they understood the tax code. They only got caught because of an audit. all tax avoidance is about definitions, classifications, and technicalities.
I am sure they must have believed what they did was legal. Since nobody was convicted, I believe the IRS must agree that they did not deliberately brake the law. Otherwise I assume they would have been convicted.
Btw what Madoff claimed about the option strategy was a collar or a "split-strike conversion" as how they called it in the book; it's a short call+long put not a bull spread, short call to earn income and long put to protect the long position in the basket of 35 stocks in the S&P.
They didn't even know Madoff had an asset management business; all they knew was the brokerage business. And Markopolos, the whistleblower specifically asked the SEC investigators to ask Madoff for the trade tickets for his supposed option trades and then all they had to do is to check them off against OPRA tapes which would have a record of all the prices and then they would've discovered that none of the prices matched because those trade tickets were all made up and they would've uncovered the scheme. Even Bernie Madoff himself was expecting that they would at least ask for his trade tickets and he would've been screwed but they never did. Just shows you the competence of SEC and those regulatory agencies.
I'm sure they didn't file their own taxes using TurboTax . Those tax accountants they hired would know what they were doing, legal or otherwise. But taxes are funny beasts. You can find a lot of loopholes that may look legal one way but illegal the other way.
It was known that Madoff was trading "split strike synthetics" which are simply synthetic bull spreads (long call at x, short call at y). Knowing this, it was impossible to produce these monthly positive returns during bear markets as he was doing (SP500 and NDX components). I read the Fairfield Greenwich FoF pitch in 2003-4 that they had sent to my in laws. I asked him, "why would you invest in a fund that buys call spreads?"
Most interesting thing is that no other fund has figured out what Medallion does, or how it does it so well, and then copied them and so reduced the edge. In terms of comparing the two, Medallion have about 88% winning months. While Maddoff claimed about 96% winning months. Maddoff claimed a better sharpe ratio than Medallion has, but probably wasn't pulling as much out the market in absolute dollars terms.
Are you r*******? Pulling as much out of the market? Whatever that means, exactly... Madoff was on the record, in court, stating that (paraphrasing) he never traded a single contract for AUM.