Funds withdrawn from jail food money account were a loan, not embezzlement income

The Tax Court held that a sheriff’s withdrawal and subsequent repayment of funds used to provide food to prisoners constituted an unauthorized loan and not embezzlement income. Additionally, the court held that a separate withdrawal in a later year that was used to pay for legal and professional services was other income, not gross receipts from a trade or business, and that the expenses were not deductible.

Facts: Ana Franklin was the elected sheriff of Morgan County, Ala., from 2011 to 2019. One of Franklin’s responsibilities as sheriff was to fulfill the mandate under Alabama law to feed prisoners held in the Morgan County Jail. The state of Alabama and the federal government provided a monthly allowance based on the number of prisoners held in the jail. Upon taking office, Franklin gained signatory authority over the “jail food money account” into which the state and federal government deposited the monthly jail food funds. In 2015, having run deficits in the account in three of the past five months and facing projected increases in the inmate population, Franklin looked for ways to subsidize the jail food money account. To this end, she withdrew $160,000 from the account, deposited $5,000 in a checking account, and kept $5,000 in the office safe as petty cash.

Based on the recommendation from her boyfriend at the time, Franklin loaned a local used car dealership and title-pawn lending service $150,000 of the money withdrawn from the jail food money account at a 17% interest rate, with the promise that the funds would be repaid in 30 days. Franklin never received her principal or the promised interest and soon learned that the company was essentially a Ponzi scheme. In December 2016, Franklin’s boyfriend, as personal guarantor for the loan, repaid the $150,000 to Franklin. Later that month, Franklin deposited the funds in the checking account that she had established in 2015.

In December 2017, having received notice that she was under investigation by the U.S. Department of Justice, Franklin filed her Form 1040, U.S. Individual Income Tax Return, for 2015, reporting her wages, taxable interest, and other income, while also itemizing her deductions and claiming a personal exemption. She did not, however, report any income on the return connected to the withdrawal of the funds from the jail food money account. In 2018, the Department of Justice filed charges for a willful failure to file a tax return for tax year 2015 against Franklin, and she pleaded guilty to the charges.

During 2018, Franklin withdrew $44,967 from the jail food money account and used it to pay for personal tax return preparation services, bookkeeping services related to the jail food money account, and legal fees incurred in connection with the federal investigation. Franklin’s timely filed 2018 return included Schedule C, Profit or Loss From Business (Sole Proprietorship), which listed her business as “Sheriff’s Jail Food Account” and reported gross income of $44,967. The Schedule C also reported legal and professional services expenses of $44,967. No other income or expenses were reported on the Schedule C, resulting in zero net profit.

In May 2021, the IRS issued a notice of deficiency for Franklin’s 2015 tax year, determining a deficiency and an addition to tax pursuant to Sec. 6651(a)(1) for failure to file. In July 2022, the IRS modified its original position and alleged that the $155,000 that Franklin withdrew from the jail food money account constituted proceeds from embezzlement. Based on this position, the IRS determined a 2015 deficiency of $43,562 and an addition to tax of $11,319 under Sec. 6651(a)(1).

In January 2022, the IRS issued a notice of deficiency related to Franklin’s 2018 tax year. The Service ultimately reclassified the $44,967 withdrawal as other income, not gross receipts from a Schedule C business, and her 2018 Schedule C business expenses as disallowed employee-related expenses and determined a deficiency of $10,311. Franklin timely petitioned the court, disputing both the 2015 and 2018 adjustments, and the cases were consolidated for trial, briefing, and opinion in December 2022.

Issues: The issues before the court were: (1) whether Franklin received $155,000 of unreported income in 2015 and, if so, its classification as other income or gross receipts from a Schedule C business; (2) whether Franklin was entitled to a net operating loss (NOL) carryback for 2015; (3) whether Franklin was liable for the addition to tax for failure to timely file for 2015; and (4) whether the funds withdrawn and spent in 2018 on legal and professional services constituted gross receipts and expenses related to a Schedule C business.

Sec. 61(a) defines gross income as all income from whatever source derived. Glenshaw Glass Co., 348 U.S. 426 (1955), further provides that gross income includes all “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” Furthermore, James, 366 U.S. 213 (1961), clarifies that gross income includes income earned from illegal activities, such as embezzlement. With respect to Franklin’s $155,000 withdrawal in 2015, the IRS argued that the withdrawal was an act of embezzlement and that Franklin “had an undeniable accession to wealth, derived realized economic value, and exercised completed dominion and control over the funds.” Franklin argued that the withdrawal constituted a loan, given the fact that, “as signatory authority on the jail food money account, she always had dominion and control over the funds in the account, and that she received no accession to wealth when she withdrew the funds because she created a corresponding obligation to repay the funds and that she ultimately did repay them.”

