JOHN M. DALTON AND CATHY M. DALTON, Plaintiffs, v. DIRECTOR, DIVISION OF TAXATION, Defendant.
Docket/Court: DOCKET No. 020540-2010, Tax Court of New Jersey
Date Issued: 11/10/2011
Tax Type(s): Personal Income Tax
John M. Dalton and Cathy M. Dalton, plaintiffs, pro se
Ramanjit K. Chawla, Deputy Attorney General, for defendant (Paula T. Dow, Attorney General of New Jersey, attorney).
MENYUK, J.T.C. NOT FOR PUBLICATION WITHOUT THE APPROVAL OF THE TAX COURT COMMITTEE ON OPINIONS
This matter comes before the court on cross-motions for summary judgment. Briefly stated, plaintiffs were victims of the fraudulent Ponzi scheme perpetrated by Bernard L. Madoff (“Madoff”). Plaintiffs filed claims for refunds of gross income taxes paid by them for tax years 2005, 2006 and 2007 with respect to capital gains and dividend income reported as earned through their investments with Madoff. They learned in 2008 that, in fact, there had been no earnings, and that Madoff's reports to them of various securities transactions and income earned from those transactions were fictitious. The defendant, Director, Division of Taxation (“Director”), denied the refund claims.
Although the Director refused to stipulate explicitly to the facts surrounding the operation of the Madoff Ponzi scheme, the court concludes that he has implicitly accepted the factual underpinnings of plaintiffs' case in his official pronouncements with respect to the Madoff scheme. 1 Counsel for the Director confirmed at oral argument that there are no factual disputes as to the operation of the Madoff scheme, the timeliness of plaintiffs' refund claim, or as to the calculation of the amounts claimed as refunds. The court concludes that the record 2 is adequate to support the plaintiffs' statement of the facts, and deems those facts admitted for purposes of the motion. R. 4:46-2(b). Both parties maintain that this matter is suitable for disposition by way of summary judgment. There are no issues of material fact in dispute, and the court agrees that disposition of this matter by summary judgment is appropriate. R. 4:46-2(c).
For the following reasons, the plaintiffs' motion is granted, and defendant's motion is denied.
I find the following facts. In 2000, plaintiffs invested $655,500 with Bernard L. Madoff Investment Securities LLC (“BLMIS”). They invested an additional $40,000 in January 2003. From the time of plaintiffs' initial investment through November 2008, BLMIS supplied plaintiffs with monthly statements showing purchases and sales of securities made for their account and interest and dividends earned by investments held in their account. BLMIS also annually issued to plaintiffs Forms 1099 on which earnings from BLMIS were reported for tax purposes. For the tax years in issue here, 2005 through 2007, plaintiffs reported capital gains, interest and dividend income from their account with BLMIS on their federal income tax returns and New Jersey Gross Income Tax (“GIT”) returns. 3 On their 2005 GIT return, plaintiffs reported that dividends in the amount of $9,605 and net gains in the amount of $61,747 had been earned by their BLMIS account. For 2006, they reported $17,375 in dividend income and $84,334 in net gains earned by the BLMIS account. For 2007, they reported dividends of $9,928 and net gains of $60,157 earned by the BLMIS account. Plaintiffs paid tax on all amounts reported by them.
Commencing in 2002, plaintiffs regularly made withdrawals from their account with BLMIS. Between March 2002 and early December 2008, plaintiffs made forty-seven withdrawals totaling $572,900.
In early December 2008, Madoff was arrested, and the fraud was made public. Madoff subsequently pleaded guilty to the federal criminal charges filed against him, admitting that BLMIS had been used to operate a Ponzi scheme since the early 1990s. Madoff admitted that he had represented to clients and potential clients that he would invest their money in shares of common stock, options and other securities of large well-known corporations, and upon request, would return to them their profits and principal. In actuality, he never invested clients' funds in securities, but deposited them in a bank account. When clients wished to withdraw profits they believed they had earned, or to withdraw principal, Madoff used the money in the bank account that belonged to them or to other clients to pay the requested amount. He knowingly caused false client account statements that reflected the bogus security transactions to be created and sent to clients.
In May 2009, the bankruptcy trustee appointed to liquidate the estate of Madoff and BLMIS issued plaintiffs a check in the amount of $122,600, representing the amount of plaintiffs' capital investment with BLMIS, after deduction of all withdrawals from their account. The payment to plaintiffs was made with funds advanced to the trustee by the Securities Investor Protection Corporation (“SIPC”).
Plaintiffs timely filed amended GIT returns for 2005, 2006 and 2007. The amended returns excluded the dividend and gains income previously reported, recalculated the tax due, and claimed refunds in the amount of $1,332 for 2005, $2,886 for 2006, and $818 for 2007.
