Deduction disallowed for criminal restitution for fraudulent loan

The Tax Court denies that $400,000 was incurred in the trade or business of being an employee or in a transaction entered into for profit.
By Sebastian Benjamin Murolo, CPA, MBA

The Tax Court denied a taxpayer's claim that $400,000 he paid in criminal restitution was deductible as a miscellaneous itemized deduction.

Facts: Martin Washburn was president of FoodPro, a California company, which owned a majority stake in Golden Sierra Partners (GSP) LLC, of which he was corporate secretary. In 2003, GSP obtained a $9.4 million loan from Overseas Private Investment Corporation (OPIC) to build a grain milling and baking operation in Estonia. FoodPro was GSP's U.S. sponsor for purposes of this loan.

In March 2005, OPIC discovered that GSP had misrepresented certain facts on its loan application. In 2011, Washburn pleaded guilty in a district court to one count each of (1) conspiracy to commit mail and wire fraud and (2) money laundering. As part of his sentence, he was ordered to pay $750,000 in restitution. In 2014 Washburn made four restitution payments totaling $400,000 from his individual retirement accounts and investment accounts.

Issues: On his 2014 federal income tax return, Washburn listed the $400,000 as estimated taxes paid. In May 2015, the IRS notified Washburn that no estimated tax payments had been made, removing the $400,000 from the calculation. During a Collection Due Process hearing, Washburn abandoned his argument that the restitution payments represented estimated tax payments but then said they should be reflected as tax credits against his 2014 tax under Sec. 1341. IRS Appeals rejected this and sustained the proposed levy. Washburn filed a petition with the Tax Court seeking review of the notice of determination.

Washburn conceded at trial that the payments were not estimated taxes or credits; instead, he said he was entitled to a miscellaneous itemized deduction for them. The court examined whether they could be deducted under Sec. 162(a) as an ordinary and necessary business expense of the trade or business of being an employee, under Sec. 165(c)(1) as a loss incurred in such a trade or business, or under Sec. 165(c)(2) as a loss from a transaction entered into for profit.

Holding: The Tax Court noted that under Sec. 67(b) and Temp. Regs. Sec. 1.67-1T(a)(1)(i), the restitution payments would be deductible as miscellaneous itemized deductions under Sec. 162(a) or 165(c)(1) if they constituted expenses or losses attributable to the performance of services of an employee and only to the extent the employee was not entitled to reimbursement from his or her employer for the expenses. Washburn's W-2 from FoodPro showed he was an employee of FoodPro in 2014, and his employee status with GSP was unclear, but he failed to show that he was not entitled to reimbursement from either of these entities for his payments.

The Tax Court further stated that even if he was not entitled to reimbursement, however, Washburn had not proved that the restitution payments were ordinary and necessary business expenses or were losses incurred as an employee of either entity. The court found that the restitution payments were in substance repayments of the loan GSP fraudulently obtained from OPIC. Under longstanding Supreme Court precedent (Kirby Lumber Co., 284 U.S. 1 (1931)), a payment of loan principal is not deductible because loan proceeds are not includible in income when received. Thus, the Tax Court held that restitution payments Washburn made were not deductible as ordinary or necessary trade or business expenses under Sec. 162(a) or 165(c)(1).

The Tax Court then considered whether the restitution payments were deductible as expenses incurred in a transaction Washburn entered into for profit under Sec 165(c)(2). Citing Supreme Court precedent (Burnet v. Clark, 287 U.S. 410 (1932)), the court found that the business that a corporation's officer conducts on behalf of the corporation is not his or her own business. The court observed that Washburn's misdeeds with regard to the loan were done in his capacity as secretary of GSP and president of FoodPro, for the benefit of those entities. Moreover, the restitution payments Washburn made were intended to compensate OPIC for its loss related to its loan to GSP. Therefore, the Tax Court concluded that Washburn had not shown he was engaged in a transaction entered into for profit and, accordingly, held that he could not deduct the restitution payments under Sec. 165(c)(2).

  • Washburn, T.C. Memo. 2018-110

— By Sebastian Benjamin Murolo, CPA, MBA, an assistant professor at Queensborough Community College, The City University of New York, Bayside, N.Y.

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