Insider Trading and Forfeiture of Millions in Stock Gains Runs into Section 1341 and Issue Preclusion

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People may remember Joseph Nacchio, who once ran Qwest Communications at the height of the telecom boom and into the bust. While CEO, in 2001 Nacchio sold shares and reported over $44 million in net gain from these stock and paid just under $18 million in taxes on the gain. The stock tanked just after the sale. The SEC and Department of Justice came down hard on him. He was convicted on 19 counts of insider trading, and eventually ordered to pay a $19 million fine and to forfeit the $44 million in net profit from the sale of the shares.

After spending over four years in low-security federal prison, he was released last September. After his release, the WSJ ran a great story on Nacchio, replete with tales of prison life, including Nacchio’s prison buddies Spoonie and Juice playing practical jokes on new inmates, Nacchio paying fellow inmates cans of tuna to do chores, and pictures of a tanned and buff Nacchio emerging from prison combative and convinced that the fed investigation of him stemmed from his refusal to turn over phone records to NSA rather than any violations of securities laws.

Well, how does this relate to tax procedure? When he forfeited the close to $44 million net gain from the stock sake in 2007, he filed a refund claim that relied on Section 1341 to allow him to be treated as if he never had the stock gain to begin with. IRS denied the claim, triggering a refund suit in the Court of Federal Claims and cross motions for summary judgment. Last week, the Court of Federal Claims issued an order denying the government’s motion and granting Nacchio’s motion in part.

Below, I will briefly explain the substantive issue in the case and how Section 1341 can apply to unwind the effects of income inclusion when income earned in an earlier year is returned in a later year. The added procedural wrinkle in this case is whether Nacchio’s criminal conviction in an insider trading case can serve to bar a taxpayer’s use of Section 1341. The government argued that under the doctrine of issue preclusion (or collateral estoppel) Nacchio’s conviction precluded the taxpayer’s use of Section 1341; the court found that issue preclusion did not apply but declined to issue a final opinion on the claim’s merits.

A brief summary and discussion follows.

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Section 1341-Introduction

The effects of the annual system of tax accounting are somewhat mitigated by Section 1341. As Nacchio v US described, that provision is triggered in the following circumstances:

The taxpayer must have subjectively believed he had an unrestricted right to the money in the year it was received based on all the facts available that year; and

The taxpayer must be entitled “to a deduction (in excess of $3,000) under another section of the Internal Revenue Code for the loss resulting from” repaying the money.

If the taxpayer meets the requirements of Section 1341, then the taxpayer is entitled to either the equivalent of a refund for income tax paid in the earlier year, or a deduction from income in the year of repayment, whichever is more beneficial to the taxpayer.

So in the refund suit that Nacchio brought, he had to establish that he had a claim of right to gain originally included in the 2001 joint return he filed with his wife, and that they were entitled to deduct the $44 million forfeited under some section of the Internal Revenue Code. The benefit he sought under Section 1341 was the equivalent of the refund of income taxes he paid in 2001, because that was more beneficial than taking a deduction in 2007—the year that Nacchio actually forfeited the net gains from the stock sales.

Is Nacchio Entitled to a Loss Deduction?

The first part of the opinion discussed whether Nacchio is entitled to deduct as a loss under Section 165(c)(2) for the forfeiture payment. Caselaw generally establishes that forfeiture is a loss for purposes of Section 165. The government argued nonetheless that Nacchio was not entitled to deduct that loss because it “would contravene public policy by ‘reducing the sting’ of the forfeiture penalty.”  Courts and IRS have applied the public policy doctrine to preclude deductions under Section 165 when allowance of the deduction would “immediately and severely frustrate sharply defined policies” (in this case relating to proscribing insider trading) or if the deduction would “directly and substantially dilute the punishment imposed.” (citing to the Supreme Court case of Tellier v US)

Those standards are hardly the stuff of clarity but in this case the Court of Federal Claims came down hard on the government.

