In the wake of the Bernard L. Madoff scandal, the Internal Revenue Service sued a suspended lawyer Monday, saying his tax-return business improperly claimed improper investment-theft loss tax deductions for clients.

In a lawsuit filed in federal court in Columbus, Ohio, the feds sought an order barring Tobias H. Elsass of nearby Worthington and two companies he runs, Fraud Recovery Group and Sensible Tax Services, from preparing any tax returns. The lawsuit and Ohio Supreme Court records say that Elsass has been "indefinitely suspended" from practicing law since the late 1990s.

The ability of taxpayers to take deductions for investment-theft losses has been much discussed since the 2008 exposure of New York money manager Madoff. His long-running Ponzi scheme, likely the largest in U.S. history, swindled investors of an estimated $65 billion. Madoff, who pleaded guilty, is serving a 150-year prison sentence.

Prior to Madoff, the IRS said investment-theft losses could be deducted under Section 165 of the Internal Revenue Code only if they met a number of stringent requirements. One was that the losses had to be certain and quantifiable, which often delayed the deduction for years. But under pressure, the IRS last year loosened the rules to allow many aggrieved investors to immediately claim up to 95% of their initial investment plus what proved to be phantom profits, less their withdrawals and recoveries from insurance or lawsuits. (This doesn't help taxpayers who invested with Madoff via individual retirement accounts, because these funds were never taxed initially as income.)

Then and now, investment losses caused by market performance rather than outright theft are not deductible, except as a capital loss when the investment position is closed or sold out, and even then only against capital gains, with just $3,000 a year deductible against ordinary income such as salary. [continue with full story]

This post has been edited by MoneyRainmaker: Apr 19 2010, 07:51 PM