Designated Orders: 9/18 – 9/22/2017

October 3, 2017 by 2 Comments

Professor Patrick Thomas brings us this week’s Designated Orders, which this week touch on challenges to the amount or existence of a liability in a CDP case without the right to that review, a pro se taxpayer fighting through a blizzard of a few differing assessments and an offset, and the somewhat odd case of the IRS arguing that a taxpayer’s mailing was within a 30-day statutory period to petition a determination notice. Les

Thank goodness for Judge Armen’s designated orders last Wednesday. In addition to Judge Halpern’s order in the Gebman case on the same day (which Bryan Camp recently blogged about in detail), Judge Armen’s three orders were the only designated orders for the entire week.

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A Review of the Underlying Liability, without a Statutory Right

Dkt. # 7500-16L, Curran v. C.I.R. (Order Here)

The Curran order presents a fairly typical CDP case, though both the IRS, and I’d argue the Court, give the Petitioners a bit more than they were entitled to under the law. Mr. Curran was disabled in 2011, and received nearly $100,000 in disability payments from his employer, Jet Blue. Under section 104(a)(3), such payments are included in gross income if the employer paid the premiums for the disability policy (or otherwise contributed to the cost of the eventual disability payments). If the employee, on the other hand, paid the premiums, the benefits are excluded from gross income.

It appears that Jet Blue paid for Mr. Curran’s benefits, but Mr. Curran did not report these on his 2011 Form 1040. Unfortunately for Mr. Curran, employers (or, in this case, insurance companies contracted with the employer to provide disability benefits) are required to report these benefits on a Form W-2. The IRS noticed the W-2, audited Mr. Curran, and issued a Notice of Deficiency by certified mail to Mr. Curran’s last known address, to which he did not respond. The IRS then began collection procedures, ultimately issuing a Notice of Intent to Levy under section 6330 and a Notice of Determination upholding the levy.

The Court does not critically examine the last known address issue, but presumes that the Petitioner has lived at the same address since filing the return in 2012. So, ordinarily, Petitioners would not have had the opportunity to challenge the liability, either in the CDP hearing or in the Tax Court.

Nevertheless, the IRS did analyze the underlying liability in the CDP hearing, yet concluded that Mr. Curran’s disability payments were included in gross income under section 104(a)(3). The Court also examines the substantive issue regarding the underlying liability, though notes that Petitioners do not have the authority to raise the liability issue. Of particular note, the IRS’s consideration of the liability does not waive the bar to consideration of the liability, and most importantly, does not grant the Court any additional jurisdiction to consider that challenge. Yet, Judge Armen still engages in a substantive analysis, concluding that Petitioners’ arguments on the merits would fail.

It’s also worth noting that the Petitioners provided convincing evidence that, at some point after 2011, they repaid some of the disability benefits (likely because he also received Social Security Disability payments, and his contract with the insurance company required repayment commensurate with those SSDI benefits). Under the claim of right rule, Petitioners were required to report the benefits as income in the year of receipt. Repayment of the benefits in a latter year does not affect taxation in that earlier year; rather, the Petitioners were authorized to claim a deduction (for the benefits repaid) or a credit (for the allocable taxes paid) in the year of repayment.

Three Assessments, Two Refund Offsets, and One Confused Taxpayer

Dkt. # 24295-16, McDonald v. C.I.R. (Order Here)

In LITC practice, we often encounter taxpayers who are confused as to why the IRS is bothering them, what the problem is, and even why they’re in Tax Court. Indeed, at a recent calendar call I attended, a pro se taxpayer asked the judge for permission to file a “Petition”. This mystified the judge for a moment; further colloquy revealed the Petitioner actually desired a continuance.

In McDonald, we see a similarly confused taxpayer, though I must also admit confusion in how the taxpayer’s controversy came to be. Initially, the taxpayer filed a 2014 return that reported taxable income of $24,662, but a tax of $40.35. Anyone who has prepared a tax return can immediately see a problem; while tax reform proposals currently abound, no one has proposed a tax bracket or rate of 0.16%. Additionally, Mr. McDonald did self-report an Individual Shared Responsibility Payment (ISRP) under section 5000A of nearly $1,000 for failure to maintain minimum essential health coverage during 2014.

