Wood v. U.S., 88-3088

• Decision Date: 20 January 1989
• Docket Number: No. 88-3088,88-3088
• Citation: 863 F.2d 417
• Parties: -709, 89-1 USTC P 9143 Glen D. WOOD, Karen Kraak Wood, and Karen Eslinger Wood, Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.
• Court: U.S. Court of Appeals — Fifth Circuit

Page 417

863 F.2d 417

63 A.F.T.R.2d 89-709, 89-1 USTC P 9143

Glen D. WOOD, Karen Kraak Wood, and Karen Eslinger Wood Plaintiffs-Appellants, v. UNITED STATES of America, Defendant-Appellee.

No. 88-3088.

United States Court of Appeals Fifth Circuit.

Jan. 20, 1989.

John Harllee, Jr., Washington, D.C., Anita M. Warner, New Orleans, La., Martha Purcell Rogers, Washington, D.C., for plaintiffs-appellants.

Paul M. Predmore, Teresa E. McLaughlin, Gary R. Allen, Chief, William S. Rose, Jr., Jonathan S. Cohen, Appellate Sec., Asst. Attys. Gen., Tax Div., U.S. Dept. of Justice, Washington, D.C., for defendant-appellee.

Appeal from the United States District Court For the Eastern District of Louisiana.

Before JOHNSON, JOLLY and JONES, Circuit Judges.

EDITH H. JONES, Circuit Judge:

At issue is the status as taxable income of, or the right to a loss deduction for proceeds from drug smuggling forfeited to the federal government. The district court ruled that the drug proceeds were taxable income, and that the Appellant was not entitled to a loss deduction on the forfeited property under 26 U.S.C. Sec. 1341 or Sec. 165 on statutory and public policy grounds. 693 F.Supp. 452. Finding no error in the district court's grant of summary judgment to the government, we affirm.

BACKGROUND

In 1978 and 1979, Appellant Glen D. Wood ¹ received commissions on marijuana that he handled. ² He earned $168,000 in commissions in 1978 and $432,000 in 1979, or a total of $600,000. The money was eventually channelled into a real estate development project at Basalt, Colorado. In 1982, Wood began cooperating with a federal investigation, and in 1983, he pled guilty to conspiracy to import marijuana and importation of marijuana. He was sentenced to serve four years in prison and to pay a $30,000 fine. Wood has paid the fine and has been released after serving his sentence.

In 1984, Wood submitted a "Counter Letter in Lieu of Forfeiture Proceeding" admitting that his interest in the Basalt properties was directly traceable to his $600,000 in commissions from drug smuggling, and thus, that the property had been impressed at all times with a constructive trust in favor of the federal government. Under the terms of the letter, he turned over his interest in the property to the Government.

In 1985, the IRS conducted an audit of Wood's personal income tax returns. The IRS asserted deficiencies for 1978 and 1979 income tax that reflected a tax on the unreported drug proceeds. Wood consequently paid $309,551 in back taxes and $154,756 in additions to tax for fraud under 26 U.S.C. Sec. 6653(b) as well as $271,249.53 in interest. Wood then filed administrative claims for refund with the IRS. The IRS denied the claims and Wood filed this suit for refund in the district court. The complaint sets out the amounts Wood asserts are due on some of his refund theories, but those are not at issue in this appeal.

On cross motions for summary judgment, the district court ruled that the proceeds were taxable income since Wood had exercised complete dominion and control over them in the taxable years, notwithstanding that they were later forfeited to the government. The district court denied a deduction under 26 U.S.C. Sec. 1341 for taxes paid on income that was later determined to be subject to a superior claim of right. The district court also denied a loss deduction under 26 U.S.C. Sec. 165 on public policy grounds. Finally, the district court ruled that an Eighth Amendment claim was barred because it was not raised in the prior IRS proceeding. Wood appeals each of these rulings.

