The Deductibility of Criminal Restitution & The Claim of Right Doctrine

You have made it a habit to screen your calls, even since your mother gave Uncle Bill your direct line at work. Sure enough, 5:59 PM rolls around, and you have one foot physically out of your office door when your phone rings.

Mother of all that is good and holy…

As you put your briefcase down in the doorway and slowly amble back to your desk, you are at once relieved that it is not your boss with a rush assignment and utterly dismayed that it is Uncle Bill, and he appears to be leaving a message.

The voicemail light begins to blink, mocking you with each seizure-inducing strobe, and despite your better judgment you listen to the message. As you calmly slam the receiver back into the cradle, curse under your breath, and silently throw a tantrum in your mind, you set your head on the desk, try your best to remember your breathing exercises, and wish that you had the patience for more than two anger management classes.

Jedediah, the more enterprising of your two reprobate cousins, both of whom you believed were still locked away in the hoosegow, apparently came upon a bit of cash last year from his job Ned’s Tire Rack, which you always had the feeling was a front for a chop shop or an illegal reptile trade. Now, Bill didn’t precisely use the word “embezzlement,” but you have enough letters behind your name to be able to read between the lines.

The State of Florida has politely asked Jedidiah to return said funds (through a plea agreement), and Jedidiah did so without too much complaint. This would have been Jed’s third out (nine strikes), and he had become increasingly more receptive to the State’s suggestions of late, which, you suppose, is something.

After you explained to Jedediah that Al Capone was finally undone by failing to report his ill-gotten gains on his tax return, Jed has reported every penny that he has received both from above-board “enterprises” and decidedly below-board ones as well. Consequently, Jedediah reported the $97,000 he “came upon” from Ned’s Tire Rack (thus confirming your suspicion that they sold more than just used whitewalls).

After the third minute of the message, in which you learned that Aunt Ethel’s goiter was back, amongst other unnecessary details, Uncle Bill gets to the damn point. Young Jed wants to take a deduction for the restitution under the “claim of right” doctrine, and he wants your blessing to do so. Of course he does, you think to yourself.

You go home, hug the wife, kiss the babies, and walk the dog, but all the while the image of Ethel’s goiter and the question of Jed’s claim of right scheme plays on your subconscious. As per usual, you awaken at an absurdly early hour, drive into work, questioning each car you pass as to what they hell they are doing on the road at this hour, and log on to your favorite legal search engine (don’t lie, it’s Google).

The Claim of Right Doctrine in the Early Courts

The Claim of Right doctrine is a creature of the Code and the courts. The claim of right doctrine relates to the includability of particular items in gross income. Specifically, if a taxpayer receives earnings under a claim of right and without restriction as to its disposition, he has received income, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable to restore its equivalent.[1]

The doctrine remained unquestioned for several years after the 1932 Supreme Court decision in North American Oil until the Supreme Court decided the Wilcox case 14 years later.[2] The court in Wilcox held that embezzled funds are not income because they are received by the embezzler “without any semblance of a bona fide claim of right.”[3] Thus, Wilcox introduced the notion that the claim of right must be bona fide, or legitimate, in order for the income to be taxable.

Codification of Claim of Right Doctrine

In 1954, Congress codified the claim of right doctrine in IRC § 1341. Importantly, the new IRC § 1341 had no effect whatsoever on claim of right as a principle of includability as set forth in Wilcox; instead, it established rules by which the side effects of the annual accounting system could be equitably adjusted when what appeared to be income in one year had to be repaid in a later year.[4]

The general rule of IRC § 1341 is that if (1) an item was included in gross income for a prior taxable year because it appeared that the taxpayer had an “unrestricted right” to such item; (2) a deduction is allowable for the taxable year because it was established after the close of such prior taxable year that the taxpayer did not have an unrestricted right to such item or to a portion of such item; and (3) the amount of such deduction exceeds $3000.