So, the IRS reasonably concluded that Mr. McDonald made a mathematical error as to his income tax, and assessed tax under section 6213(b)(1). Such assessments are not subject to deficiency procedures. Because the assessment meant that Mr. McDonald owed additional tax, the IRS offset his 2015 tax refund to satisfy the liability. Another portion of his refund was offset to his ISRP liability (which appeared on a separate account transcript—likely further confusing matters for Mr. McDonald).

But then the IRS noticed, very likely through its Automated Underreporter program, that Mr. McDonald did not report his Social Security income for 2014. Unreported income does not constitute a mathematical error, and so the IRS had to use deficiency procedures to assess this tax. The IRS sent Mr. McDonald a Notice of Deficiency, from which he petitioned the Tax Court.

Mr. McDonald filed for summary judgment, pro se, arguing that he had already paid the tax in question. Indeed, he had paid some unreported tax—but not the tax at issue in this deficiency proceeding. Rather, this was the tax that had already been assessed, pursuant to the Service’s math error authority—and of course the ISRP, that Mr. McDonald self-assessed. Accordingly, Judge Armen denied summary judgment, since Petitioner could not prove his entitlement to the relief he sought.

Headline: IRS Argues for the Petitioner; Loses

Dkt. # 23413-16SL, Matta v. C.I.R. (Order Here)

I just taught sections 7502 and 7503 to my class, so this order is fairly timely. Judge Armen ordered the parties to show cause why the case shouldn’t be dismissed for lack of jurisdiction due to an untimely petition.

Now why the Petition was filed in the first instance, I can’t quite discern. The Notice of Determination, upon which the Petition was based, determined that the taxpayer was entitled to an installment agreement, and did not sustain the levy. The Notice was dated on September 12, 2016, but the mailing date was unclear. (This is where the eventual dispute lies).

A petition was received by the Court on October 31, 2016. Clearly, this date is beyond the 30-day period in section 6330(d) to petition from a Notice of Determination. However, the Court found that the mailing date of the petition was October 13, 2016, as noted on the envelope. The mail must have been particularly slow then. This creates a much closer call.

The twist that I can’t quite figure out is that it’s the Service here that’s arguing for the Petitioner’s case to be saved, rather than the Petitioner, who doesn’t respond. The Service argues that, although the Notice was issued on September 12, it wasn’t actually mailed until September 13—which would cause the October 13 petition to fall within the 30-day period. The Service argues that because the Notice arrived at the USPS on September 13, that’s the mailing date.

But Judge Armen digs a bit deeper, noting that the USPS facility the Service references is the “mid-processing and distribution center”, and that it arrived there at 1:55a.m. Piecing things together, Judge Armen surmises that the certified mail receipt, showing mailing on September 12, must mean that the Notice was accepted for mailing by the USPS on September 12, and then early the next morning, sent to the next stage in the mailing chain. That means the Notice was mailed on September 12, and that accordingly, the Petition was mailed 31 days after the determination.

Helpfully for Petitioner, it looks as if decision documents were executed in this case, as Judge Armen orders those to be nullified. Perhaps the Service and the Petitioner can come to an agreement administratively after all, as Judge Armen suggests.

Filed Under: Claim of Right, Collection Due Process, Timely Mailing Tagged With:

Appeals Court Rejects Tax Refund For Former Qwest CEO Nacchio’s $44 Million Forfeiture

June 15, 2016 by 1 Comment

An earlier version of this post appeared on the Forbes PT site on June 13, 2016.

Former Qwest CEO Joseph Nacchio is no stranger to lots of attention;  his conviction for insider trading was front page news, and following his release from prison he has been an outspoken critic of the US penal system and the laws with respect to insider trading. While Nacchio has served his time,  the tax consequences of his $44 million in court-ordered forfeiture payments have been the continuing subject of litigation.

A couple of years ago, our Forbes colleague Janet Novack discussed Nacchio’s refund suit at the Court of Federal Claims in Former Qwest CEO Could Score $18 Million Tax Refund For Forfeited Insider Trading Profits and in a follow up US Avoids Trial on EX Qwest CEO’s Claims With $18 Million Tax Refund Deal. In Procedurally Taxing I looked at some of the issues in Insider Trading and Forfeiture of Millions in Stock Gains Runs into Section 1341 and Issue Preclusion.

