Taxpayers Did Not Have Unrestricted Right to Funds Fraudulently Acquired

(Parker Tax Publishing March 2017)

The First Circuit held that a court-appointed receiver could not assert, on behalf of certain taxpayers, a refund claim for taxes paid on fraudulently obtained income. The court rejected the claim because the taxpayers on whose behalf the claim was filed did not have an unrestricted right to the income and thus did not meet the applicable requirements under Code Sec. 1341 to obtain a refund. Robb Evans & Associates, LLC, v. United States, 2017 PTC 91 (1st Cir. 2017).

Background

In 1996, brothers John and Richard Puccio formed Cambridge Credit Counseling Corporation (CCCC), a Massachusetts nonprofit corporation. They established several other profit and nonprofit corporations whose business dealings were intertwined with CCCC. CCCC held itself out as skilled in improving credit ratings and trumpeted its ability to help financially strapped individuals by creating debt management plans for a fee. Under such a plan, an individual in straitened circumstances would make a single monthly payment to CCCC, and CCCC would (at least in theory) sprinkle payments around to the individual's creditors. Business boomed: from 1996 to 2004, CCCC harvested over $250 million from hopeful clients. However, the money received from clients didn't go to pay off client debts, but instead ended up in the brothers' pockets. The Puccios' fraudulent scheme ended in 2003 with a class action lawsuit brought by individuals who had been defrauded. A judgment was entered against the Puccios' corporations in the amount of $259 million and against the Puccio brothers in the amount of $257 million.

Robb Evans & Associates, LLC, a court-appointed receiver, filed a tax-refund suit to assist in collecting the judgments rendered against the Puccios and their corporations.

The receiver claimed that (1) he could assert a refund claim on behalf of the brothers and their credit counseling corporations (the taxpayers); (2) those taxpayers reported as income, and paid taxes on, monies they tricked out of the defrauded persons; (3) because of the class action judgment, the taxpayers must restore those monies to the defrauded persons; (4) the taxpayers could deduct those repayments and could reduce their tax liability for the year of repayment by the amount they overpaid in the years they originally reported the income; and (5) the amounts of these deductions would exceed the taxpayers' tax liability for the year of repayment and result in refunds that should be paid to the receiver.

Code Section 1341

A taxpayer must include all of gross income in taxable income each year. This obligation extends even to income obtained unlawfully. It may become later evident that the taxpayer did not have a right to items included in gross income. If the taxpayer restores such an item of income to its lawful owner, the taxpayer may deduct that repayment in the current year. But because the taxpayer's situation may have changed (say, the taxpayer's annual income may have decreased or the taxpayer's tax bracket may have been lowered), the taxpayer may be at a disadvantage by taking the deduction in the year of repayment. To guard against any such inequity, Congress enacted Code Sec. 1341.

Code Sec. 1341(a) addresses the situation of a taxpayer who pays taxes on income that the taxpayer must later restore when it is established in a later year that the taxpayer did not have an unrestricted right to the income. The statute permits such a taxpayer to reduce his or her tax liability for the year of repayment by the amount that the taxes in the year the item was included in income would have been reduced had the restored funds been excluded from income in that year. However, Code Sec. 1341(a) requires that the taxpayer must have had what appeared to be an "unrestricted right" to the income when first reported.

Code Sec. 1341 does not itself provide for a deduction but, rather, applies only if a deduction is available under some other provision of the Internal Revenue Code. In that event, Code Sec. 1341(a) allows a taxpayer to choose between two different ways of calculating an otherwise available deduction for the restored funds. Under the first option, the taxpayer may simply deduct the amount of the restored funds in the year of repayment. Under the second option, the taxpayer may calculate taxes for the year of repayment without deducting the amount of the restored funds and then reduce that tax liability by the amount that the taxpayer's taxes were increased in the year (or years) of receipt because the disputed items were included in gross income. It was this latter method, which more or less puts the taxpayer in the position that he or she would have occupied had the taxpayer never reported the income, that the receiver wished to use.

District Court's Decision

The IRS rejected the refund claim, arguing among other things that the receiver was not entitled to the benefit of Code Sec. 1341(a) because the Puccio brothers never had an unrestricted right to the funds fraudulently obtained from their customers. The receiver challenged the IRS in a district court and the IRS moved to dismiss the case. The district court, noting that Congress had enacted Code Sec. 1341 in a spirit of fairness, fashioned a judicially created exception to the statute's unrestricted right requirement. Applying that judicially created exception, the court denied the IRS's motion to dismiss and granted relief. The IRS appealed.

First Circuit's Analysis

The First Circuit concluded that the district court erred and reversed the district court's decision. Congress, in the spirit of fairness, tailored a statute to iron out a wrinkle in the Internal Revenue Code, the court said; however, the statute does not give a court license to make the application of the statute "wrinkle-free."

The First Circuit noted that the dispositive issue was whether, when the income at issue was reported, it appeared to the taxpayers they had an unrestricted right to the funds. If the funds were derived from fraudulent activity, it could not have appeared to the taxpayers they had an unrestricted right to them.

The court noted that, under Reg. Sec. 1.1341-1(a)(2), an item is included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to such item. The law is clear, the court said, that it cannot be said to appear to an embezzler or fraudster that he has an unrestricted right to his ill-gotten gains (although he must report those gains in his annual gross income).

Code Sec. 1341(a)'s unrestricted right language excludes all income reaped by taxpayers who know at the time of receipt that they have no right to the income. If the taxpayers acquired the funds by fraud, the court observed, they could not have thought they had an unrestricted right to those funds.

The First Circuit noted that the district court had decided, in the earlier class action lawsuit that resulted in the judgments against the Puccios and their corporations, that the taxpayers were swindlers who had defrauded individuals. This finding was affirmed on appeal. Thus, the court said, the receiver was collaterally estopped from challenging that finding. And because it was conclusively determined that the taxpayers procured the funds through fraud, the taxpayers could not have thought they had an unrestricted right to the funds.

With respect to the receiver's argument that it could obtain a refund even though the taxpayers themselves could not, the court held that nothing in the legislative intent justified carving out an exception from the unrestricted right requirement for parties in either the receiver's or the defrauded persons' position. The legislative history of Code Sec. 1341, the court observed, contains no reason to think that the provision should give the victims of a taxpayer's fraud a free pass around the unrestricted right requirement. The statute alleviated an entirely separate problem the plight of taxpayers inadequately compensated for taxes paid on income later restored. When a statute's plain language permits only one interpretation, a court may not make an end run around that language by looking at the statute's equitable purpose.

For a discussion of the appropriate application of Code Sec. 1341, see Parker Tax ¶70,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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