Revisiting Wilcox – Shaping the Claim of Right Doctrine

Finally, in James v. United States,[5] the Court overruled the Wilcox exception to claim of right. The court held that when a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, he has received income which he is required to report on his return.[6]

After James, gross income includes earnings without regard to the lawfulness of their acquisition; includability turns instead on the taxpayer’s control over the funds. Ill-gotten gains are included in gross income because they are within IRC § 61(a), as construed in James. The Supreme Court left no room to distinguish one gain from another “on the basis of the ill by which they were gotten.”[7]

When a Right to Funds is Unrestricted

A taxpayer is likely not entitled to IRC § 1341 treatment upon repayment of illegal funds, such as kickbacks.[8] In Perez, the Middle District of Florida noted that the “unrestricted right” language of IRC § 1341 must be read to exclude from its coverage all those who receive earnings knowing themselves to have no legal right thereto.[9]

Similarly, in the case of McKinney v. U.S., the taxpayer embezzled $90,000 from his employer.[10] He reported and paid taxes on the embezzled money as “miscellaneous income” in 1966, and he refunded the entire amount in 1969. The taxpayer sought relief under IRC § 1341. The taxpayer was convicted in the state courts of embezzlement. The Fifth Circuit held that the benefits of IRC § 1341 are not available when the “item” in question is embezzled funds.[11] It stated simply and straightforwardly that IRC § 1341 could not be read to cover embezzled funds because it could not appear to the taxpayer that he had any right to the funds, much less an “unrestricted right” to them.”[12]

The Supreme Court has held that gain “constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.”[13] However, even though the payments were income, the taxpayer does not hold such income under a “claim of right” because the taxpayer does not have “an unrestricted right to such item.”[14]

Simply put, when a taxpayer knowingly obtains funds as the result of fraudulent action, it “simply cannot appear from the facts known to him at the time” that he has a legitimate, unrestricted claim to the money.[15] When committing an intentional wrong, a taxpayer must be prepared for the eventuality of being discovered and being held liable for repayment in the form of restitution, disgorgement, civil or criminal penalties, or the like.[16]

Plea Agreement & Restitution Not “Same Circumstances” of Income Inclusion

In Kraft v. U.S.,[17] the taxpayer was a doctor who submitted false claims to his insurance provider. This resulted in the insurance company overpaying the amount of its reimbursement to the taxpayer for such tax year. Pursuant to a plea agreement the taxpayer reimbursed the insurance company and claimed an IRC § 1341 deduction. The Sixth Circuit held that, under IRC § 1341, the obligation to pay the money must arise from the same circumstances, terms and conditions of the transaction whereby the amount was included in income and that the money paid based on the plea agreement the salary that he had included as income did not result from the same circumstances.[18]

Similarly, in Bailey v. Commissioner,[19] the taxpayer was obligated to pay $1,036,000 as judgment in a suit brought by the FTC to recover certain penalties. The taxpayer argued that this amount arose from his original receipt of salary and dividend payments in an earlier tax year; however, the Sixth Circuit held that the amount of the penalty bore no relationship to the previous amounts.[20]

What About § 165 Deductions?

The Tax Court has plainly held that IRC § 1341 does not apply to the restoration of illegally obtained funds.[21] As such, the Tax Court held that the provisions of IRC § 1341 will not be applicable in the computation of his income tax liability with respect to such repayment. An old Revenue Ruling from 1965, however, opened the door to deductions pursuant to IRC § 165 with respect to the repayment of illegally received funds as restitution.[22]

In following the Revenue Ruling, the Fifth Circuit in McKinney acknowledged that the embezzler/taxpayer was entitled to a loss deduction under IRC § 165 in the year he repaid the embezzled funds.[23] Similarly, in Stephens v. Commissioner,[24] the Second Circuit held that taxpayers, who repay embezzled funds, are ordinarily entitled to a deduction in the year in which the funds are repaid, so long as the restitution is “primarily a remedial measure to compensate another party,” and is not “a fine or similar penalty.” Similarly, a taxpayer was entitled to deduction provided by IRC § 1211 against capital gains in the year in which he paid restitution under a plea agreement.[25]

However, it is important to note that taxpayers generally have been prohibited from carrying back losses arising from repayments of [ill-gotten] funds.[26] For instance, the courts have held that since embezzlement is not a “trade or business,” repayments of embezzled funds are deductible only under IRC § 165(c)(2), as losses incurred in a transaction for profit, rather than under IRC § 165(c)(1), as trade or business losses. This is critical, because deductions under IRC § 165(c)(2) are not included in net operating losses to the extent provided by IRC § 172(d)(4).[27]

Following Up with Uncle Bill

You wait until noon to call Bill, because he is generally a “late riser” as he likes to say (or a “bum,” as your mother is wont to say). Sure enough, Aunt Ethel answers and tells you that Bill is still snoring like a drunk with a jackhammer, and (after expressing your sorrow at the goiter news) you ask her to have Bill call you back.