Last week the Court of Appeals reversed the lower court and held in a precedential opinion that Nacchio is not entitled to deduct the forfeited funds as either a trade or business expense under Section 162 or a loss under Section 165. Because the Court held that Nacchio was not entitled to deduct the forfeited funds, it did not reach the issue under Section 1341. The upshot of the opinion is that Nacchio effectively had to use after tax dollars to pay his the $44 million forfeiture payment.

This is a significant opinion, as the Court of Federal Claims opinion below had looked to the underlying nature of what the US did with the forfeited funds to determine whether it would treat the forfeited amounts as analogous to a nondeductible “fine or similar penalty.” In rejecting that approach the Court of Appeals makes forfeiture payments doubly painful as those funds will have to come from after-tax dollars.

I will briefly summarize the facts, highlight the procedural posture of the case, describe the special relief Nacchio sought, and discuss the main points of the Court of Appeals opinion.

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As I described in 2014, while he was 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.”

The Court of Federal Claims had partially resolved the case on summary judgment motions that both parties filed. In resolving those motions, it held that Nacchio was entitled to deduct the forfeiture payment as a loss under Section 165, but that he was not entitled to deduct the loss under Section 162. It also held that his criminal conviction for insider trading did not necessarily collaterally estop him from arguing that he was entitled to use Section 1341 to help unwind the inclusion in the year he remitted the forfeited funds, as Section 1341 turned in part on whether he had a subjective belief that he was entitled to the ill gotten gains. It thus kicked the 1341 issue down the road to a trial.

To take advantage of Section 1341 1) 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 2)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.

Nacchio was pushing for the special treatment in Section 1341 that would allow him to get a credit for the taxes he paid in the earlier year when he included in income the funds that he eventually used to forfeit the $44 million in profits.

The 1341 issue was never tried at the Court of Federal Claims. The procedural posture of the case on appeal was somewhat unusual. As the Court of Appeals described,

“[r]ather than proceed to trial on Nacchio’s claim for special relief under I.R.C. § 1341, the government stipulated to the entry of final judgment in favor of Nacchio, waiving its right to challenge Nacchio’s claims under § 1341 on other than deductibility and estoppel grounds; the government expressly reserved its right to appeal the court’s adverse rulings on those issues. Nacchio reserved his right to appeal the court’s adverse ruling as to deductibility under § 162.”

On appeal, the government argued that, despite being a “loss,” the forfeiture is not deductible under § 165 because allowing the deduction would contravene public policy, as codified in § 162(f), which disallows deductions for fines or similar penalties.

In setting up the legal issue, the Court of Appeals recognized the special pain associated with possibly disallowing Nacchio’s refund claim:

We further understand Nacchio’s argument that not being allowed to deduct his forfeited income from his taxes would result in a sort of “double sting”: both giving up his ill-gotten gains and paying taxes on them. But in this case, the relevant statutes, regulations, and body of relevant case law lead us to conclude that Nacchio’s criminal forfeiture must be paid with after-tax dollars, just as fines are paid with after-tax dollars. Specifically, as explained below, the government has demonstrated that Nacchio’s criminal forfeiture is a “fine or similar penalty” within the meaning of § 162(f).

Despite that, the Court held in favor of the government, in part because it felt that “the plain language of the statutory provision [under US Code Title 18] under which the amount Nacchio forfeited was calculated supports the view that Congress intended the forfeiture to be paid with after-tax dollars.” It also looked to the tax regulations under Section 162 (1.162-21(b)(1)), which casts a wide net around “an amount—(i) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding.”

In finding for the government, the opinion also distinguished forfeiture from deductible restitution, which has a compensatory purpose. There are a number of cases allowing deductibility of restitution payments. Recognizing that cases have blessed a tax deduction for restitution, Nacchio argued that in his case the government effectively used the forfeited funds for the same purpose as restitution payments:

Nacchio clings to this last point—the fact that the forfeited funds made their way to the victims of the crimes. He argues that the remission process by which the funds were distributed to the victims is governed by the Civil Asset Forfeiture Reform Act of 2000, which has a compensatory purpose: to restore forfeited assets to victims of the offense giving rise to the forfeiture. He also points out that the remission payments were made to identifiable persons who would have a civil cause of action against Mr. Nacchio to recover those funds. He insists that the forfeiture was tantamount to restitution.

