(Changes sourcing to IRS document from New York Times; adds background)
July 9 (Reuters) - The U.S. Internal Revenue Service is cracking down on hedge funds, challenging a tax strategy called "basket options" that they have used to avoid taxes estimated at billions of dollars.
Under IRS guidance issued on Wednesday, hedge funds using the options must report them on their tax returns and correct past returns if they used them since Jan. 1, 2011.
The guidance came after a U.S. Senate subcommittee reported last year that at least 13 hedge funds were using basket options created by banks to avoid federal taxes.
"The law is very clear in this area - basket options are a tax shelter," Senator Ron Wyden, the top Democrat on the Senate Finance Committee, said in a statement.
Wyden sent a letter to U.S. Treasury Secretary Jack Lew last month calling for the tax shelter to be closed.
Former Senator Carl Levin, a Democrat who was then head of the powerful U.S. Senate Permanent Subcommittee on Investigations, presented the findings of a year-long probe into basket options last July, accusing Deutsche Bank AG and Barclays Plc of helping hedge funds avoid taxes and calling for tougher action from the authorities. .
Spokesmen for Deutsche Bank and Barclays declined to comment.
The basket options were in accounts nominally held by the banks, but were in fact controlled by the hedge funds, which bought and sold the assets and profited from taxable short-term trading, the Senate subcommittee said.
The hedge funds then paid the lower tax rate on long-term capital gains, saying profits came from exercising the options rather than from the underlying short-term trades.
But the basket options were not really options, the Senate panel found.
The largest user of the options, Renaissance Technologies Corp, saved an estimated $6.8 billion in taxes, the panel's report said.
A spokeswoman for Renaissance did not immediately return a call seeking comment. At the time of the report, a spokesman for the hedge fund said Renaissance believed the tax treatment was appropriate under current law.
The IRS said in 2010 that basket options did not function like actual options and should not be treated as such. That opinion had no status as an official rule, however, and the IRS has not yet pressed any cases.
(Reporting by Supriya Kurane in Bengaluru; Additional reporting by Dena Aubin in New York; Editing by Kevin Drawbaugh and Lisa Von Ahn)