March 17 (Bloomberg) -- Investors allegedly defrauded by Bernard Madoff and R. Allen Stanford will be allowed to claim theft losses as deductions on their tax returns, Internal Revenue Service Commissioner Douglas Shulman said.

Shulman told the Senate Finance Committee today the agency is explaining how losses can be claimed and is creating procedures for investors who may need to amend their tax returns.

“The IRS is today issuing guidance articulating the tax rules that apply and providing ‘safe harbor’ procedures for taxpayers who sustained losses in certain investment arrangements discovered to be criminally fraudulent,” Shulman said.

The guidance classifies the losses as theft losses rather than capital losses, giving most victims a bigger deduction. In addition, a special limitation that sometimes reduces deductions by 10 percent won’t apply, according to the new guidance.

“They can be utilized immediately,” Shulman said.

Madoff, 70, pleaded guilty to bilking investors around the world even as he promised steady returns, including fictitious capital gains he may have falsely reported to the IRS. Many of Madoff’s investors were charities and pension funds that were tax exempt and wouldn’t be owed a refund.

Stanford, 58, is accused by the Securities and Exchange Commission of running an $8 billion Ponzi scheme through an offshore bank in Antigua that offered certificates of deposit that promised unrealistically high rates of return. He hasn’t been charged with a crime.

Charles Ponzi

A Ponzi scheme, named for the swindler Charles Ponzi, promises high returns and relies on raising money from new investors to pay off earlier ones. The IRS guidance applies to victims of all Ponzi schemes, not just those perpetuated by Madoff and allegedly Stanford, Shulman said. It doesn’t necessarily apply to other kinds of fraud.

The IRS guidance says defrauded investors can claim theft losses not only for amounts originally invested, but also for fictitious income. The IRS stands to refund as much as 35 percent of Madoff’s $60 billion fraud, or about $21 billion, although actual refunds will be much smaller because money lost by charities and retirement accounts won’t benefit from deductions.

Current IRS rules say losses can be carried back up to five years. Legislation has been proposed to expand that period to as long as 13 years, the length of time Madoff was collecting money from investors while not engaging in trading.

Theft-Loss Deduction

Investors who sue Madoff and may receive some settlement are limited to a 75 percent theft-loss deduction. Those who don’t sue can deduct 95 percent of their losses immediately and claim the rest at a later date if they receive none of their funds back.

Senator Charles Schumer, a New York Democrat, said the new IRS guidance “is clear, comprehensive and comes at a crucial time.”

“We are hearing from victims and their lawyers that they are very pleased by what the IRS has done,” Schumer said.

Schumer urged the IRS to find a way to extend relief to individuals who lost money through tax-deferred retirement accounts including IRAs and 401(k)s. Such retirement accounts likely won’t benefit from the new guidance because they were never taxed and in most cases investors already took tax deductions for their initial investment.

Shulman said the IRS would work to expedite claims for relief from Ponzi schemes, but said those taxpayers will have to fill out a special form that may subject them to closer audit scrutiny.

“‘We will balance expediting the relief but we will also have enforcement and audit coverage to look behind it and be sure we don’t have a lot of fraud,” he said.

To contact the reporter on this story: Ryan J. Donmoyer in Washington at rdonmoyer@bloomberg.net

Last Updated: March 17, 2009 16:25 EDT