In likely the most significant part of the opinion, the Court explicitly rejects Nacchio’s approach:

Allowing Nacchio to deduct his forfeiture because the AFMLS[the DOJ Asset Forfeiture and Money Laundering Section] decided to distribute it to victims through remission would mean that whether two people convicted of the same crimes could deduct their criminal forfeiture would turn not on their actions, or the statutes governing their sentencings, but on the after-the-fact discretionary decisions of a third party. This is not the law. Instead, “[t]he characterization of a payment for purposes of § 162(f) turns on the origin of the liability giving rise to it.” Bailey v. Comm’r, 756 F.2d 44, 47 (6th Cir. 1985) (citing Middle Atl. Distribs. v. Comm’r, 72 T.C. 1136, 1145 (1979); Uh- lenbrock v. Comm’r, 67 T.C. 818, 823 (1977)). We think Congress could not have intended to create a scheme in which the applicability of § 162(f) would depend upon how the government, in its discretion, later decided to use the funds generated by a fine or similar penalty. (my emphasis).

For good measure, and I suspect not insignificant in why the court came out this way, the opinion also distinguishes the forfeited payments from restitution in the sense that the forfeited amounts have no direct relationship to the losses that the public claims to have suffered as a result of Nacchio’s actions:

While Nacchio forfeited his criminal “proceeds”—about 44 million dollars—the victims claim to have suffered almost 12 billion dollars in cumulative losses. J.A. 513. Though not dispositive, the fact that Nacchio’s forfeiture was pegged to his profits and not to the victims’ losses weighs against a conclusion that Nacchio’s forfeiture was restitution to those victims.

Conclusion

Nacchio has maintained his innocence of the insider trading charges that led to the forfeited amounts (see WSJ article Former Qwest CEO Joseph Nacchio: Tales From a White-Collar Prison Sentence). He has been outspoken following his release from prison regarding the need for prison reform (see his 2015 commentary in CNBC called Six Myths About Prison). No doubt that after this case he will be outspoken about the need to possibly remove some of the limitations on deductibility of forfeited payments.

Filed Under: Claim of Right

Paying Tax on the Same Income Twice, and Getting a Civil Penalty to Boot

June 9, 2016 by 2 Comments

I came across the case of Udeobong v Commissioner, a Tax Court case from last month. The case involves a clash of two principles of our tax system: 1) that the tax system is based on an annual accounting system, so each year stands on its own, and 2) that a taxpayer should not have to pay tax on the same income twice. As I discuss below, the Tax Court hung its hat on the first principle, reaching a result that violates the second principle. In so doing it also penalized the taxpayer, who unless he appeals will pay tax and a 20% penalty on income he previously included.

In this post I will discuss the way the Tax Court resolved the opinion and flag some issues that perhaps the Tax Court should have considered.

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Receiving Income, Returning it After a Dispute and Getting Some of it Back

The case involves a taxpayer, Ita Andrew Udeobong, who started a medical supply business in 2001 (I assume as a sole proprietor) and received millions of dollars in Medicaid reimbursement payments from CIGNA. The taxpayer apparently had some issues with the law with respect to the Medicaid reimbursements. Despite whatever nontax issues Udeobong had with respect to the Medicaid reimbursement the opinion states that in the early 2000s he reported as gross income those payments and paid the tax on the payment he received from Cigna. The opinion states that in a subsequent year as a result of a dispute with Cigna over whether the taxpayer was entitled to the reimbursements the taxpayer repaid those payments to Cigna. When Udeobong repaid those amounts he did not deduct the payments.

Udeobong’s tax problems arose because in 2010 (the year at issue in the Tax Court) after the dispute with Cigna was resolved Cigna returned some of the repaid amounts to Udeobong and issued a new 1099 MISC.

The facts are somewhat muddied because there was some confusion over the precise amount Cigna paid to the taxpayer in 2010 (and the 1099 was incorrect). In 2010 Cigna sent Udeobong 82 checks but stopped payment on all but 4 of those checks. The 1099 Cigna issued included the amounts in the checks for which it stopped payment.

It is clear that Udeobong did not have to include as gross income the amounts reflected in the checks that Cigna stopped payment on, but the IRS continued to press Udeobong on including the amounts reflected in the 4 checks despite his having included as gross income in an earlier year the amounts reflected in those checks.

Udeobong, who appeared to be pro se, argued that he should not pay tax on the amounts Cigna returned to him in 2010 because he properly reported those amounts as gross income in earlier years and in fact paid tax on that income in the earlier year:

[H]e argues that those payments represented the return to him of Medicaid reimbursement payments on which he had paid tax and which he subsequently had returned to Cigna (before 2005). He argues that he should not have to pay tax again on the same income.