Citing Todd, T.C. Memo. 2011-123, the court explained that there must be a good-faith intent on the part of the borrower to repay the debt and a good-faith intent by the lender to enforce payment of the debt in order for genuine indebtedness to exist. Although Franklin may have exercised poor judgment in withdrawing the funds and lending them to a company that was ultimately a Ponzi scheme, the fact that she intended to (and did) return the funds to the jail food money account persuaded the court that the withdrawn funds constituted a loan and not embezzlement income. Additionally, the court held that Franklin’s repayment of the funds in 2016 “constituted a loan repayment, rather than a repayment of embezzled funds,” and thus Franklin was not entitled to an NOL carryback for 2015. Furthermore, sustaining the 2015 Sec. 6651(a)(1) addition to tax for failure to timely file, the court found that Franklin had not established that her failure to timely file her return was due to reasonable cause and that she had already pleaded guilty to willful failure to file a tax return for 2015.

With respect to Franklin’s 2018 withdrawal of $44,967 from the jail food money account reported on Schedule C, the court examined whether her operation of the jail food money account constituted a trade or business. The court reasoned that Franklin “did not separately or independently undertake the operation of the jail food money account with the intent to make a profit, but rather she was specifically obligated to do so in her position as sheriff.” Furthermore, the court noted that Franklin had not treated the jail food money account as a separate trade or business. In particular, the court highlighted the fact that she had not reported any gross receipts or reported any expenses other than the legal and professional services expenses and had not hired any employees. As a result, the court found that Franklin was not engaged in the trade or business of operating the jail food money account; instead, she did so in the course of her employment as sheriff. Therefore, the court sustained the IRS’s characterization of the withdrawal as other income and not gross receipts from a trade or business.

Franklin’s $44,967 expenditure in 2018 of the funds on legal and professional services consisted of $10,867 paid to an accounting firm for preparing original and amended tax returns and other services and $34,100 paid to two law firms in connection with her criminal tax case.

Sec. 162(a) permits a deduction for ordinary and necessary trade or business expenses paid or incurred during the year. Citing O’Malley, 91 T.C. 352 (1988), the court further explained that “the performance of services as an employee may constitute a ‘trade or business.'” In this framework, “a deduction under [Sec.] 162(a), 167(a), or 179 is a miscellaneous itemized deduction if it is related to the business of performing services as an employee” (Secs. 67(b), 63(d), and 62(a)). Miscellaneous itemized deductions (subject to the 2%-of-adjusted-gross-income floor), however, are suspended for tax years 2018 through 2025 (Sec. 67(g)).

Additionally, Sec. 262 prohibits the deduction of personal, living, or family expenses. Given the court’s determination that Franklin’s operation of the jail food money account was not a trade or business but instead part of her duties as an employee, any nonpersonal expenses would be miscellaneous itemized deductions (subject to the 2% floor) and, therefore, not deductible in 2018 under Sec. 67(g). Similarly, if any of the expenses constituted personal, living, or family expenses under Sec. 262, they would not be deductible. As a result, the court held that it did not need to decide “whether the legal claim was inherently personal or arose in connection with [Franklin’s] status as an employee of the Morgan County Commission, because the expenses would not be deductible under either circumstance.” The court also held that Franklin’s tax return preparation expenses would have been a miscellaneous itemized deduction under Sec. 212(3) but were not deductible because of the suspension of miscellaneous itemized deductions in 2018. Ultimately, the court found that none of the $44,967 of expenses reported on Franklin’s Schedule C were deductible.

Holding: The Tax Court held that Franklin’s 2015 withdrawal from the jail food money account was a loan and, therefore, was not included in her 2015 gross income. The court also held that she was not entitled to an NOL carryback for 2015 and was liable for the Sec. 6651(a)(1) addition to tax for failure to timely file her 2015 tax return. Furthermore, the court held that Franklin’s 2018 withdrawal was appropriately characterized as other income and sustained the IRS’s disallowance of her deduction for legal and professional services.

• Franklin, T.C. Memo. 2025-8

— Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, and John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, both at Cornell University in Ithaca, N.Y. To comment on this column, contact Paul.Bonner@aicpa-cima.com, the JofA‘s tax editor.