By letter dated October 1, 2009, the Director disallowed the amended returns. Plaintiffs filed an administrative protest on or about November 1, 2009. On September 29, 2010, the Director issued a final determination, upholding the denial of plaintiffs' refund claims. Plaintiffs timely appealed that determination to the Tax Court.
Plaintiffs maintain that they are entitled to refunds of taxes paid on what they contend is fictitious income. The Director responds that the dividend and capital gain income reported by plaintiffs in 2005, 2006 and 2007 was constructively received by plaintiffs and was taxable. Consequently, no refund is available.
Plaintiffs also assert that their election to treat the loss as a theft loss on their federal income tax return (which loss can be carried back and forward for federal income tax purposes, but not GIT purposes), does not preclude them from claiming refunds under the Gross Income Tax Act, N.J.S.A. 54A:1-1 to 54A:9-29 (“GIT Act”).
According to the Director, the only relief available to victims of the Madoff fraud was to report a capital loss pursuant to N.J.S.A. 54A:5-1(c) for tax year 2008, the year in which the fraud was discovered. The latter position is consistent with the April 15, 2010 4 notice issued by the Division. That notice specifically took note of the Madoff Ponzi scheme and Madoff's March 12, 2009 guilty plea. In pertinent part, the notice states:
The IRS issued a ruling which states that Madoff investment losses should be written off in tax year 2008 as a “theft loss”. The New Jersey Gross Income Tax Act does not have a theft loss provision as exists for federal law, but does allow investment losses. Individual taxpayers who invested with Madoff can only claim an investment loss in accordance with N.J.S.A. 54A:5-1c Net gains or income from the disposition of property.
The New Jersey Income Tax Act requires taxpayers to claim losses in accordance with their Federal method of accounting, including federal basis rules. Therefore, taxpayers must report and claim their Madoff investment losses for New Jersey Gross Income Tax purposes in tax year 2008. The investment loss deduction is calculated as follows, in accordance with IRS Bulletin 2009-14 and Revenue procedure 2009-20 (see Appendix A): the original investment plus income reported in prior years minus distributions received in prior years. The New Jersey Gross Income Tax Act does not follow federal law regarding carry-forward and carry-back losses and the loss on the 2008 New Jersey individual income tax return can only be netted against gains or income reported in the category Net gains or income from disposition of property.
For New Jersey purposes, Madoff investment income reported by taxpayers in prior years which was not distributed is considered to be constructively received. Taxpayers cannot amend prior year returns to eliminate this undistributed income, nor are refunds available.
The notice also included information about filing an amended return for tax year 2008.
The court considers first, the plaintiffs' primary contention that the dividend and capital gains income that they reported in tax years 2005, 2006 and 2007 never existed. To support this contention, they assert that they cannot spend it, their net worth was not increased by it, and they cannot leave it to their heirs. Plaintiffs maintain that they should be permitted to obtain a refund of the tax paid on what amounts to fictitious income.
In response, the Director contends that plaintiffs constructively received the capital gains and dividend income in the years in which that income was reported and that the income was therefore taxable in those years. He notes that plaintiffs withdrew funds from their BLMIS account in each of the tax years at issue, and presumably could have received a distribution of the dividend and capital gains income earned in each of those years had they requested it.
The Director relies on case law holding that a cash basis taxpayer must report and pay taxes on income in the year in which it is actually or constructively received. In Smoyer v. Director, Division of Taxation, 4 N.J. Tax 42 (Tax 1982), aff'd o.b., 6 N.J. Tax 251 (App. Div. 1982), aff'd o.b., 95 N.J. 139 (1983) , the Tax Court concluded that a deferred compensation installment payment received after the July 1, 1976 effective date of the GIT Act by a taxpayer who had retired before July 1, 1976 was taxable. The court noted that, under N.J.S.A. 54A:8-3(c) , a taxpayer is required to use the same accounting method that he uses for federal tax purposes. Smoyer, supra, 4 N.J. Tax at 46 .
Under federal income tax accounting methods, a cash basis taxpayer reports income in the year in which it is received. I.R.C. § 451(a) . Receipt may be actual or constructive. Treas.Reg. 1.451-1(a) (1957); 1.446-1(c)(1)(i) (1957).... A taxpayer constructively receives income when cash or property is credited to his account or is made available for withdrawal, on the giving of proper notice, and is not subject to substantial limitations or restrictions. Treas.Reg. 1.451-2(2) (1957).