Rather than consider whether the amounts reflected in the checks are gross income, the Tax Court opinion focused its inquiry on whether Udeobong was entitled to a deduction under Section 1341. The opinion rightly notes that Section 1341 provided no relief in the year at question:

Here, petitioner received payments from Cigna in earlier years with respect to which he paid Federal income tax. In a later tax year he returned the payments to Cigna. Section 1341 might have allowed him to adjust his tax for the year that he repaid Cigna, if he were entitled to a deduction in that tax year under another Code provision.

Section 1341 mitigates the sometimes-harsh consequences of the annual system of accounting, and allows the unwinding of a prior inclusion of income when later events demonstrate that the earlier income inclusion was unwarranted. If its conditions are met, Section 1341 provides that a 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. We have discussed that provision before; see my earlier post on Joseph Nacchio and his efforts to use 1341 to generate a refund on funds forfeited following an insider trading guilty plea and David Vendler’s two part guest post Can a Receiver Take Advantage of the Claim of Right Provisions to Benefit Defrauded Consumers? )

Citing then to Section 61(a), the opinion goes on to conclude that in light of 1341 providing no relief, “the amounts petitioner received from Cigna must be included in his income for 2010 irrespective of whether they represent payments that had been taxed but not retained for prior years.”

Some Thoughts on the Tax Court Approach: Tax Benefit And Accrued Receivable Arguably Provide Support for No Inclusion of Gross Income

It is not surprising that the opinion discusses Section 1341 but I was surprised by its somewhat casual referencing to the amounts constituting gross income under Section 61.

The court is correct that 1341 does not have any relevance to the year in issue. That is because in 2010 Udeobong did not return anything to Cigna; rather it received from Cigna payments that it had previously included and returned to Cigna following a dispute.

I discussed this opinion with my colleague Jim Maule, who nudged me to think about the tax benefit rule. The tax benefit rule provides that recoveries are taxable only to the extent the taxpayer received a tax benefit from the deduction—that is, the deduction must have reduced taxes or increased a credit carry-forward in the prior year.

As Jim points out, “had Udeobong taken the deduction in the earlier year, the tax benefit rule would have required inclusion in gross income to the extent the previous year deduction provided a benefit.”

But one of the challenges in this case was that Udeobong did not deduct any of the amounts he returned to Cigna in earlier years. Does the lack of Udeobong’s deduction mean that tax benefit principles are of no moment in the case? Jim pushes further and points to an analogous situation involving the payment of state income taxes in one year and a refund of those state income taxes in a later year:

Suppose a taxpayer pays state income tax but does not deduct the payment because the taxpayer uses the standard deduction. Part of the state income tax is refunded. It is excluded from gross income because the payment with respect to which it was made was not deducted (there was no deduction). Is it not possible to argue that the Cigna payments in 2010 were refunds of amounts paid in the earlier year, and that because no deduction was claimed for those amounts, that the payments are excluded because of the lack of a tax benefit?

A recent Tax Court opinion, Maines v Commissioner, explains this point further and discusses the payment and refund of state income taxes and how inclusion is tethered to an earlier year’s tax benefit from paying an amount that was deducted:

But what if someone who doesn’t itemize in year 1 gets a refund in year 2? The answer in that case is that he does not have to include his state income-tax refund on his year 2 return, see Tempel v. Commissioner, 136 T.C. 341, 351 n.19 (2011) (stating that state-tax refunds are not income unless the taxpayer claimed a deduction for them–for example, by itemizing for the previous year), aff’d sub nom. Esgar Corp. v. Commissioner, 744 F.3d 649 (10th Cir. 2014): He got no deduction in year 1 for the state income tax that he paid, so he got no federal tax benefit. And without a federal tax benefit, he doesn’t have to bear a federal tax burden on a refund he receives in year 2. See, e.g., Clark v. Commissioner, 40 B.T.A. 333, 335 (1939) (holding that so long as “petitioner neither could nor did take a deduction in a prior year,” any amount he receives the next year “is not then includable in his gross income.”); Rev. Rul. 79-315, 1979-2 C.B. 27.

So perhaps the tax benefit principles might have provided an avenue to find that Udeobong did not have gross income in the first instance.

