While State Taxing Authorities Have Shown Little Sympathy for Victims of Madoff, At Least One Court Has Disagreed – Installment 63

November 18, 2011Articles White Collar Defense & Compliance Blog

About a year ago, Installment 39 of this blog series, on the aftermath of the Madoff scandal, discussed an article by Harold Brubaker in The Philadelphia Inquirer. His article dealt with the fact that the Pennsylvania Department of Revenue had made it extraordinarily frustrating and difficult for victims of Ponzi schemes to recover state tax refunds for tax payments on income that turned out to be “fictitious profits” and illusory. Brubaker quoted a tax expert as saying that New Jersey did not even have a state tax refund process for such victims. The Brubaker article also pointed out that this approach was totally contrary to the “relatively simple process” for refunds established by the Internal Revenue Service.

Now New Jersey Tax Court Judge Gail Menyuk, in an unpublished memorandum opinion (Dalton v. Director, Division of Taxation, NJTC Docket No. 020540-2010), has disagreed with the position of the State of New Jersey to find that Madoff investors under the circumstances of the Dalton case can file amended tax returns for refunds applicable to open tax years. As discussed below, the decision has limited value as precedent for other cases. Nonetheless, Judge Menyuk provided a detailed analysis of the arguments of the parties, including the similarities and differences between federal and New Jersey income taxation principles and how they endeavor to treat losses from Ponzi schemes. In granting the plaintiff taxpayer’s motion for summary judgment and denying the Division of Taxation’s similar motion, Judge Menyuk said the following:

Because . . . [Madoff] generated no earnings and profits, the distributions reported on plaintiffs’ income tax returns could not and were not made out of earnings and profits. Moreover, the monies plaintiffs’ account was credited with receiving were not corporate distributions at all, since there were no securities in plaintiffs’ account with . . . [Madoff]. . . . The court cannot find a statutory reason why plaintiffs should not be permitted to amend and correct their returns to remove income that was never properly taxable under the GIT [New Jersey Gross Income Tax] Act and to recalculate the tax. . . .

Plaintiffs received no economic gain from the dividend and gains income reported
on their 2005, 2006, and 2007 GIT returns. They were nevertheless taxed on it. The court can find no statutory basis for prohibiting them from recovering the tax paid on that phantom income.

In a footnote to the opinion, Judge Menyuk differentiated between the case before her court and one in which the taxpayer received more in Madoff distributions than the actual principal such taxpayer invested with Madoff:

Where there was actual receipt of money in excess of capital investment, those monies could conceivably be characterized as “[i]ncome, gain or profit derived from acts or omissions defined as crimes or offenses under the laws of this State or any other jurisdiction.” N.J.S.A. 54A:5-1(o). That issue is not present in this case and the court does not decide it.

While the case is helpful guidance as to how Judge Menyuk may view the efforts of her state to retain “tax” revenues, it has very limited value as precedent for other cases, even in New Jersey. It is an unpublished memorandum opinion and can be appealed by the Division of Taxation to the New Jersey Appellate Division. Moreover, there may be other cases pending in the New Jersey Tax Court involving the same or similar facts that can be decided differently. As is true of so many issues generated by Madoff, more on this matter can be expected to unfold in the future.

[To be continued in Installment 64]