No unrestricted right to fraudulently obtained income

A receiver suing on behalf of fraud victims is denied a refund of taxes paid by the taxpayers who defrauded the victims.
By Charles J. Reichert, CPA

The First Circuit held that a court-appointed receiver acting on behalf of defrauded plaintiffs could not use Sec. 1341 to receive a refund of prior taxes paid by the perpetrators of the fraud, reversing a district court decision. According to the appellate court, the fraudsters who had reported the fraudulently obtained income could not have believed that they had an unrestricted right to that income; therefore, the requirements of Sec. 1341 were not satisfied.

Facts: In 2008, as a result of a class-action lawsuit, a group of plaintiffs was granted a $259,085,983 judgment by the District Court of Massachusetts against Cambridge Credit Counseling Corp. (CCCC) and its related corporations due to their fraudulent activity. In 2009, a $256,527,000 judgment against the two brothers who founded the corporations, John and Richard Puccio, was also granted by the court.

Robb Evans & Associates LLC (Evans) was appointed by the court as the receiver to collect those judgments on behalf of the plaintiffs. In an attempt to increase the $2,437,851 recovered as of July 2012, Evans, citing Sec. 1341, filed with the IRS a claim for a $9,387,235 refund of the taxes paid on the fraudulently obtained income reported by the Puccio brothers, CCCC, and CCCC's related corporations on their prior tax returns. The IRS denied the refund claim, and Evans sued for the refund in the District Court of Massachusetts in 2012.

The district court held that, even though the Puccio brothers, CCCC, and CCCC's related corporations did not have an unrestricted right to the income due to their fraud, their fraud should not be imputed to Evans; therefore, the receiver's refund request should be granted as a matter of equity to the victims. The court limited the refund to taxes paid on the actual amounts recovered. Both parties appealed the decision.

Issues: If a taxpayer later repays an amount exceeding $3,000 that, in a prior tax year, was included in income because the taxpayer believed that she or he had an unrestricted right to that income, Sec. 1341 provides two relief options. The taxpayer may take a tax deduction in the year of repayment or reduce his or her tax liability in that year by an amount equal to the additional taxes paid in the prior year due to the inclusion of that income. Courts have held that taxpayers who have fraudulently obtained income could not have believed they had an unrestricted right to that income.

Evans argued that the fraud finding in the original suit filed by the fraud victims did not establish whether the taxpayers had an unrestricted right to the income for income tax purposes. In addition, the receiver argued that Congress enacted Sec. 1341 to reduce inequities and that imputing the taxpayers' fraud to the receiver would deny relief to the fraud victims, a result not intended by Congress.

Holding: The First Circuit held that the taxpayers, due to their fraud, could not have believed they had an unrestricted right to the income when they received it, as required by Sec. 1341. Because a district court and an appellate court in the original fraud case had already determined that the taxpayers committed fraud, Evans was collaterally estopped from claiming that the requirements of Sec. 1341 had been satisfied, the First Circuit held.

The court also rejected Evans's equity argument. The court explained that if a statute has a plain meaning, that meaning must govern. The court found that there was no reason to believe that Sec. 1341 "was intended to give the victims of a taxpayer's fraud a free pass around the 'unrestricted right' requirement" but instead was "plainly designed" to provide relief for taxpayers who are inadequately compensated for taxes paid on income later restored. It further noted that while Sec. 1341 was enacted to address a specific inequity in the Internal Revenue Code, "[w]hen a statute is aimed at addressing a particular inequity in the tax code, it does not follow that the statute may be interpreted to address every inequity attributable to the tax code." Accordingly, the court reversed the district court's decision and remanded it to that court.

  • Robb Evans & Associates, LLC, No. 15-2540 (1st Cir. 3/3/17), rev'g and remanding 9 F. Supp. 3d 165 (D. Mass. 2014)

—By Charles J. Reichert, CPA, instructor of accounting, University of Minnesota—Duluth.

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