She tells you to hold on, puts the receiver on the double-wide’s counter, and you hear quite a kerfuffle as she endeavors to awaken Bill, whose snoring you can hear through the other end of the phone. You laugh at how accurate Ethel’s characterization of Bill’s snoring actually is. As you’re chuckling, Bull scuffles to the phone.

Bill, who like a redneck, Mainer Jay Gatsby insists on calling you “Old Sport,” asks for the good news. You explain that the claim of right doctrine is not going to pan out for Jedediah, but that there is a silver lining with regard to IRC § 165. Bill whistles through his teeth (most of which are fake, after his brief but eventful career as an enforcer for the Hartford Whalers), and he tells you that he knew he could count on you.

Because you are your mother’s son, and you can’t help yourself, you tell him to give you a call if he has any other questions. He tells you that he surely will (of which you have zero doubt), and he thanks you with a newfound lightness in his voice.

Something about his jocund, almost liberated tone tells you that he is not wearing pants, and you thank God for the firm’s policy against house calls.


[1] North American Oil Consolidated v. Burnet, 286 U.S. 417, 424 (1932).

[2] Commissioner v. Wilcox, 327 U.S. 404, 408 (1946).

[3] Id.

[4] See, Perez v. United States, 553 F.Supp.558, 560 (M.D. Fla. 1982).

[5] 366 U.S. 213, 219 (1961).

[6] Id.

[7] Perez, 553 F.Supp. at 560.

[8] Perez v. U.S., 553 F.Supp. 558, 560-61 (M.D. Fla. 1982); see also Zadoff v. U.S., 638 F.Supp 1240, 1243 (S.D.N.Y. 1985).

[9] Perez, 553 F. Supp. At 560.

[10] 574 F.2d 1240, 1241 (5th Cir. 1978).

[11] Id. at 1243.

[12] Id.

[13] Rutkin v. United States, 343 U.S. 130, 136 (1952).

[14] Perez, 553 F.Supp. at 1243 (citing Treas. Reg. § 1.1341-1(a)(1), (a)(2)).

[15] Culley v. United States, 222 F.3d 1331, 1335 (Fed. Cir. 2000); see also Parks v. United States, 945 F.Supp. 865, 866–67 (W.D.Pa.1996) (denying taxpayers’ motion for summary judgment because there would be no unrestricted right to proceeds of sale of business if allegations of fraud were proven at trial); Zadoff v. United States, 638 F.Supp. 1240, 1243 (S.D.N.Y.1986) (no unrestricted right to illegal kickbacks and salary received while acting in a manner disloyal to employer); Wang v. Commissioner, T.C. Memo 1998-389 (no unrestricted right to profits from sale of insider information in violation of securities laws); Yerkie v. Commissioner, 67 T.C. 388, 392 (1976) (no unrestricted right to embezzled funds).

[16] Culley, 222 F.3d at 1336.

[17] 991 F.2d 292, 298-99 (6th Cir. 1993).

[18] Id.

[19] 756 F.2d 44 (6th Cir. 1985); see also Dominion Resources Inc., v. U.S., 219 F.3d 359 (4th Cir. 2000) (same).

[20] Id.

[21] O’Hagan v. Commissioner, T.C. Memo. 1995-409; Yerkie v. Commissioner, 67 T.C. 388, 390 (1976).

[22] Rev. Rul. 65-254.

[23] McKinney, 574 F.2d at 1231 (noting that the “Government does not dispute the taxpayer’s entitlement to a deduction for the year [the funds were paid back]”); see also Wood v. U.S., 863 F.2d 417, 420 (5th Cir. 1989) (same).

[24] 905 F.2d 667, 671 (2d Cir.1990).

[25] Culley, 222 F.3d at 1336.

[26] Mannette v. Commissioner, 69 T.C. 990, 992–93 (1978).

[27] Id.; see also Yerkie, 67 T.C. at 393; Hankins v. United States, 403 F. Supp. 257 (N.D. Miss.); Rev. Rul. 65-254; Fox v. Commissioner, 61 T.C. 704, 712-714.

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