Taxpayer Couldn't Deduct Loss for Forfeited Proceeds from Insider Trading

(Parker Tax Publishing June 2016)

The Federal Circuit, reversing the Court of Federal Claims, held that a taxpayer was barred from deducting proceeds from a stock sale he was later required to forfeit due to a conviction for insider trading. The court determined that although the forfeiture was a loss under Code Sec. 165, because it was similar to a fine or penalty Code Sec. 162(f) precluded the deduction. Nacchio v. U.S., 2016 PTC 204 (Fed. Cir. 2016).

Background

From 1997 to 2001, Joseph Nacchio served as Chief Executive Officer (CEO) of Qwest Communications International, Inc. (Qwest). As part of his compensation, Nacchio received options to purchase shares of Qwest stock. When Qwest opened a "trading window" in April 2001, Nacchio exercised his options to purchase, and then sold 1,255,000 of his shares. Subsequently, Nacchio entered into an automatic sales plan and continued to sell additional Qwest stock until May 29, 2001, at which point the stock was in the early stages of protracted decline. Nacchio reported a net gain from these stock sales of $44.6 million in his 2001 joint tax return and paid approximately $18 million in taxes on this gain.

In 2005, a federal grand jury indicted Nacchio on forty-two counts of insider trading, alleging that he knowingly and willfully sold more than $100 million worth of Qwest common stock while aware of, and on the basis of, material non-public information. The indictment alleged that Nacchio knew that Qwest was facing financial risks that could prevent the company from achieving its aggressive publicly stated financial targets, and began selling his stock to protect his interests. A federal district court found Nacchio guilty of insider trading and sentenced him to serve 70 months in prison, pay a $19 million fine, and forfeit the $44.6 million net proceeds from his insider trading.

In 2009, following his forfeiture, Nacchio amended his 2007 tax return, claiming a credit of approximately $18 million under the Code Sec. 1341 "claim-of-right" doctrine, representing the amount of tax Nacchio and his wife had paid on the forfeited profits attributable to Nacchio's exercise of Qwest options. Later that year, the IRS disallowed Nacchio's credit, explaining that Code Sec. 1341 may be invoked only after the right to claim a deduction is established elsewhere in the tax code. The IRS found that Nacchio's forfeiture was the payment of a penalty for a violation of the law, so, pursuant to Code Sec. 162(f), a deduction was not permitted under any section of the tax code.

Nacchio brought suit before the Court of Federal Claims in 2012, again seeking a credit of approximately $18 million under Code Sec. 1341. The court determined that Nacchio's forfeiture payment was deductible under Code Sec. 165(c)(2), and held he could thus qualify for relief under Code Sec. 1341. The IRS appealed.

Analysis

Code Sec. 1341 provides special relief to a taxpayer who is required to restore funds to a third party where the taxpayer included the funds in his income in a prior taxable year when it then "appeared that the taxpayer had an unrestricted right" to the funds. In effect, Code Sec. 1341 permits a taxpayer to obtain a refund of the tax paid in the prior year on the restored funds that were included in gross income. As a prerequisite to relief under Code Sec. 1341, the taxpayer must establish that he is entitled to a deduction under another section of the Code for the loss.

Code Sec. 165(c)(2) provides for the deduction of losses incurred in any transaction entered into for profit, though not connected with a trade or business. Under Code Sec. 162(f), no deduction is allowed for any fine or similar penalty paid to a government for a violation of the law.

The Federal Circuit observed that the IRS had conceded before the Court of Federal Claims that Nacchio's forfeiture was a "loss" under Code Sec. 165(c)(2), but on appeal argued that the forfeiture was nevertheless not deductible by reason of Code Sec. 162(f).

The court noted that Reg. Sec. 1.162-21(b)(1) defines "fine or similar penalty" for the purposes of Code Sec. 162(f) as including "an amount paid pursuant to conviction or a plea of guilty or of no contest for a crime (felony or misdemeanor) in a criminal proceeding." In the instant case, the court said, Nacchio's criminal forfeiture met that definition of a "fine or similar penalty." Nacchio's criminal forfeiture, the court observed, was imposed pursuant to 18 U.S.C. Sec. 981(a)(1)(C) as part of his sentence in the criminal case. The court noted that section authorizes the forfeiture of "proceeds" traceable to numerous felony offenses, including any offense involving fraud in the sale of securities (e.g. insider trading).

The court observed that other courts of appeals had repeatedly concluded that forfeitures of property to the government similar to the one at issue are not deductible because they are punitive. For example, the court noted, in Wood v. United States, 863 F.2d 417, (5th Cir. 1989), the Fifth Circuit denied a loss deduction under Code Sec. 165 for the civil forfeiture of proceeds from the taxpayer's drug trafficking activities. In that case, the taxpayer pled guilty to a criminal offense, conspiracy to import marijuana and importation of marijuana, and was sentenced to serve four years in prison and pay a $30,000 fine. The taxpayer argued that, because he already paid his criminal debt by means of imprisonment and the $30,000 fine, he should not have to pay taxes on proceeds he forfeited to the government. The Fifth Circuit found that his drug proceeds were taxable income and that "forfeiture cannot seriously be considered anything other than an economic penalty for drug trafficking."

Based on the regulations and the reasoning of the Fifth Circuit and similar precedents, the Federal Circuit determined that Code Sec. 162(f) barred a deduction for the amounts Nacchio forfeited. Accordingly, the Federal Circuit reversed the trial court's holding that Nacchio could deduct his forfeiture as a loss under Code Sec. 165. Because deductibility under another provision of the tax code is a prerequisite to deductibility under Code Sec. 1341, the court held that Nacchio also could not seek special tax relief under Code Sec. 1341.

For a discussion of the prohibition on deductions for fines and penalties, see Parker Tax ¶96,510.

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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