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Government piles on, taxpayer pushes back: a case of disgorgement

The celebrated judge Oliver Wendell Holmes once said that taxes are the price we pay for a civilized society.

Justice Holmes issued his famous pronouncement at a time when the very idea of a federal income tax was a new one. Today, a century or so later, all sorts of modern (or postmodern) corollaries and questions are possible.

One of those might be: taxes are arguably not meant to be used as sanction against wrongdoing by an individual or company.

The question of tax deductions for losses due to a government forfeiture proceeding is in the news this week. It is posed by a case involving a former corporate executive who argued that he should be able to take a tax deduction for income that he had to forfeit to the government in an insider trading case.

The former executive and his wife had sought a tax refund after paying extensive capital gains taxes after the executive sold shares in his company, Qwest. Federal authorities charged the man with insider trading - and he was eventually convicted of that crime.

He was also ordered to forfeit millions of dollars in proceeds from the sales of the shares. But the former executive then reasoned that he should not have had to pay taxes on the forfeited amount - a large amount, considering that the forfeiture was for more than $44 million.

The IRS did not accept this argument. But in the ensuing tax litigation, the Court of Federal Claims did. The claims court said a tax deduction could not be denied in order to increase the penalty for a criminal violation.

The claims court pointed to a U.S. Supreme Court case called Commissioner v. Tellier. In that case, the Supreme Court said that taxes in our society are not a "sanction against wrongdoing."

After all, the former executive had already received significant punishment. He was sentenced to a 6-year prison term, as well as a $19 million fine. And, through the forfeiture, he had to disgorge what he had gained through insider trading.

Source: The New York Times, "Deducting the Costs of a Government Settlement," Peter J. Hennig, March 24, 2014

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