Taxes are inevitable, but not so deductions. And that has become an issue of late as the courts weigh in on whether a taxpayer â€" either an individual or a company â€" can deduct the costs related to a government enforcement action.
A recent decision from the Court of Federal Claims in Washington looked at whether the forfeiture of the proceeds from insider trading qualifies for a deduction, raising the question of how the tax code may be seen as indirectly subsidizing wrongdoing.
The law allows for the deduction of “any loss sustained during the taxable year and not compensated for by insurance or otherwise.†But another provision specifically excludes “any fine or similar penalty paid to a government for the violation of any law.†Criminal fines imposed by a court are clearly not deductible, but it is not so easy to categorize the treatment of orders requiring the forfeiture of the proceeds derived from criminal activity.
Joseph P. Nacchio, the former chief executive of Qwest Communications, and his wife challenged a decision by the Internal Revenue Service that denied them a refund of nearly $18 million for capital gains taxes they paid when he sold shares of the company in 2001. Six years later, he was convicted of insider trading for those sales and ordered to forfeit more than $44 million as the proceeds of his crime.
Having paid taxes on the profits, Mr. Nacchio took the common sense approach that he shouldn’t have to pay taxes on earnings he later had to turn over because the forfeiture stripped him of the proceeds, generating the loss for tax purposes. The Internal Revenue Service denied his claim, however, by finding that the forfeiture operated as a “similar penalty†for his violation and, therefore, could not be deducted.
The government argued that allowing the refund would be against public policy by taking some of the sting out of a criminal conviction for fraudulent conduct. But the claims court relied on the Supreme Court’s statement in Commissioner v. Tellier that taxes are “not a sanction against wrongdoing.†So denying the deduction to increase the penalty for a violation was improper.
The claims court also rejected the I.R.S.’s argument that the forfeiture was similar to a fine because it came as the result of a criminal conviction. The court found that, unlike the 72-month prison term and $19 million fine imposed on Mr. Nacchio, “the forfeiture exclusively represented the disgorgement of Mr. Nacchio’s illicit net gain from insider trading.†So it was not a punishment.
The Supreme Court distinguished between forfeitures in criminal and civil cases in United States v. Bajakajian. The court noted that a civil forfeiture was not intended to punish a defendant but instead applied the legal fiction of punishing the property. As a result, it would not be considered a type of fine.
Criminal forfeiture, however, had traditionally been viewed as “part of the punishment imposed for felonies and treason in the Middle Ages and at common law.†Thus, a criminal forfeiture operates much the same as a prison sentence and fine.
Of course, the tax code does not always follow the same logic as other areas of the law. The claims court found that the forfeiture of Mr. Nacchio’s insider trading gains deprived him of the benefit of his illegal conduct, and thus was more an equitable remedy of disgorgement of ill-gotten gains than a punishment. So the amount could be deducted.
Another issue in the case was whether Mr. Nacchio actually believed he had the right to the profits from his trading, which is required by the tax law before he can deduct the forfeited money. The claims court concluded that this was an issue requiring a trial because it revolves around subjective intent, which requires testimony about his state of mind when selling the Qwest shares.
The issue of taking a deduction for the costs of a settlement is much more important for corporations, which have paid out billions of dollars in recent cases. There has been debate about whether the government effectively subsidizes those payments by allowing for a deduction from income when companies pay large civil settlements.
The $13 billion settlement that JPMorgan Chase reached with the Justice Department last November over its sales of residential mortgage-backed securities included a $2 billion penalty and another $7 billion in payments to states and federal agencies, including Fannie Mae and Freddie Mac. As DealBook reported, JPMorgan’s chief financial officer emphasized on the day the settlement was announced that te bank believed the $7 billion was tax deductible.
The Justice Department’s settlement with Toyota last week requires the company to forfeit $1.2 billion, described in the agreement as the proceeds of Toyota’s illegal activity in covering up defects in its vehicles. That type of payment would ordinarily be deductible because it was not a fine, but a provision in the deferred prosecution agreement provides that it “shall be treated as a penalty paid to the United States government for all purposes, including all tax purposes.â€
Legislation has been introduced in the House and the Senate to prohibit taxpayers from deducting payments made in connection with a government investigation, lawsuit or settlement related to a violation of the law. That would probably knock out the deduction for future settlements like the one JPMorgan reached.
There is also the question whether companies and individuals should be treated the same, which the legislative proposals do.
When the government settles with a company, the amount paid is usually the product of negotiations and, at best, a rough estimate of the benefit the company obtained from illegal conduct. Toyota’s $1.2 billion forfeiture, for instance, is described as its gains from a wire fraud scheme to deceive car buyers and the general public. But there is no specific calculation in the charging documents of the benefits the company received by covering up the vehicle defects.
A large company will have multiple revenue streams, and separating out illegitimate gains from normal profits may be impossible. So prohibiting a tax deduction can be part of a calculation to achieve rough justice in resolving a case.
Individuals, however, have much more clearly identifiable sources of income tied to illegal conduct, like increased bonuses or profits from the sale of inflated shares. For them, a forfeiture is closely tied to their actual gains, like the $44 million that Mr. Nacchio realized from the sales that were found to be based on material nonpublic information.
The calculation of a defendant’s gain does not usually incorporate the taxes the person paid on the money received. So refusing to refund that amount is much more likely to appear to be unfair. If legislation is necessary to preclude the deduction of settlements, an exception can be included to let a taxpayer like Mr. Nacchio show that he ought to get back what he paid to the government on money later forfeited.
