IRS May Refund Taxes Paid on ‘Phantom’ Profits from Madoff Ponzi Scheme

Investors who lost money in the $50 billion Ponzi scheme run by Wall Street money manager Bernard Madoff are getting some breaks from the Internal Revenue Service.

The IRS is issuing new guidelines for taxpayers taken by Madoff for they should handle income taxes paid for “phantom” profits from the investments. According to the IRS, investors who paid taxes on profits they thought they were earning from Madoff’s fraudulent investments should be entitled to refunds of those funds.

Madoff pleaded guilty last week to a scheme in which he took in billions from thousands of investors who thought he was investing their money in securities. In reality, Madoff never purchased a single security for a client. Clients who were told they were earning profits and in some cases were sent fake account statements showing how much they were earning paid income taxes on the earnings, but in reality, it was all a fraud.

In Ponzi schemes, early investors are paid returns from money put in by later investors.

Theft Loss Deductions, Other Aid

Defrauded Madoff investors may also be entitled to a “theft loss” deduction not subjected to limits on capital losses from investments, typically set at $3,000  a year, according to the IRS guidelines outlined today before a Senate Finance Committee hearing. A theft loss deduction can be taken in the year a fraud is discovered, excluding funds the investor has a reasonable prospect of recovering, the IRS said.

However, the IRS guidelines caution that determining the amount and timing of losses from Ponzi schemes is “factually difficult” and could take years to sort out.

The IRS guidelines do not address one argument put forth by some Madoff investors, who content they should be allowed to amend tax returns they filed for years before discovering the theft to remove phantom income and receive a refund of taxes paid in those years.

Massive Losses Linked to Ponzi Schemes

So far, investigators have identified about $1 billion in assets for Madoff investors, a drop in the bucket of about $65 billion investigators believe he took from nearly 5,000 investors over a period of nearly 20 years. The IRS says it could be out as much as $17 billion in lost tax revenue from refunds to investors who earned fictitious profits in the Madoff scheme.

Texas billionaire Allen Stanford is accused of swindling about $8 billion from investors who bought fraudulent certificates of deposit in his Stanford International Bank. Federal authorities have said a small fraction of that amount remains in Stanford accounts to be returned to investors or paid to creditors. Stanford has not been convicted and therefore, it is unclear whether the IRS guidelines for Madoff’s investors would apply to Stanford Financial investors.

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