The United States Tax Court, in Pascucci v. Commissioner, T.C. Memo. 2024-43 (Apr. 15, 2024), and subsequently the United States Court of Appeals for the Second Circuit in Pascucci v. Commissioner of Internal Revenue, No. 24-2429 (2d Cir. Nov. 12, 2025) (Summary Order), addressed the critical question of property ownership in the context of a claimed theft loss deduction stemming from the Bernard L. Madoff Ponzi scheme. The courts determined that indirect investors in variable life insurance policies, though victims of the underlying fraud, lacked the requisite property interest in the stolen funds necessary to sustain a deduction under I.R.C. § 165(c)(3).

Facts of the Case

The Petitioners, Christopher S. Pascucci and Silvana B. Pascucci, appealed the Commissioner of Internal Revenue’s (Commissioner) determination of deficiencies for tax years 2005, 2006, and 2008. The deficiencies arose from the disallowance of a claimed theft loss deduction of $8,238,674 taken on their 2008 return, which was attributable to a decline in the value of sixteen variable life insurance policies (the Policies) owned by Mr. Pascucci. This decline occurred after the Madoff Ponzi scheme exposure in December 2008.

The investment structure was multilayered and indirect. Premiums paid by Mr. Pascucci were allocated to separate accounts held by the insurance companies, Security Equity Life Insurance Co. (SELIC) and General American Life Insurance Co. (GenAm). The Private Placement Memoranda (PPMs) for both the SELIC and GenAm Policies explicitly stated that the insurance company was the legal owner of the assets in all Separate Accounts.

The insurance companies, through their separate accounts, acquired limited partnership interests in the Tremont Opportunity Fund III, LP (Tremont). Tremont subsequently invested a portion of its assets (approximately 21.64%) into the Rye Select Broad Market Series of funds (Rye Broad funds). The Rye Broad funds were "feeder funds" that invested nearly all their assets with Bernard L. Madoff Investment Securities LLC (BLMIS), from which Mr. Madoff committed his theft. The collapse of BLMIS rendered the Rye Broad investments worthless, causing a concomitant reduction in the value of the separate accounts and the cash value of the Policies.

Taxpayers’ Request for Relief

On their 2008 income tax return, the Pascuccis claimed the $8.2 million loss related to the variable life insurance policies as a theft loss deduction under I.R.C. § 165. This deduction contributed to a Net Operating Loss (NOL), which they carried back to tax years 2005, 2006, and 2007, claiming tentative refunds using Form 1045.

The core argument put forth by the Petitioners was that although they may not have owned the assets in the separate accounts under state law or the investor control doctrine, they nonetheless possessed a sufficient "property interest" and bore the "tax and economic benefits and burdens of appreciation and depreciation of the assets" to be considered the owner for purposes of claiming a theft loss deduction. Furthermore, they argued that the diminution in the value of the Policies, which they unquestionably owned, was a "loss" that "arose from theft" under section 165(a) and (e).

Tax Court’s Analysis of the Law

The Tax Court first noted that a taxpayer generally bears the burden of proving entitlement to a deduction (Welch v. Helvering, 290 U.S. 111, 115 (1933); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 85 (1992)).

The applicable statute, I.R.C. § 165(c)(3), allows a deduction for non-business losses if they arise from fire, storm, shipwreck, casualty, or theft. The Tax Court confirmed that the Commissioner conceded the occurrence of a theft (by Mr. Madoff) and the lack of a reasonable prospect of recovery by the close of 2008. The sole disputed prerequisite was whether the Pascuccis owned the property at the time it was stolen (Grothues v. Commissioner, T.C. Memo. 2002-287). The deduction is available only to the person who was the owner of the stolen property when it was criminally appropriated (Lupton v. Commissioner, 19 B.T.A. 166 (1930); Malik v. Commissioner, T.C. Memo. 1995-204).

The Tax Court discussed the investor control doctrine, which determines whether a policyholder, despite the insurance company holding legal title, should be considered the owner for tax purposes if his "incidents of ownership over those assets become sufficiently capacious and comprehensive" (Webber v. Commissioner, 144 T.C. 324, 350 (2015)). This doctrine is typically applied to determine who is taxed on the inside buildup. The court reasoned that since entitlement to a theft loss deduction attaches to the ownership of the property, the investor control doctrine is appropriate for informing the decision of whether the policyholder truly owns the assets in the separate accounts.

