Buff v. Comm'r of Internal Revenue

• Decision Date: 08 May 1972
• Docket Number: Docket No. 3573-68.
• Citation: 58 T.C. 224
• Parties: WILBUR BUFF, PETITIONER v. COMMISSIONER OF INTERNAL REVENUE, RESPONDENT
• Court: U.S. Tax Court

58 T.C. 224

WILBUR BUFF, PETITIONER

v.COMMISSIONER OF INTERNAL REVENUE, RESPONDENT

Docket No. 3573-68.

United States Tax Court

Filed May 8, 1972.

Robert D. Heyde, for the petitioner.

Marwin A. Batt and Marlene Gross, for the respondent.

1. Held, the funds embezzled by the petitioner in the taxable year 1965 did not constitute gain or income to him since in the same taxable year, there was, by agreement of the parties, a confession of judgment entered against him for the amount taken.

2. Held, the petitioner is not entitled to deductions claimed in 1965 for the payment of real property taxes and for the payment of home mortgage interest payments.

3. Held, petitioner has carried his burden of proving that he is entitled to a carryover capital loss.

4. Held: No part of any underpayment of any tax for 1965 was due to negligence or intentional disregard of rules and regulations. Therefore, the petitioner is not liable for the addition to the tax under sec. 6653(a).

QUEALY, Judge:

The respondent determined a deficiency in the Federal income tax of the petitioner and an addition to the tax as follows:

+---------------------------------------------------------------------+
                ¦    ¦      ¦            ¦Addition to tax        ¦Addition to tax     ¦
                +----+------+------------+-----------------------+--------------------¦
                ¦    ¦Year  ¦Deficiency  ¦under sec. 6651(a) 1  ¦under sec. 6653(a)  ¦
                +----+------+------------+-----------------------+--------------------¦
                ¦    ¦      ¦            ¦                       ¦                    ¦
                +----+------+------------+-----------------------+--------------------¦
                ¦1965¦      ¦$10,650.40  ¦$518.34                ¦$532.52             ¦
                +---------------------------------------------------------------------+
                

In addition to the confession of judgment, the petitioner obtained a loan in the amount of $1,000 from the Lafayette Bank, Brooklyn, New York, which he paid to his employer. At the same time, the employer retained the petitioner as an employee pursuant to an agreement whereby $25 per week of the total wages payable to the petitioner would be withheld in partial repayment of the petitioner's debt.

We thus have a simple situation where an embezzler is discovered and within the same taxable year the embezzler and his employer agree that the amount taken shall be treated as a judgment debt due from the embezzler. Whether it is a matter of self interest or otherwise, the employer initially deemed it to be to his advantage to disregard the criminality of the petitioner's act in consideration for the agreement by the petitioner to repay the debt.

The respondent argues that once there has been a misappropriation of funds by the employee— the die is cast— the embezzler realizes taxable income. The respondent contends that the only offset to the realization of such income is through the ‘deduction’ allowed by the respondent under section 165(c)(2) on account of the repayment of the amount embezzled. Thus, the respondent contends that the income of the embezzler is subject to diminution only by repayment of the amount embezzled, and he concludes that such diminution occurs only in the taxable year of such repayment.

The petitioner argues that in determining whether petitioner realized income as a result of taking funds which belonged to his employer, the transaction must be looked at as of the close of the taxable year. In that light, the petitioner cannot be said to have realized any gain. While he had taken and spent some $22,000 belonging to his employer, there was entered against him a judgment for an equivalent amount. New York Civil Practice Law section 5201 (McKinney 1963) provides as follows:

A money judgment may be enforced against any property which could be assigned or transferred, whether it consists of a present or future right or interest and whether or not it is vested, unless it is exempt from application to the satisfaction of the judgment.

Section 5203 of the New York Civil Practice Law then provides that a judgment, when docketed, constitutes a lien on any real property for a period of 10 years, which period can be renewed.