Mr. Nacchio’s forfeiture is a loss. The proceeds from Mr. Nacchio’s insider trading evaporated — they were disgorged. Yet, the Government seeks to tax these proceeds not on the ground that they are income, but on an amorphous notion that the public policy against securities fraud must prevent the deductibility of monies that were received due to insider trading even though the monies were disgorged….

Indeed, because Plaintiffs paid over $17.9 million in taxes on a $44.6 million gain they did not retain, disallowing Plaintiffs’ loss deduction would impose a punitive tax consequence uncalled for by criminal statute, the Internal Revenue Code, or precedent. See Tellier, 383 U.S. at 694-95 (“We decline to distort the income tax laws to serve a purpose for which they were neither intended nor designed by Congress.”). Disallowing the deduction would result in a “double sting” by requiring the taxpayers to both make restitution and pay taxes on income they did not retain. In sum, the public policy against insider trading does not prevent the deduction of the amount forfeited here as a loss under § 165.

The government also argued that Section 162(f) applied, which disallows trade or business expense deductions for “any fine or similar penalty paid to a government for the violation of any law.”  The government argued that the forfeiture was a fine or similar penalty for these purposes. The court disagreed with the government. Recall that Nacchio did not attempt to justify the deduction as a trade or business expense, but sought a deduction under Section 165(c)(2) for losses related to a profitseeking transaction. Regulations under Section 162 and Section 165 essentially incorporate the 162(f) standard into Section 165. Courts have sidestepped the issue as to whether the regulations under Section 165 are valid; after all Congress in codifying Section 162 did not similarly amend Section 165.

The Court of Federal Claims cited a Second Circuit case Stephens v US that provides the justification for incorporating 162(f) into a Section 165 analysis:

Though Congress, in amending Section 162, did not explicitly amend Section 165, we believe that the public policy considerations embodied in Section 162(f) are highly relevant in determining whether the payment to Raytheon was deductible under Section 165. Congress can hardly be considered to have intended to create a scheme where a payment would not pass muster under Section 162(f), but would still qualify for deduction under Section 165. (citation omitted)

Recall that 162(f) precludes deduction for a “fine, or similar penalty.” So the issue that Court of Federal Claims considered was whether the forfeiture was not just a penalty but a penalty that is similar to a fine. Here the court discussed how Nacchio was ordered to pay both a $19 million fine that was paid to a state general crime victims fund and $44 million or so in forfeited profit to a separate fund to compensate victims of the Qwest securities fraud. That distinction was key to the court, as the forfeiture payment’s compensatory purpose severed it from being a “similar” penalty for purposes of Section 162(f) and 165.

Issue Preclusion, Section 1341 and Subjective Belief

The government still had more arrows in its quiver. It argued that under the doctrine of issue preclusion, Nacchio should be barred from litigating whether “he had a claim of right to the gain he forfeited because a jury convicted him of engaging in insider trading willfully, knowingly and with the intent to defraud.”

As the Court of Federal Claims correctly summarized, issue preclusion requires that the party seeking to invoke the doctrine must establish that the action “presents an issue identical to that previously adjudicated in the criminal case.” The problem with the government’s argument was that according to the Court of Federal Claims whether Nacchio subjectively believed he had an unrestricted right to the income is key for purposes of Section 1341, not whether as a matter of law he had a right to the funds.

Nacchio did not testify at the criminal trial, having invoked the Fifth Amendment. The court felt that the criminal conviction did not directly bear on Nacchio’s subjective beliefs:

The precise issue of whether Mr. Nacchio himself subjectively believed he had an unrestricted right to the funds he received from trading in 2001 was not adjudicated in the criminal proceeding. Mr. Nacchio did not plead guilty to insider trading — an admission which could result in a finding that he had subjectively believed he was not entitled to the gain.” See Culley, 222 F.3d at 1335-36 (holding that taxpayer who pled guilty to mail fraud could not have subjectively believed that he had an unrestricted right to the fraudulently obtained proceeds); Kraft v. United States, 991 F.2d 292, 297-99 (6th Cir. 1993); Wang v. Comm’r, 76 T.C.M. (CCH) at *8 (finding that a taxpayer who plead guilty to insider trading was not entitled to § 1341 relief because he knowingly received illegally obtained income).