Application of the Law to the Facts and Conclusions

The Tax Court concluded that Mr. Pascucci did not own the assets in the separate accounts at the time of the Madoff theft.

First, the court noted that the Pascuccis did not qualify for the Revenue Procedure 2009-20 safe harbor because they were too far removed from the fraudulent arrangement. Mr. Pascucci invested in the separate accounts, which invested in Tremont, which invested in Rye Broad, which invested in BLMIS. Revenue Procedure 2009-20, § 4.03, specifies that a "qualified investor" does not include a person who invested solely in a fund (separate for tax purposes) that invested in the specified fraudulent arrangement.

Second, regarding actual ownership, the PPMs stated that the insurance companies owned the assets. Furthermore, Mr. Pascucci lacked investor control. He had no right to manage or influence the selection of investment managers or investment decisions made by Tremont. The limited rights Mr. Pascucci possessed—such as restricted ability to withdraw cash via policy loans—did not represent the "unfettered command" over the assets required for constructive ownership (Corliss v. Bowers, 281 U.S. 376, 378 (1930)). The court found that because Mr. Pascucci lacked investor control, the insurance company was the owner for tax purposes.

Third, the court rejected the argument that Tremont and Rye Broad were "merely" middlemen. Unlike the broker scenario in Jensen v. Commissioner, T.C. Memo. 1993-393, the investments by the insurance companies in Tremont were for limited partnership interests unavailable to individual investors like Mr. Pascucci. The courts found that the multiple distinct transactions separated Mr. Pascucci from ownership of the BLMIS funds.

The Tax Court concluded that while Mr. Pascucci owned the Policies, the Policies themselves were not stolen; rather, the money in BLMIS was stolen, leading to a diminution in the Policies’ value. Theft loss jurisprudence confines the deduction to the owner of the stolen property. The court observed that the Pascuccis benefitted from tax deferral on the separate accounts by successfully arguing they did not own those assets, and they cannot simultaneously claim a tax deduction available only to the owner.

Second Circuit’s Reasoning

The Second Circuit affirmed the Tax Court’s decision on appeal. Reviewing the legal rulings de novo (Alphonso v. Comm’r, 708 F.3d 344, 350 (2d Cir. 2013)), the court agreed that Petitioners did not possess a sufficient property interest in the funds stolen by Madoff to claim the deduction.

The Second Circuit emphasized that state law controls the determination of the nature of the taxpayer’s legal interest in the property (Alphonso v. Comm’r, 708 F.3d at 351, quoting United States v. National Bank of Commerce, 472 U.S. 713, 722 (1985)). Petitioners failed to demonstrate that the Policies conferred a cognizable property interest in the separate account assets under state law, noting that New York Insurance Law suggests the opposite (e.g., N.Y. Ins. Law § 4240(a)(12)).

Crucially, the Second Circuit relied on its prior holding in In Re Bernard L. Madoff Inv. Securities LLC (Madoff), 708 F.3d 422 (2d Cir. 2013). In Madoff, the court held that limited partnership interests in feeder funds (like the Rye Broad funds) did not confer an ownership interest in the money invested in BLMIS. Since the separate accounts held limited partnership interests in Tremont, which invested in Rye Broad, the connection was too tenuous.

Furthermore, the Second Circuit noted that the Tremont fund was organized under Delaware law. The Delaware Revised Uniform Limited Partnership Act, Section 17-701, dictates that a partner has no interest in specific limited partnership property (In re Marriott Hotel Props. II Ltd. P’ship, 2000 WL 128875, at *15 (Del. Ch. Jan. 24, 2000)). Thus, the Petitioners had no property interest in the money invested by Tremont, let alone the funds Madoff stole.

In summary, the Second Circuit concluded that based on the multilayered corporate structure and the applicable state laws governing partnership interests, the Tax Court correctly found that the Pascuccis lacked the necessary ownership of the stolen property to qualify for a theft loss deduction under I.R.C. § 165(c)(3).

The Pascucci decisions serve as a reminder that for losses arising from theft under I.R.C. § 165(c)(3), the chain of ownership is paramount. Like a complex relay race, if a taxpayer transfers control and legal ownership of assets to an intermediate entity (here, the insurance company’s separate account, which then invested in various partnerships), they relinquish the direct connection to the underlying property that is later stolen, even if they bear the economic risk of that theft. The courts will not disregard the existence of distinct legal entities—even in the presence of demonstrable economic harm—if those entities maintain legal title and control pursuant to state law and the investor control doctrine.

Prepared with assistance from NotebookLM.