The petitioner's argument would clearly be correct if the Court in the instant case were faced with a situation where there had been a receipt of income through error or mistake. United States v. Merrill, 211 F.2d 297 (C.A. 9, 1954); J. W. Gaddy, 38 T.C. 943 (1962), reversed in part on other grounds 334 F.2d 460 (C.A. 5, 1965). See also Bates Motor Trans. Lines v. Commissioner, 200 F.2d 20 (C.A. 7, 1952), affirming 17 T.C. 151 (1951), and Norman Mais, 51 T.C. 494 (1968). In United States v. Merrill, supra, the taxpayer received a payment of $7,500 in executor's fees which were mistakenly paid out by his wife's estate in 1940. The mistake was discovered in the same year, and the taxpayer made appropriate adjustments to his records and those of his wife's estate in recognition of the mistake. The $7,500 was subsequently repaid by the taxpayer in 1943. The court held that the taxpayer was not taxable on the payment in 1940. In so holding, the court said in pertinent part:

We think the $7500 receipt in 1940 was thereby placed outside the operation of the ‘claim of right’ rule. * * * The usual case for application of the rule involves a taxpayer who has received funds during a taxable year, who maintains his claim of right thereto during that year, and who subsequently, in a later year, is compelled to restore the sum when his claim proves invalid. We are not aware that the rule has ever been applied where, as here, in the same year that the funds are mistakenly received, the taxpayer discovers and admits the mistake, renounces his claim to the funds, and recognizes his obligation to repay them. * * * We think there is no warrant for extending the harsh claim of right doctrine to such a situation. * * *

In J. W. Gaddy, supra, this Court said:

The case of United States v. Merrill, supra, admittedly creates an exception to the claim-of-right doctrine. The Tax Court in Charles Kay Bishop, 25 T.C. 969 (1956), has accepted the doctrine of United States v. Merrill, supra. We have not found any decision which has eliminated the exception to the claim-of-right doctrine announced in United States v. Merrill. * * * The claim-of-right doctrine and the exception to that doctrine announced in the Merrill case are both in essence predicated upon the practical principle of requiring taxpayers to account on the basis of an annual accounting period; cf. Burnet v. Sanford & Brooks Co., 282 U.S. 359 (1931). Therefore, if the taxpayer does not discover the mistaken overpayment, renounce his claim of right thereto, and recognize his obligation for repayment in the same taxable accounting period, the general rule of the claim of right applies and the exception to the doctrine is inapplicable. See Healy v. Commissioner, 345 U.S. 278.

We must determine if there is a difference with respect to an illegal taking which would call for the application of a different rule.

The treatment of embezzled funds as income to the embezzler is of relatively recent origin. James v. United States, 366 U.S. 213 (1961). Fifteen years prior to the James case, the Supreme Court had held that the proceeds of embezzlement were not taxable as income. Commissioner v. Wilcox, 327 U.S. 404 (1946). In the consideration of the question presented here, we must therefore look to the James case as a starting point.

In James v. United States, supra, the petitioner, a union official, had embezzled large sums during the years 1951 through 1954, inclusive. He failed to report these amounts in his gross income. He was indicted and convicted of willfully attempting to evade the Federal income tax on such funds. His conviction was affirmed on appeal by the U.S. Court of Appeals for the Seventh Circuit (273 F.2d 5). On certiorari, the Supreme Court reversed that decision and remanded the case with direction to dismiss. In so doing, however, a majority of the Supreme Court took occasion to overrule its prior decision in Commissioner v. Wilcox, supra. Writing the opinion for the Court, Chief Justice Warren said:

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.’ North American Oil v. Burnet, supra, at p. 424. In such case, the taxpayer has ‘actual command over the property taxed—the actual benefit for which the tax is paid,‘ Corliss v. Bowers, supra. This standard brings wrongful appropriations within the broad sweep of ‘gross income’; it excludes loans. When a law-abiding taxpayer mistakenly receives income in one year, which receipt is assailed and found to be invalid in a subsequent year, the taxpayer must nonetheless report the amount as ‘gross income’ in the year received. United States v. Lewis, supra; Healy v. Commissioner, supra. We do not believe that Congress intended to treat a law-breaking taxpayer differently.

Clearly, the opinion of the majority in the James case holds that embezzled funds constitute income in the hands of the embezzler, notwithstanding the indebtedness or obligation to repay which arises as a matter of law from the taking of property belonging to another. The dominion and control over the funds which the embezzler acquires through his act and the economic enjoyment which he derives from such funds are relied upon as a basis for the tax. The opinion goes on to state that ‘to the extent that the victim recovers back the misappropriated funds, there is of course a reduction in the embezzler's income.’ As authority for this latter proposition, the opinion refers to the brief filed on behalf of the Government.

Following the James ...