The court concluded that, under the facts of the case, there were substantial limitations on the taxpayer's right to the deferred compensation income prior to its actual receipt in 1977. Consequently, the taxpayer did not constructively receive the 1977 installment prior to the July 1, 1976 effective date of the GIT Act.
See also McMenamy v. Director, Division of Taxation, 3 N.J. Tax 356 (Tax 1981), aff'd o.b., 6 N.J. Tax 250 (App. Div. 1982), aff'd o.b. 95 N.J. 139 (1983) , where the court found that the exercise of a nonqualified stock option granted prior to the effective date of the GIT Act but exercised after the effective date, produced taxable income. Relying on N.J.S.A. 54A:9-27 , which provides that the GIT Act is applicable to income occurring in taxable years ending on or after July 1, 1976, but only to the extent that the income was earned after that date, the taxpayer contended that the income had been earned prior to the effective date. The court concluded that the word “earned” “must be construed to include income which was not actually or constructively received prior to July 1, 1976.” McMenamy, supra, 3 N.J. Tax at 362 . Because it found that there were substantial limitations and contingencies that precluded the income from being constructively received prior to actual exercise of the option, the court concluded that the income had not been earned prior to July 1, 1976. Id. at 362-63.
The Director also relies on the following language contained in Fetzer Refrigeration v. United States, 437 F.2d 577, 579 (6th Cir. 1971) (quoting Ross v. Comm'r of Internal Revenue, 169 F.2d 483 (1st Cir. 1948) ): “The doctrine of constructive receipt treats as taxable income which is unqualifiedly subject to the demand of a taxpayer on the cash receipts and disbursement method of accounting, whether or not such income has actually been received in cash.'” The issue in0 Fetzer Refrigeration was whether its controlling shareowner, a cash basis taxpayer, had constructively received rental income from the corporation, which used the accrual method, in the year in which the rent obligation accrued. The court concluded that the rental income had been constructively received by the shareowner in the same year that the corporation had accrued the rental obligation because the shareowner had the unrestricted right to receive the payments.
The foregoing cases are inapposite. As a preliminary matter, the nature of this Ponzi scheme, as described in Rev. Rul. 2009-9, supra , and Rev. Proc. 2009-20, supra, (which is incorporated by reference in the Director's notice), and of Ponzi schemes in general, is that investors who demand and receive a distribution of income on their investment are not receiving income, but are receiving either their own original investment or the funds of others who have also invested in the scheme. When all or a significant number of investors demand withdrawal of their investment (and the income the investment has purportedly earned), the scheme collapses. Fortuitously, BLMIS returned to plaintiffs much of their original investment when they asked for withdrawals. However, all investors could not unqualifiedly demand and receive a complete return of capital as well as the income that had been reported as earned on the investment or the scheme would collapse. There is no way for the Director to determine which investors would have received income had they demanded it, and which investors would not have received the income. Given the substantial limitations and restrictions on the ability of plaintiffs to actually demand and receive the dividend and capital gains income that BLMIS reported they had earned, the court concludes that plaintiffs did not and could not constructively receive the money that plaintiffs had reported as income on their GIT returns. Accordingly, the very definition of constructive receipt relied upon by the Director fails in this case.
Moreover, in each of the cases discussing constructive receipt, there was no question that the income in question was “gross income” within the meaning of the GIT Act. The issue in each case was when, if at all, the income was taxable. Smoyer involved a payment of deferred compensation, includable in New Jersey gross income pursuant to N.J.S.A. 54A:5-1(a) (salaries and “other remuneration received for services rendered whether in cash or property”). McMenamy concerned the exercise of a stock option, also included in gross income as remuneration under N.J.S.A. 54A:5-1(a). The income in Fetzer Refrigeration was rental income. Although Fetzer Refrigeration is a federal tax case, the rental income involved would be gross income pursuant to N.J.S.A. 54A:5-1(d).
Plaintiffs here claim a refund of taxes paid on income originally reported as net gains from the disposition of property, pursuant to N.J.S.A. 54A:5-1(c) , which includes “[n]et gains or net income, less net losses, derived from the sale, exchange or other disposition of property ... as determined in accordance with the method of accounting allowed for federal income tax purposes.” However, there was never any gain derived from the sale, exchange or other disposition of property because the transactions reported by BLMIS on the monthly statements sent to plaintiffs and reported on Form 1099 for the tax years in issue never took place. There was never any sale, exchange or other disposition of property at all, except for the theft of some of plaintiffs' capital investment. The gains income reported by plaintiffs and on which they paid tax was not stolen — it never existed.