In addition to the tax benefit argument, Jim suggested an argument that essentially analogizes Udeobong to having in effect an accrued receivable with a corresponding basis:

Udeobong returned the payments but continued to argue that he had a right to payment. Thus, does he not have a basis in his claim because he paid amounts back to CIGNA for which he did not claim a deduction? When CIGNA made payments in the year in issue, cannot the taxpayer offset them by the basis he has in those claims? In other words, are they not accrued receivables?

Parting Thoughts

Both arguments seem to me worth consideration, as they would provide a way for the court to not violate the principle that a taxpayer should only have to include amounts in gross income only once. The upshot of this opinion is now Udeobong will be subject to tax twice for the same income. On top of that unhappy result the Tax Court also sustained a 20 per cent accuracy-related penalty because his “mistaken view of the law does not rise to the level of ‘reasonable cause’ or ‘good faith’. To be sure, the opinion provided some relief for the taxpayer as the Tax Court did not allow the IRS to amend its answer to conform to the evidence that showed that the amount reflected in the retained checks was over $250,000, rather than about $150,0000, which was what IRS originally argued. Nonetheless, this is a harsh result, and while Udeobong might not be the most sympathetic taxpayer, it seems to me that some tax issues were left on the table.

This case blends procedure and substance. Section 1341 and other timing concepts like the tax benefit rule seem to fall on the procedural side because they provide a mechanism to fix a substantive mismatch in income or deductions. Because Mr. Udeobong handled his case pro se, the Court lost the benefit of strong arguments on his side that might have explained the basis for the procedural and substantive rules providing protection in circumstances like this and how tax principles might offer a way around the harsh result produced here. When the adversarial process is unbalanced, the Court and tax law suffers in addition to the underrepresented party.

 

 

 

Filed Under: Claim of Right, Tax Benefit Rule

Can a Receiver Take Advantage of the Claim of Right Provisions to Benefit Defrauded Consumers?

March 14, 2016 by Leave a Comment

Today we welcome back David Vendler of Morris Polich & Purdy who discusses a fascinating procedural issue involving the claim of right doctrine in a setting involving a receiver acting on behalf of a group of defrauded consumers who seek recovery of taxes paid by the entity that defrauded them. Les

Section 1341 and the claim of right doctrine occupy an interesting place in tax procedure, essentially allowing the unwinding of a prior inclusion of income when later events demonstrate that the earlier income inclusion was unwarranted. While Les has written about Section 1341 in PT before (see his post on Joseph Nacchio and his efforts to use 1341 to generate a refund on funds forfeited following an insider trading guilty plea), this post discusses a different wrinkle on the issue, namely whether, and to what extent, a receiver appointed on behalf of a defrauded class of consumers can recover from the IRS under Section 1341 taxes that the wrongdoer paid to the IRS from funds obtained from the fraud. There are several thorny issues arising from this question currently pending in the First Circuit Court of Appeals in the case of Robb Evans & Associates, LLC v. US, First Circuit Case No. 15-2540, the resolution of which could have a wide impact on the ability of consumers, such as the victims of such scoundrels as Bernie Maidoff, to recover at least some of their losses from the IRS. (links here to the magistrate report and  district court order on appeal).

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Section 1341 codifies what is known as the “claim of right” doctrine and derives from equity. Very roughly, it provides that where a taxpayer reported income as being taxable in one year, but then has to repay that money in a future tax year, s/he can deduct in that later year the amount s/he paid back if that amount is over $3,000; alternatively if the deduction does not produce a tax savings equal to the tax imposed on the earlier inclusion, Section 1341 allows a taxpayer to essentially recompute the prior year’s tax and receive a credit based upon the lower tax that would have been imposed in the earlier year without including the proceeds. Courts have held that Section 1341 must be liberally construed to effectuate its underlying remedial purpose. Kappel v. U.S., 281 F.Supp. 426 (D.C.Pa. 1968) (liberal construction of Section 1341 is required because it is remedial in nature and its purpose is to avoid inequities).