Although the jury in the criminal trial believed Mr. Nacchio was guilty of willfully engaging in insider trading, this does not equate to a finding of what Mr. Nacchio himself believed. Mr. Nacchio professed his innocence, and nothing in this Court’s record from the criminal proceeding sheds any light on the bona fides of Mr. Nacchio’s belief. Indeed, Mr. Nacchio did not testify in his criminal trial, invoking his Fifth Amendment privilege against self-incrimination. Mr. Nacchio’s subjective belief as to his claim of right to the forfeited gain was not adjudicated in his criminal trial, and Plaintiffs are not barred from litigating his belief under the doctrine of issue preclusion. So too, Mr. Nacchio’s subjective belief as to his entitlement to the trading gains in 2001 is a question of material fact that cannot be resolved on summary judgment.

Conclusion

I do not know much about Nacchio other than the little I have read in the opinion and some articles I read before writing this post. He seems like a very combative individual, and if the case goes to trial, I suspect the government will have its hands full in trying to show that Nacchio himself believed he had no right to the gains.  The denial of the deduction here seems doubly punitive in light of the fact that it essentially requires the payment of taxes on income that was not retained. That does not seem like a fair result.

On the other hand, if the benefit of Section 1341 when it comes to forfeited funds turns on whether a defendant pleads guilty it does potentially change the dynamics for those facing insider trading charges.  This will increase the costs of pleading guilty and at a minimum create another issue defendants must consider when facing those charges. While I have not done extensive research on the cases that the Nacchio opinion cites for the proposition that a guilty plea could result in a finding of no entitlement to qualify for Section 1341, it is not readily apparent to me that a guilty plea should equate to a finding that a taxpayer did not subjectively believe he had a right to the income in the first place.

I know the IRS has fought hard when taxpayers have attempted to use Section 1341, especially in cases where taxpayers have less than clean hands. Perhaps in a later post we will explore the contours of illegally gained funds and the applicability of Section 1341. We will keep our eyes on this case as it presents a chance to consider when taxpayers may have the appearance of the right to funds even when their criminal activity generated the gains that were eventually forfeited.

UPDATE3.20

Janet Novack, Forbes Washington D.C. bureau chief,  who writes insightful pieces on tax (among other areas) ran a nice story last week that also discussed the Nacchio case.  It has some more detail on Qwest and Nacchio, including his criminal trial and a quote from his attorney on the tax case.

 

 

 

Leslie Book About Leslie Book

Professor Book is a Professor of Law at the Villanova University Charles Widger School of Law.

Comments

  1. william garofalo says:

    Excellent article.

    On the collateral estoppel point, it seems to me that the effect of a guilty plea and conviction should be identical – issue preclusion only for the elements of the crime. So the holding of the court is correct if subjective belief as to rights to the proceeds is not an element of the crime of insider trading. But it should not matter whether the defendant plead or was convicted.

    The key take away is that what you plead to or are convicted of, and what you say in elocution or at trial, can have a big tax effect. $19M in this case. A valuable lesson that suggests non-tax crime defendants need to have tax advice early, before moving forward in the criminal case.

  2. Thanks William. Great point. Especially when the amount at stake is so high and tax may not be the first thing on a defendant or counsel’s mind.
    We will write a post soon on the procedural issues surrounding restitution, an area that has had much change in the past few years. The revised Saltzman/Book chapter on assessments extensively discusses these changes. It comes out in the next month or so and we will blog aspects of the changes that I cover in the book.

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