Madoff takes a big bite out of the IRS

In the latest Madoff news, the IRS has decided to extend broader benefits to the Ponzi schemer's former clients. Depending upon the level of litigation that the victims are seeking, the government will allow them to claim theft-loss deductions of up to 95% for up to five years.

For all his faults, there is no question that Bernie Madoff was thorough. One of his victims, Judith Welling, said of her investment with him: "I paid taxes on it every year. You would get a statement from Madoff, with all his supposed buys and sells." In addition to providing his racket with an apparently legal cover, Madoff's statements have also given his victims a record of the taxes that they paid, the money that they invested, and the benefits that they may now receive from the IRS.

As the government continues in its efforts to recover Madoff's money, it is becoming increasingly clear that it is definitely among his victims. The ultimate IRS payout is estimated to be somewhere between $7 and $10 billion, and the costs of investigating, protecting, and housing him will also be sizeable.

In some ways, the benefits offered to Madoff's former clients seem designed to reduce the government's ultimate expenditure. Victims who plan to sue him are eligible to claim a deduction of 75% of their investments, while those who choose to forego a lawsuit may claim 95 percent. By reducing lawsuits, the government will also greatly reduce court costs.

The IRS' ruling should make life a lot easier for Madoff's victims, but it also illuminates a larger point. While analysts have already begun attacking the SEC for its failure to effectively police Madoff, the taxman appears to have dropped the ball as well. From all accounts, the agency has been receiving improperly reported income from hundreds of taxpayers over a period of decades. In context, it's odd that they failed to notice that Madoff was claiming to make money from thousands of transactions that never occurred. Between the SEC and the IRS, it looks like Wall Street in the last decade might have been a wonderful place to launder money.

It's also ironic that tax payments may be the saving grace for many of Madoff's victims. While they are undoubtedly happy to be able to recover their improperly paid taxes, it's clear that, ultimately, they were injured by the competitive tax rate that they once embraced. If their Madoff earnings had been taxed at the standard rate, most of them would have paid between 28 percent and 35 percent, and would now be getting most of that money back. As it is, the capital gains tax rate has been 15 percent since 2003. For many of Madoff's victims, this will be one of the few times when they find themselves hitting their foreheads and complaining about having paid too little in taxes.

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