Was The IRS As Culpable As The SEC In The Madoff Scam?

April 17, 2009

            This posting raises the question whether the IRS may be as culpable as the SEC and FINRA for the continued success of Madoff’s Ponzi scheme.  If the possibility raised here turns out to be true, as I suspect will be the case, this would be a disaster for the country.  For it would mean that what is perhaps the one agency which above all others must be kept competent and clean as a whistle, the agency that collects taxes, was instead a witting or unwitting facilitator of the worst kind of fraud.  The consequences of this might accurately be called incalculable.

            It is unknown to most people that, as part of its extensive authority over pension plans of all types, the IRS has the authority to approve so called non-bank custodians for IRAs and various other kinds of accounts (e.g., medical health plans).  This goes back to the Employment Retirement Income Security Act of 1974.  Congress, greatly concerned over many aspects of pension plans -- it wanted them, for example, to vest and be portable -- passed the 1974 act because

One of the most important matters of public policy facing the nation today is how to assure that individuals who have spent their careers in useful and socially productive work will have adequate incomes to meet their needs when they retire.  This legislation is concerned with improving the fairness and effectiveness of qualified retirement plans in their vital role of providing retirement income.  In broad outline, the objective is to increase the number of individuals participating in employer-financed plans; to make sure to the greatest extent possible that those who do participate in such plans actually receive benefits and do not lose their benefits as a result of unduly restrictive forfeiture provisions or failure of the pension plan to accumulate and retain sufficient funds to meet its obligations; and to make the tax laws relating to qualified retirement plans fairer by providing greater equality of treatment under such plans for the different taxpayer groups concerned.

Congress had found that problems with pension plans had included, among others, “Inadequate coverage,” “Discrimination against the self-employed and employees not covered by retirement plans,” “Inadequate vesting,” “Inadequate funding,” “Misuse of pension funds and disclosure of pension operations.”  Congress determined that “It is time for new legislation to conform the pension provisions [of prior legislation] to the present situation and to provide remedial action for the various problems that have arisen . . . .” (Emphasis added.)  Congress provided “additional rules regarding fiduciary requirements,” and relied heavily on the IRS to enforce fiduciary standards:

However, because the bill increases the administrative job of the Service in this respect, your committee believes that it is desirable to add to its administrative capability for handling pension matters.  For this reason, the committee bill provides for the establishment by the Internal Revenue Service of a separate office headed by an Assistant Commissioner of Internal Revenue to deal primarily with pension plans and other organizations exempt under section 501(a) of the Internal Revenue Code, including religious, charitable, and educational organizations.  In order to fund this new office, the bill authorizes appropriations at the rate of $70 million per year for such administrative activities.  [That is $70 million per year in 1974 dollars, which is somewhere in the neighborhood of $250 million to $350 million today.]  (Emphases added.)

            Congress decreed that, although the trustee or custodian of an IRA account is usually a bank, a nonbank could also be a trustee or custodian if the nonbank provided “evidence,” or “substantial evidence,” that it met the necessary standards.

            Under the governing instrument, the trustee of an individual retirement account generally is to be a bank (described in sec. 401(d)(1), [FN71].  In addition, a person who is not a bank may be a trustee if he demonstrates to the satisfaction of the Secretary of the Treasury that the way in which he will administer the trust will be consistent with the requirements of the rules governing individual retirement accounts.  It is contemplated that under this provision the secretary of the Treasury generally will require evidence from applicants of their ability to act within accepted rules of fiduciary conduct with respect to the handling of other people’s money; evidence of experience and competence with respect to accounting for the interests of a large number of participants, including calculating and allocating income earned and paying out distributions to participants and beneficiaries; and evidence of other activities normally associated with the handling of retirement funds.

* * * * *

Although the bill generally requires that a trustee administer an individual retirement account trust, the bill also provides that a custodial account may be treated as a trust, and that a custodian may hold the account assets and administer the trust.  Under the bill, a custodial account may be treated as a trust if the custodian is a bank (described in sec. 401(de)(1)) or other person, if he demonstrates to the satisfaction of the Secretary of the Treasury that the manner in which he will hold the assets will be consistent with the requirements governing individual retirement accounts.  Again, it is contemplated that the Secretary will require substantial evidence (as described above) to determine if a person other than a bank may act as custodian.  (Emphases added.)

            Congress further required the trustee of an IRA to file annual reports:

The bill provides that the trustee of an individual retirement account (or issuer of a retirement annuity) is to report annually to the Secretary of the Treasury regarding contributions to the account or annuity and regarding other matters as prescribed by regulations.  Your committee intends that the regulations will include a requirement that the trustee or issuer file annual information returns with the Internal Revenue Service (with copies to each individual for whose benefit a retirement account or a retirement annuity is maintained) on the amount of contributions to and distributions from the account or annuity.

            So, it is clear beyond peradventure that Congress enacted the 1974 law in order to be certain that pensions, IRAs and similar kinds of arrangements are safeguarded -- that “individuals who have spent their lives in useful and socially productive work will have adequate incomes to meet their needs when they retire.”  Subsequently, the IRS established regulations -- carrying out Congress’ purposes -- that had to be met for an institution to be approved as a nonbank custodian (NBC).  Among the regulations are ones which ensure continuity of the NBC by providing “Sufficient diversity in the ownership of an incorporated applicant,” diversity requiring that any person who owns more than 20 percent of the voting stock in [an NBC] cannot own more than 50 percent of it.  An NBC applicant also has to “demonstrate in detail its experience and competence with respect to accounting for the interests of a large number of individuals,” and must have a “separate trust division” in which “the investments of each account will not be commingled with any other property.” Also, “Assets of accounts requiring safekeeping will be deposited in an adequate vault” with “A permanent record . . . of assets deposited in or withdrawn from the vault.”  As well, the NBC “must keep its fiduciary records separate and distinct from other records.” 

In addition, by an IRS General Counsel Memorandum that was “Date Numbered: April 13, 1984” (but that also bears the date October 11, 1983), the IRS insisted that, in carrying out the duties Congress gave it, “The legal authority for the inspections of books and records of . . . [an] approved nonbank trustee for individual retirement accounts . . . is inherent in the language of the [statutory section] which allows substantive discretion to the Commissioner in the setting of standards for nonbank trustees as well as the method of enforcement of those standards.” Because the IRS had reason to believe that various nonbank trustees “may not be in compliance with the applicable requirements for nonbank trustees,” the Internal Revenue Service “propose[d] to institute a program to verify compliance of specific nonbank trustees with the applicable requirements of the regulations.”

            Thus, to carry out Congress’ desire for the safeguarding of pension plans and IRAs, the IRS established rules limiting percentages of ownership in NBCs, requiring NBCs to show expertise in relevant accounting, requiring a separate trust division, requiring a separate vault and separate records, and demanding access to an NBC’s books and records.

            All of this raises an overarching question with regard to Madoff, to wit, how in the hell did Madoff become an approved nonbank custodian for IRA accounts in 2004?

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