The basic rule is simple: the taxpayer bears the burden of proof. That is, all income is gross income unless the taxpayer proves a statutory entitlement to an exclusion; and no expenditure is deductible unless the taxpayer proves a statutory entitlement to a deduction.
Complexity comes in the statutes that allow exclusions and deductions. But the basic burden does not change: it is ultimately the taxpayer who must persuade either the IRS or the Tax Court of their entitlement to the exclusion or deduction claimed.
Clement Ziroli and Dawn M. Ziroli v. Commissioner, T.C. Memo. 2022-75 (July 14, 2022) (Judge Nega), shows us how the burden of persuasion applies in the complexity of a deduction statute. There, the taxpayer sought to deduct an expenditure that was allowed by §162(a) but might or might not be disallowed by the §162(f) prohibition of deductions for penalties. The taxpayer was unable to persuade the Tax Court that the expenditure was not a penalty. He could not prove the negative. Hence, no deduction.
The lesson relates back to the idea we looked at last week: the ambiguity of penalties. Here, that ambiguity worked against the taxpayer because of the burden of persuasion. Details below the fold.
Law: Illegal Income
When Congress first revived the income tax in the Underwood Tariff and Revenue Act of 1913, 38 Stat. 114, there was some question of whether income from illegal sources has to be reported as gross income. Lower courts were conflicted.
In 1946, the Supreme Court decided that at least certain illegal income did not have to be reported. Commissioner v. Wilcox, 327 U.S. 404 (1946). There, the taxpayer had embezzled money from his employer. The Court held the embezzled funds were not taxable, likening the embezzler’s obligation to repay to the obligation a borrower had to repay a lender. Since loans were not taxable, neither were embezzled funds: “It is obvious that the taxpayer in this instance, in embezzling the $12,748.60, received the money without any semblance of a bona fide claim of right.*** The employer, moreover, at all times held the taxpayer liable to return the full amount. The debtor-creditor relationship was definite and unconditional. All right, title, and interest in the money rested with the employer. The taxpayer thus received no taxable income from the embezzlement.” Id. at 409-410.
In 1961, the Supreme Court changed its mind in James v. United States, 366 U.S. 213 (1961). Now, all illegal income constituted gross income, including embezzlement income. The Court said it refused to “perpetuate the injustice of relieving embezzlers of the duty of paying income taxes on the money they enrich themselves with through theft while honest people pay their taxes on every conceivable type of income.” Id. at 220.
It rejected the loan analogy because with loans, there is consent between the lender and the borrower. Instead, the Court looked to the recently decided claim of right doctrine for the proper rule. Here’s the meat of it:
“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 return, 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. In such case, the taxpayer has actual command over the property taxed-the actual benefit for which the tax is paid. This standard brings wrongful appropriations within the broad sweep of "gross income;" it excludes loans.” Id. at 220.
What is interesting about James is that it overruled Wilcox in dicta. The actual issue in the case was whether the taxpayer had committed the crime of tax evasion. He had been convicted of that crime for failing to report embezzled funds. The Circuit Court had upheld the conviction but the Supreme Court reversed, finding that the taxpayer lacked sufficient mens rea because he had relied on Wilcox. But, said the Court, since it was now disapproving of Wilcox, future embezzler’s could no longer rely on that case.
The other interesting dicta in James takes us to our lesson today. The Court noted that the embezzler would be able to deduct any embezzled monies returned to the victim:
“Just as the honest taxpayer may deduct any amount repaid in the year in which the repayment is made, the Government points out that...to the extent that the victim recovers back the misappropriated funds, there is, of course, a reduction in the embezzler's income.”
What the Supreme Court left out was the important point of today's lesson: a taxpayer must still find some statutory basis for any claimed deduction for that “reduction in income.” And it’s the taxpayer’s burden to persuade both the IRS and courts of their entitlement. Whoops.
Law: The Ambiguous §162(f) Restriction on Deductions
Section 162 is often called the workhorse of the deduction statutes. Just as gross income broadly includes both legal and illegal income, so does §162(a) broadly permit a deduction of the ordinary and necessary expenses of carrying on both legal and illegal trades or businesses. For example, a taxpayer can deduct under §162 the costs of defending against criminal prosecution for conducting an unlawful business, even when the taxpayer is found guilty. Commissioner v. Tellier, 383 U.S. 687 (1966) (“The criminal charges...found their source in his business activities as a securities dealer. The...legal fees, paid in defense against those charges, therefore clearly qualify...as expenses paid or incurred...in carrying on any trade or business within the meaning of §162(a).”) Id. at 689.
