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  • Court Rules for Insider Trader Seeking Deduction for Taxed Income Later Forfeited
    March 2014
    On March 12, 2014 the Court of Federal Claims granted a motion for partial summary judgment in favor of the taxpayers in the case of Joseph P. Nacchio and Anne M. Esker v. United States.[1] The taxpayers have filed suit seeking a credit pursuant to section 1341 of the Code. That section allows a credit for amounts included in income in a prior year under “a claim of right” when that income is later determined not to be the taxpayer’s. The amounts at stake in the case are significant and the facts are unusual because the taxable income at issue was derived from criminal activity.
    Facts of the case
    In 2007, Mr. Nacchio, the former CEO of Qwest Communications International, Inc., was convicted of violating U.S. securities laws, and he later was sentenced to serve 70 months in prison, pay a $19 million fine and forfeit “insider trading” profits of approximately $44 million. The profits were derived from the exercise of stock options, and the taxpayers had included those profits in income and paid tax in the year the option income was realized.
    The taxpayers believed that they satisfied the requirements of section 1341 with respect to the income tax paid on the option income and, in 2009, filed an amended return claiming a refund. The IRS denied the refund, the taxpayers then brought suit in the Court of Federal Claims and later moved for partial summary judgment.
    In order to satisfy section 1341, the taxpayers must prove that Mr. Nacchio believed he was entitled to the amounts he later forfeited and that the taxpayers are entitled to a deduction for the amount forfeited. The taxpayers’ motion stated that (i) Mr. Nacchio believed he had a claim of right to the insider trading profits and (ii) once he forfeited those profits he was entitled to deduct the amount forfeited under section 165. Section 165(c) allows a deduction for losses from a for-profit transaction unconnected with a trade or business.
    The government also moved for summary judgment on the grounds that the taxpayer should not be allowed a deduction under section 165, because to do so would contravene public policy. In particular, the government argued that allowing the taxpayers to deduct the amount Mr. Nacchio forfeited “would frustrate the policy of the federal criminal code prohibiting deception, misrepresentation and fraud in connection with the purchase or sale of any security and diminish Mr. Nacchio’s punishment.”
    Opinion of the court
    The court granted a partial summary judgment in favor of the taxpayers on the grounds that the forfeited profits were deductible under section 165, and that to allow the deduction would not contravene public policy. The court stated “in the instant case, there is no reason to compound Mr. Nacchio’s criminal punishment with a tax burden Congress neither expressly nor impliedly directed.”
    In reaching its conclusion, the court cited the Supreme Court in Commissioner v. Tellier: “the federal income tax is a tax on net income, not a sanction against wrongdoing.”[2] The court also relied on the opinion of the Court of Appeals for the Second Circuit in Stephens v. Commissioner[3]. In Stephens the taxpayer had embezzled funds, but later repaid them as restitution. In addressing the taxpayer’s claim for a deduction of the forfeited income, the Second Circuit reasoned that allowing the deduction would not contravene public policy because a taxpayer had received a “stern” sentence.
    The government also argued the taxpayers should be denied the deduction for the forfeited profits under section 162(f), which denies a deduction under section 162(a)[4] for “any fine or similar penalty” paid to a government for the violation of any law. The government sought to extend section 162(f) to amounts deductible under section 165. Relying on Stephens, the court rejected the government’s argument. The government also argued that Mr. Nacchio’s forfeiture was a “similar penalty” within the meaning of section 162(f). The court reasoned that the forfeiture was not a “similar penalty” because it was used to compensate Quest’s shareholders.
    Finally the court granted only a partial motion for summary judgment in favor of the taxpayers, finding that whether Mr. Nacchio received the profits that he later forfeited under a claim of right was an issue of material fact that may only be determined at trial. The court states that “the precise issue of whether Mr. Nacchio himself subjectively believed he had unrestricted right to the funds received from trading in 2001 was not adjudicated in the criminal proceeding. . . . Mr. Nacchio professes innocence, and nothing in this court’s record from the criminal proceeding sheds any light on the bona fides of Mr. Nacchio’s belief.” Thus, only after a civil trial will Mr. Nacchio learn whether he will receive a refund of taxes paid on his forfeited income.
    [1] Court of Federal Claims, No. 1:12-cv-00020, decided March 12, 2014.
    [2] 383 U.S. 687, 691-692.
    [3] 905 F.2d 667 (2d Cir. 1990).
    [4] Section 162(a) allows a deduction for ordinary and necessary business expenses.
    KEYWORD: Amended Returns