The remainder of the tax for which plaintiffs seek a refund was paid with respect to dividends reported by BLMIS as earned by stock purchased for plaintiffs and held for them in their BLMIS account. Again, there was no stock and there were no dividends. N.J.S.A. 54A:5-1(f) defines dividends included in gross income as “any distribution in cash or property made by a corporation out of earnings and profits ” (emphasis added). Because BLMIS 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 BLMIS.
In other words, the income reported by plaintiffs on their 2005, 2006 and 2007 GIT returns does not fall within any of the categories of gross income enumerated in N.J.S.A. 54A:5-1. 5 At oral argument, it was conceded that a taxpayer who had incorrectly reported income would be permitted to amend a GIT return to correctly state the actual income earned. 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 Act and to recalculate the tax.
The Director characterizes the relief sought by plaintiffs as an improper attempt to deduct a theft loss, and maintains that the only relief available to them is to claim a capital loss for tax year 2008, as outlined in his April 15, 2010 notice. The courts of this state have recognized the Director's expertise in the specialized and complex area of the GIT Act and have generally deferred to his interpretation of that Act. Koch v. Dir., Div. of Taxation, 157 N.J. 1, 8 (1999) . “[T]he [Director's] interpretation of the operative [tax] law is entitled to prevail, so long as it is not plainly unreasonable.” Metromedia, Inc. v. Dir., Div. of Taxation, 97 N.J. 313, 327 (1984) . “However, this deference is 'not total, as the courts remain the 'final authorities' on issues of statutory construction and are not obliged to 'stamp' their approval of the administrative interpretation.'” Koch, supra, 157 N.J. at 8 (citations omitted). The court concludes that the Director's position, as applied to plaintiffs' claim for a refund, is plainly unreasonable.
In its April 15, 2010 notice, the Division asserted that “taxpayers who invested with Madoff can only claim an investment loss in accordance with N.J.S.A. 54A:5-1(c) ,” that is, in the category of gross income for net gains or income from the disposition of property. Neither the notice nor the Director's motion papers or its counsel at oral argument explained how property that never existed and that was not actually or constructively received by the plaintiffs can be converted into a loss that must be reported pursuant to N.J.S.A. 54A:5-1c.
The Division's notice references (without citation) Rev. Rul. 2009-9, supra , and also Rev. Proc. 2009-20, 2009-14 I.R.B. 749 (with citation). The Director maintains that, because the GIT Act requires taxpayers to claim losses in accordance with their federal method of accounting, including federal basis rules, they must report and claim their Madoff losses for GIT purposes in tax year 2008, calculated in accordance with Rev. Proc. 2009-20.
Initially, Rev. Rul. 2009-9 explicitly concludes that Ponzi scheme investment losses such as those incurred by investors in BLMIS are theft losses rather than investment losses. 2009-14 I.R.B., supra at 735-36. The federal tax code explicitly provides for the tax treatment of theft losses. I.R.C. § 165(c)(3) . As noted in the Director's notice, the GIT Act, unlike the federal tax code, makes no provision for theft losses. Although no authority is cited, the Director presumably relies on judicial constructions of the GIT Act that have concluded that “when the Legislature intended to incorporate federal income tax concepts, it did so explicitly.” Smith v. Dir., Div. of Taxation, 108 N.J. 19, 33 (1987) . Because the GIT Act makes no provision for theft losses, the Director's notice instructs taxpayers that Madoff Ponzi scheme losses must be treated as investment losses.
The notice, then, is self-contradictory, because it advises taxpayers that they must follow federal procedure for theft losses, even though the GIT Act does not recognize theft losses. Moreover, while Rev. Rul. 2009-9 states that the Madoff Ponzi scheme losses are not investment losses, the Director's notice nevertheless directs taxpayers to treat the same losses as investment losses. There is no principled reason why taxpayers should be required to use a federal procedure that relies upon federal tax code concepts that are not recognized by the GIT Act.
Rev. Proc. 2009-20 provides an optional safe harbor treatment for victims of the Madoff and other Ponzi schemes. 2009-14 I.R.B. , supra at 749 (emphasis supplied). It notes that use of the procedure “avoids potentially difficult problems of proof in determining how much income reported in prior years was fictitious or a return of capital, and alleviates compliance and administrative burdens on both taxpayers and the [IRS].” Ibid. However, Rev. Proc. 2009-20 explicitly provides that a taxpayer that chooses not to utilize the safe harbor procedure, “and that files or amends federal income tax returns for years prior to the discovery year to exclude amounts reported as income to the taxpayer from the investment arrangement must establish that the amounts sought to be excluded in fact were not income that was actually or constructively received by the taxpayer.” 2009-14 I.R.B., supra at 751. In other words, the IRS permits taxpayers to file amended returns claiming refunds with respect to tax paid on amounts previously reported as income. In the case now before the court, there is no question that amounts returned to plaintiffs by BLMIS consisted solely of a return of their capital investment.
