McKnight v. Commissioner of Internal Revenue

• Citation: 127 F.2d 572
• Decision Date: 29 April 1942
• Docket Number: No. 10121.,10121.
• Parties: McKNIGHT v. COMMISSIONER OF INTERNAL REVENUE.
• Court: United States Courts of Appeals. United States Court of Appeals (5th Circuit)

127 F.2d 572 (1942)

McKNIGHT v. COMMISSIONER OF INTERNAL REVENUE.

No. 10121.

Circuit Court of Appeals, Fifth Circuit.

April 29, 1942.

R. B. Cannon, of Fort Worth, Tex., for petitioner.

Warren F. Wattles and J. Louis Monarch, Sp. Assts. to the Atty. Gen., Samuel O. Clark, Jr., Asst. Atty. Gen., and J. P. Wenchel, Chief Counsel, Bureau of Internal Revenue, and Vernon F. Weekley, Sp. Atty., Bureau of Internal Revenue, both of Washington, D. C., for respondent.

Before FOSTER, SIBLEY, and HUTCHESON, Circuit Judges.

SIBLEY, Circuit Judge.

The great question here is whether the embezzler of the money or mercantile paper of a bank, who is unable to restore it, makes a taxable gain thereby. Subsidiary questions are as to the precise time the gain, if any, is realized, and as to what deductions are allowable against it.

The petitioner is the administrator of Thomas Spruance, whose estate has assets of only $6,000, and liabilities of $95,000 besides the claim of First State Bank of Arlington, Texas, hereafter discussed. Spruance for several years before his death had been an officer of the Bank, active in its affairs. On April 8, 1937, during an examination of the Bank, shortages began to appear, and one or more were admitted by him. He took his own life on April 12. Thereafter the audit of the Bank revealed shortages and misapplications attributed to Spruance amounting to over $135,000, during the years 1934, 1935, 1936 and 1937. Those of the first three years are in controversy here. The administrator admitted a liability in that amount, subject to credit for about $37,000 remaining in an account to which many of the misapplications were traced, and $25,000 recovered from Spruance's official bond. The administrator did not concern himself with the particular years in which the misapplications may have occurred, as none were barred. The Commissioner of Internal Revenue adopted the claim thus formulated without any independent examination, and expressly on the basis of it distributed the total embezzlements of $135,000 over the four years and assessed additional income taxes accordingly. The Board of Tax Appeals, 43 B.T.A. 221, sustained the Commissioner in treating the misapplications as taxable income, but deducted the $37,000 in the above mentioned special account because it was recovered by the Bank, but refused to deduct the $25,000 paid by the surety on the bond because the surety was subrogated to that extent to the Bank's claim with no reduction in the amount Spruance received. It also refused to charge the wife of Spruance with any tax.

We find insuperable difficulties in the way of the conclusion that one who embezzles funds entrusted to him realizes gain and receives taxable income thereby. Gain is very broadly defined, as to its sources, in the Revenue Acts, Revenue Act 1934, Sect. 22; Revenue Act 1936, Sect. 22(a), 26 U.S.C.A. Int.Rev.Code § 22. The classic definition of income is: "`Gain derived from capital, from labor, or from both combined,' provided it be understood to include profit gained through a sale or conversion of capital assets." Eisner v. Macomber, 252 U.S. 189, 40 S.Ct. 189, 193, 64 L.Ed. 521, 9 A.L.R. 1570. It does not appear here what the embezzler did with what he took, whether he realized any profit from its use or conversion, or even got any enjoyment by spending it. All we know is it is gone and he is left insolvent. Was gain realized by the act of taking? We think not. He got no title, void or voidable, to what he took. He was still in possession as he was before, but with a changed purpose. He still had no right nor color of right. He claimed none. This the Board seems to concede, and finds that the gain arose on his using the funds for his own purposes, whatever they where. The time of using, and not the time of taking, then would determine the incidence of the tax, and about that nothing is known. But when the entrusted fund is used, or even when taken with the purpose of dishonest use, the law immediately and absolutely fixes upon the embezzler the duty to account for and to repay the value of what is taken. No action or election by the owner is necessary. By the taking the embezzler incurs an equivalent debt as surely as if he had borrowed with the consent of the owner. The first takings are, indeed, nearly always with the intention of repaying, a sort of unauthorized borrowing. It must be conceded that no gain is realized by borrowing, because of the offsetting obligation. This would be true even though at the time there was no intention to repay. It seems to us that the same thing is true of each act of embezzlement. Commissioner v. Turney, 5 Cir., 82 F.2d 661.¹

But it is suggested that if a long period elapses without discovery, during which the embezzled funds are enjoyed or made way with, and the embezzler becomes insolvent, so he cannot on discovery be made to restore them, there has been practical gain. If so, it is the insolvency that causes the gain, and its date determines the incidence of the tax. If so, also, a borrower who becomes insolvent similarly realizes gain, but no one has ever thought a bankrupt could be taxed on the debts from which he obtained a discharge; and the doctrine of forgiven debts, sometimes giving rise to gain, has never been extended to insolvent persons. We cannot think that discovery of Spruance's embezzlement and his insolvency in 1937 made taxable gain of that which had not been such before.

Moreover, the direct result of such a doctrine would be that the United States would assert a preferential claim for part of the dishonest gain, to the direct loss and detriment of those...