He said the guidelines will apply to victims of all Ponzi schemes - financial scams in which early investors are paid returns from money put in by later investors. But given the scope of the Madoff scandal, the IRS wanted to establish an easy system for investors to recover taxes they paid on "fictitious income," Shulman said.
Madoff investors should have reported earnings from their investments with him through the years - the scheme stretched from the early 1990s to Madoff's arrest on Dec. 11 - and thus paid taxes on those earnings. Given that some of those were "phantom" profits, investors have said they should be entitled to refunds of the taxes they paid.
Investors in some of these cases are entitled to a "theft-loss" deduction, not subject to the limits on normal capital losses from investments, according to the IRS guidelines, Shulman testified at a Senate Finance Committee hearing.
The theft-loss deduction can be taken in the year a fraud is discovered, except to the extent an investor has a "reasonable prospect" of recovering the lost money, Shulman said. Investors will be able to deduct 95 percent of their losses immediately. If they are unable to recover the remaining 5 percent, they can claim those deductions in subsequent years.
Determining the amount and timing of losses from Ponzi schemes is "factually difficult" and it can take years to determine the prospects for recovering the lost money, he noted.
Sen. Charles Schumer, D-N.Y., a member of the Finance Committee who has been pushing for tax relief for victims of Ponzi schemes, said that with the new guidelines the IRS "has done the right thing here."
"In most every area where there was a major dispute, they have sided with the victims," Schumer said. "These victims were not only sophisticated financial professionals, but also ordinary people who believed they were making safe, responsible investments for their future. The steps announced today mean victims won't owe taxes on income they never received."
If deductions claimed this year result in a "net operating loss" for taxpayers, meaning they would owe no taxes, they can apply excess deductions to prior years, getting a refund for taxes already paid. They can also use the deductions in future years to lower their tax burden, under the guidelines.
By some estimates, the IRS could be out as much as $17 billion in lost tax revenue from refunds to investors who earned fictitious profits in the Madoff scheme.
To date, about $1 billion in assets have been identified for investors, a tiny portion of the $65 billion that Madoff told his 4,800 investors he had on hand in November. Authorities say they believe the figure included what would have existed if much smaller original investments had grown for decades.
The 70-year-old disgraced money manager and former chairman of the Nasdaq Stock Market has been living in a small cell at the Metropolitan Correctional Center in lower Manhattan since he pleaded guilty Thursday to securities fraud, perjury and nine other charges. He could be sent to prison for up to 150 years at a June sentencing.
The Securities Investor Protection Corp., the industry-funded organization that steps in when brokerage firms fail, has begun sending out the first checks to Madoff victims. Investors are eligible for up to $500,000 from the organization and have until July to file claims.
Around $1.6 billion or so is currently available to SIPC.
Shulman said that investors should deduct the $500,000 they receive from SIPC from the amount they claim as a "theft loss" from their Madoff investment.
The IRS expects that statements provided to investors by Madoff's fund, showing the amounts they invested, should be sufficient documentation to establish losses for filing tax claims, he told the hearing.
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