But §162 contains many other subsections. Most of them impose conditions and restrictions on the basic and broad language in (a). Some of these restrictions concern illegal expenditures. For example, §162(c)(2) prohibits deduction of any payment that “constitutes an illegal bribe, illegal kickback, or other illegal payment under any law of the United States, or under any law of a State (but only if such State law is generally enforced).” Thus a taxpayer in the business of fencing stolen goods can deduct their reasonable office rents, but not the cost of bribing local law enforcement to look the other way.
Today’s lesson involves the restrictions on deductions in §162(f). That subsection gives the general rule that “no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.” §162(f)(1). If the taxpayer can show, however, that the payment was for “restitution,” §162(f)(2) permits the deduction.
Note the burden of persuasion here still lies with the taxpayer. Contrast that with the §162(c)(2) restriction on deductions for illegal payments. There, Congress explicitly shifted the burden of persuasion onto the government to prove that a given payment was illegal. “The burden of proof in respect of the issue, for purposes of this paragraph, as to whether a payment constitutes an illegal bribe, illegal kickback, or other illegal payment shall be upon the Secretary to the same extent as he bears the burden of proof under section 7454 (concerning the burden of proof when the issue relates to fraud).” §162(c)(2).
In contrast, §162(f) contains no such burden-shifting language. Thus, the general rule still applies: the burden rests on the taxpayer to show that a payment either was not paid “in relation to the violation of any law” or, in the alternative, constituted “restitution.” That proves the taxpayer’s undoing in today’s case.
In 2016 the SEC filed a criminal complaint against Mr. Ziroli and several others regarding their business of creating and selling to investors clumps of residential mortgage-backed securities. Mr. Ziroli and the others eventually settled with the SEC. Without admitting or denying the allegations in the Complaint, Mr. Ziroli agreed to accept various consequences, including (1) an obligation to disgorge $412,000 representing profits linked to the allegedly illegal conduct and (2) an obligation to pay a $200,000 civil penalty. Mr. Ziroli paid these amounts directly to the SEC. The record is silent on whether SEC segregated the funds or otherwise attempted to pass on the $412,000 to the former clients allegedly wronged by Mr. Ziroli. For Mr. Ziroli that silence is not golden.
On his 2015 tax return Mr. Ziroli deducted the $412,000. On audit the IRS disallowed the deduction. The matter went to Tax Court where Judge Nega teaches our lesson.
Lesson: Taxpayer’s Burden of Persuasion Matters
It seems pretty clear to me that Mr. Ziroli’s disgorgement was deductible under §162(a) as an ordinary and necessary expenses of carrying on his trade or business. Tellier, supra. It was part of the “cost” of resolving the criminal indictment, just like attorneys fees.
It also seems pretty clear Mr. Ziroli would lose under the current regulations. The current set of regulations provide that disgorgement can only constitute “restitution” within the meaning of the statute if the disgorged funds are reliably paid to the harmed investors. See Treas. Reg. 1.162-21(e)(4)(i)(B). Here, there was no indication that the SEC segregated the funds or otherwise made any attempt to return those funds to the harmed investors.
But the current regulations do not apply to this case. And the former regulations did not directly address the status of “disgorgements.” Instead, the former regulations applied the statutory prohibition to “fines” and “penalties” and then provided that “compensatory damages...paid to a government do not constitute a fine or penalty.” Op. at 7 (quoting the old regs).
Thus, the fight in this case was thus about whether disgorgement was a “penalty” or was instead “compensatory damages.” After going through the case law, Judge Nega concludes that “disgorgement can serve both a compensatory and a punitive purpose, operating both as potential compensation to victims and as a financial sanction meant to deter securities fraud.” Op. at 8.
That conclusion is fatal to the taxpayer. Why? Because of the burden of persuasion. “Specifically, since disgorgement can serve both a compensatory and a punitive purpose, petitioner must show that the disgorgement at issue was primarily designed to serve a compensatory purpose and not a law enforcement purpose.” Op. at 9. But Mr. Zioli could produce only the paltriest of evidence that the purpose of the disgorgement was to compensate his alleged victims. Likewise, Mr. Zioli was unable to persuade Judge Nega that the purpose of the disgorgement was to compensate the federal government. Indeed, the commonsense of it is that the disgorgement was calculated to restore the status quo ante so that the additional civil fine would have actual bite. It was part of the financial sanction meant to deter such conduct in the future.
Quite often the Tax Court does not need to resolve a dispute by relying on the burden of persuasion. The facts will point one way or another. Today, however, we learn that the burden of persuasion remains important and it’s up to the taxpayer not only to prove they meet the requirements of the statutory language granting the deduction, but they must also prove they avoid any statutory language restricting the deduction granted.
Bryan Camp is the George H. Mahon Professor of Law at Texas Tech School of Law. He invites readers to return each Monday (or Tuesday, if Monday is a federal holiday) for another Lesson From The Tax Court here at TaxProf Blog.