits paid seems painful. If the IRS prevails, isn’t the government getting a windfall at the expense of a defrauded victim on account of Madoff’s fraud? Should investors really be required to pay a tax on nothing? We’ll have to wait and see what happens with this case at trial.