The Internal Revenue Service issued new rules on Tuesday that would allow victims of Ponzi schemes like the one run by Bernard Madoff to recoup some money by claiming theft losses on their tax returns for 2008.
Investors in Madoff's scheme would theoretically have been paying capital gains taxes on the profits they made from his investments. Since those profits turned out to be phony, the IRS said investors should be entitled to what amounts to a refund of those taxes.
As theft losses, investors are entitled to a much larger deduction than the normal "capital loss" deduction, which is typically capped at $3,000 per year.
Under the new rules, victims would be able to take a deduction of as much as 95 percent of the amount they invested, plus investment income they thought they had earned, subtracted from any money given back to them by the government's insurance program, the Securities Investor Protection Corporation.
The new rules were announced by IRS Commissioner Douglas Shulman in testimony to the Senate Finance Committee.
"It is unfortunate in these otherwise difficult economic times that we are here today to discuss a situation where thousands of taxpayers have been victimized by dozens of fraudulent investment schemes," Shulman told the committee.
Bernard Madoff, 70, was jailed on Thursday after pleading guilty to running the biggest investment fraud in Wall Street history that drew in as much as $65 billion over 20 years.
His sentencing on 11 criminal charges is scheduled for June 16, when he could be imprisoned for the rest of his life.
Shulman underlined that the new rules are not specific to Madoff and would apply to any victim of a Ponzi scheme, though they must be filed in 2008.
The plan also allows the "theft loss" deductions to be carried back five years for returns filed in 2008, rather than the traditional 2-year carryback for "theft loss." The extension to five years is only for small businesses with gross annual receipts of $15 million. Under IRS rules, individuals are considered small businesses.
Those who invested in a so-called "feeder fund" that in turn invested in Madoff will have to wait for the direct investor to get the money back, which will then be passed on to the original investor.
However, the rule applies for investments made with "after-tax" money, which does not include 401(k) and other retirement plans already given preferential tax treatment.
"If an investment was deductible going in, you can't take a loss going out because there weren't taxes on it," Shulman told the panel.
The announcement was well received by lawmakers.
"It's a rare day that someone can be very happy with the IRS and this is it," said Senator Charles Schumer. The New York Democrat represents many of the investors swindled by Madoff.