Plaintiffs acknowledge that that they followed Rev. Proc. 2009-20 with respect to their federal tax return for 2008. 6 They had no loss on their capital investment with BLMIS either for federal income tax or GIT purposes because they had withdrawn part of their investment from BLMIS, and had been reimbursed for the remainder by SIPC. Pursuant to Appendix A to Rev. Proc. 2009-20, 2009-14 I.R.B. at 753, however, plaintiffs were able to increase the basis of their federal loss by the amount of income reported in prior years. As a consequence, they reported a significant loss as a consequence of interest, dividend and capital gains income previously reported on their federal tax returns. Pursuant to Rev. Rul. 2009-9, 2009-14 I.R.B. 737, that loss can be carried back three years and forward twenty years for federal tax purposes.
However, under the GIT Act, plaintiffs can only net a 2008 loss against a 2008 gain reported pursuant to N.J.S.A. 54A:5-1(c). N.J.S.A. 54A:5-2. As noted by the Director in his notice, the GIT Act makes no provision for the carry back or the carry forward of capital losses. Plaintiffs had no N.J.S.A. 54A:5-1(c) gain in 2008. Accordingly, plaintiffs would have received no GIT benefit from the characterization as a loss in 2008 of the dividend and capital gains income purportedly received by them in 2005 through 2007, as they were permitted to do for federal tax purposes pursuant to Rev. Proc. 2009-20.
In Koch, supra 157 N.J. at 9 , the court concluded that the GIT Act was intended only to tax transactions from which a taxpayer recognizes an economic gain. Id. at 9. It therefore rejected the Director's position that a taxpayer was obliged to use his federal basis in reporting a gain on the sale of a partnership interest, where the effect was to tax return on capital in addition to the economic gain on the sale. Id. at 14. Similarly, in Moroney v. Director, Division of Taxation, 376 N.J. Super. 1 (App. Div. 2005) , the Appellate Division affirmed the Tax Court's conclusion that, in determining the net gain from the sale of rental property for GIT Act purposes, the taxpayers must be permitted to increase their federal adjusted basis by the “cumulative allowed and allowable depreciation deductions that were not utilized by the taxpayers in computing net income” for GIT Act purposes during the years of ownership. Id. at 3.
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. They derive no GIT benefit from the larger loss resulting from application of Rev. Proc. 2009-20. There is no statutory reason that they should be compelled to utilize that procedure for GIT purposes.
For the foregoing reasons, plaintiffs' motion for summary judgment is granted and the Director's motion is denied. An order will be sent by separate cover.
Specifically, the Division of Taxation issued a notice on April 15, 2010, referencing an “IRS ruling.” Although not cited, the ruling in question is Rev. Rul. 2009-9, 2009-14 I.R.B. 735 (April 6, 2009). That ruling, in turn, incorporates a factual statement describing a Ponzi scheme operation that is substantially the same as Madoff's as he explained it in his plea allocution. Plaintiffs rely on the plea allocution as published in the media as factual support for the details of the fraud perpetrated on them.
The record consists of the certification of an employee of the Division of Taxation, to which are appended certain documents generated in connection with plaintiffs' administrative protest of the denial of their refund claim, and the certification of the deputy attorney general representing the Director in this action, to which are appended the defendant's interrogatories and document demands served on plaintiffs, and plaintiffs' responses to those discovery requests. As initially submitted to the court in connection with this motion, the latter certification appended only selected documents supplied by plaintiffs in discovery, but noted that all documents would be supplied at the request of the court. The court did request complete copies of the additional documents, which were promptly delivered to the court.
Interest said to have been earned by securities held in the BLMIS account was reported on the GIT returns as tax exempt income from treasury bills. Consequently, no tax was paid with respect to that income and plaintiffs make no claim for a refund with respect to tax paid on that income.
See Gross Income Tax — Ponzi Schemes-Madoff, http://www.state.nj.us/treasury/taxation/madoff_notice.shtml (last visited October 31, 2011). The notice indicates that it was “updated” on April 15, 2010. That statement is the only one that could be located by the court on the website of the Division of Taxation, and neither party has provided or referred to an earlier statement. At oral argument, when asked about the date of the notice, neither party could identify any earlier advice given by the Division with respect to the Madoff Ponzi scheme.
The court recognizes that plaintiffs' refund claim is distinguishable from those of Madoff victims who received some return from BLMIS in addition to their capital investment. 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.
Neither party has supplied the court with plaintiffs' 2008 federal income or GIT returns.