The underlying facts in the Robb Evans case are that the original class action plaintiffs obtained a $250 million dollar judgment under the Credit Repair Organizations Act (“CROA”) 15 U.S.C. 1679, et seq. and other theories against Cambridge Credit Counseling Corp., two of its owners, and several of their related corporations. The judgment, which was upheld by the First Circuit in a separate appeal, provided for a constructive trust over all consumer funds and appointed an equity receiver (Robb Evans & Associates) to marshal all of the defendants’ available assets to satisfy the judgment. Because the judgment was largely uncollectable against the various defendants, the receiver brought an action against the IRS, alleging that under the “claim of right” doctrine, the IRS should be compelled to hand over to the receiver under Section 1341 the taxes that the defendants had paid to the IRS in the years in which they had been committing their fraud because those monies properly belonged to the defrauded consumers. The case primarily relied upon by the receiver was Cooper v. United States, 362 F. Supp. 2d 649 (W.D.N.C. 2005). In response to the receiver’s suit, the District Court entered judgment in favor of the receiver. However, the amount of the judgment was not for the roughly $13 million that the fraudsters had paid in taxes, but was limited to roughly $1.1 million, which was the amount that the receiver had already “actually restored” to the plaintiff class from other funds seized by the receiver. Both the U.S. and the receiver have appealed from this judgment.

The appeal will decide several novel issues. The first is whether a court appointed equity receiver should be barred from recovering anything against the IRS under Section 1341 in a case where the taxpayer is found to have committed fraud because the receiver is tarred with the brush of the fraudster’s conduct, i.e. is the receiver in pari delicto. The IRS claims that the receiver should be barred. Relying on Cooper, the district court sided with the receiver on this issue. Cooper stated:

Admittedly, Courts, on public policy grounds, consistently find that persons who receive income as a result of bad acts, and who later repay the money are not entitled to calculation under § 1341 See McKinney v. United States, 574 F.2d 1240 (5th Cir.1978) (same); Wood v. United States, 863 F.2d 417 (5th Cir.1989); see also Revenue Ruling, Rev. Rul. 68–153, 1968 WL 15327 (1968) (holding proceeds from embezzlement activity later repaid, the embezzler not permitted a refund calculated pursuant to I.R.C. § 1341). As such, the Court concedes that if the debtor in this case were the plaintiff seeking a refund, the I.R.S.’s denial of refund computation under § 1341 likely is warranted. In the least, Plaintiff’s summary judgment motion would not survive. However, the debtor is not the plaintiff. The plaintiff, here, is the creditor, represented by the trustee.

Imputing the bad acts of the debtor onto the bankruptcy trustee in the present case renders a categorically inequitable result, that is, the innocent victimized creditors get nothing, and the government gets a windfall.

The second issue raised is whether the “actual restoration” requirement, which has been read into Section 1341 by courts, but which appears nowhere in the actual language of the statute, should apply to an equity receiver. Basically, the “actual restoration” requirement holds that until the taxpayer actually relinquishes dominion of the funds he originally claimed as income, but which later events proved he was not entitled to retain, he cannot seek any refund from the IRS. The rationale for the “actual restoration” requirement is to prevent a taxpayer from receiving a refund from the IRS and then not actually restoring the funds to the person who it turned out had the superior right to them. In short, the requirement is there to prevent the taxpayer from simply keeping the money that is refunded by the IRS. But the receiver’s position is that since there is no danger that a court appointed receiver will keep the money that is refunded by the IRS, the “actual restoration” requirement does not make sense in this context. In fact, it only serves the inequitable purpose of preventing consumers from having their money restored to them by the court pursuant to a lawful judgment and creates a windfall for the IRS. Finally, while Treasury Regulation § 1.1341–1(e) does explicitly include the prior restoration requirement, the drafters of this regulation were clearly not contemplating receivership situations. The district court ultimately sided with the IRS on this issue concluding that Section 1341 implicitly contains the “actual restoration” requirement because the deduction must be “allowable,” and that other provisions of the tax code require taxpayers to make actual restoration before that condition can be met.

The third issue is that all prior Section 1341 cases involve cash basis taxpayers, whereas several of the defendants in the subject case were accrual based. The difference, of course, is that for an accrual basis taxpayer, it is the order to pay the funds back, which, at least from an accounting perspective, makes the deduction “allowable.” So why should actual restoration – which is a cash basis concept – apply to accrual basis taxpayers? The district court, however, sided with the IRS on this issue as well.

It is expected that the First Circuit will issue an opinion on the Robb Evans case sometime in early 2017.

 

Filed Under: Claim of Right Tagged With:

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

March 17, 2014 by 2 Comments

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.

 

 

 

Filed Under: Claim of Right, Issue Preclusion