I. DRUG PROCEEDS AS TAXABLE INCOME

We first consider whether the district court erred in including proceeds from drug smuggling as taxable income when the proceeds were forfeited to the federal government. Wood rests his claim regarding what is taxable income on an "estoppel" or "preclusion" argument. Section 61 ³ of the federal tax code plainly defines gross income as "all income from whatever source derived." Wood concedes that the gains from illegal activities are just as taxable as gains from legal activities. See James v. United States, 366 U.S. 213, 81 S.Ct. 1052, 6 L.Ed.2d 246 (1960) (overruling Commissioner v. Wilcox, 327 U.S. 404, 66 S.Ct. 546, 90 L.Ed. 752 (1946)). Instead, Wood claims that prior cases are distinguishable because this is the first case where the IRS has imposed a tax on proceeds that were already forfeited to the government. The government, he asserts, is acting inconsistently when it secures title to property and then taxes that property. Wood's entire argument is summarized in his assertion that "to require such a result is fundamentally unfair." Wood asks this Court to forbid or preclude the government from acting in this way.

Yet, Wood's claim must fail, because the test for taxable income is not title. The test is actual dominion and control. In James, 366 U.S. at 219, 81 S.Ct. at 1055, the Supreme Court explained that a "gain 'constitutes taxable income when its recipient has such control over it that, as a practical matter, he derives readily realizable economic value from it.' " (quoting Rutkin v. United States, 343 U.S. 130, 137, 72 S.Ct. 571, 575, 96 L.Ed. 833 (1952)). There is no dispute that Wood exercised complete dominion and control over the proceeds from the drug smuggling. It does not matter that by operation of law all right and title vested in the government as soon as the money was earned. The government did not even know the proceeds existed until some years later.

Thus, it is not inconsistent to tax income for years in which it was of economic benefit to the taxpayer. Moreover, whether or not forfeiture proceedings have begun should not affect the determination whether particular income is taxable. Nor should the test for taxable income turn, as Wood argues, on whether a taxpayer had to forfeit the proceeds to the federal government rather than make restitution to other victims. See James, supra (an embezzler was required to include embezzled funds in his gross income in the year when the funds were misappropriated, notwithstanding that he might later have to make restitution to the victim). The legal test for taxable income is dominion and control, and that test in its terms excludes consideration of what happens to income after it flows from the taxpayer's hands.

There are of course statutory exemptions from taxable income. Wood admits there is no case law on point, but he requests this Court to carve out an exemption for ill-gotten proceeds that were already forfeited to the federal government and for which no taxes have yet been paid. Even if we thought such an exemption equitable, it is for Congress to carve out such exemptions, not the courts.

II. LOSS DEDUCTION UNDER 26 U.S.C. Sec. 1341

We next consider whether the district court erred in denying a deduction for the forfeited proceeds under 26 U.S.C. Sec. 1341. ⁴ The district court concluded that "[t]he case of McKinney v. United States, 574 F.2d 1240 (5th Cir.1978), makes it very clear that Sec. 1341 cannot be used as authority to give plaintiff a deduction for a loss." (footnote omitted) In McKinney, this Court held that Sec. 1341 could not be invoked to justify a refund where the taxpayer restored embezzled funds to his employer. The Court ruled that the initial statutory requirement that "it appeared that the taxpayer had an unrestricted right to such item" was not met. ⁵ Id. at 1243. Wood argues that McKinney can either be distinguished, or that it should be overruled.

Wood asserts that it appeared to him that he had an unrestricted right to the drug proceeds even though they were subject to forfeiture to the federal government. Although the embezzler in McKinney knew that the funds did not belong to him, Wood alleges he did not know of the common law forfeiture in effect at the time of his drug activity. Thus, Wood argues that the availability of Sec. 1341 should turn on his knowledge, or lack thereof, that he had no right to the drug proceeds.

We are reluctant to hold that a wholly subjective test of a claim of right to ill-gotten gains governs Sec. 1341(a)(1). Speculation on the grounds for Wood's claim of right to drug trafficking money ⁶ is, however, unnecessary, as his Sec. 1341 claim is foreclosed for an additional reason.

Section 1341 only applies where the taxpayer is entitled to a deduction under another provision of the tax code. United States v. Skelly Oil Co., 394 U.S. 678, 683, 89 S.Ct. 1379, 1382-83, 22 L.Ed.2d 642 (1969). Even if Wood prevailed on his theory that McKinney is distinguishable or must be overruled, he must then furnish another statutory source for a deduction. As will be seen, he cannot do this. ⁷

III. LOSS DEDUCTION UNDER 26 U.S.C. Sec. 165

The district court ruled that the "forfeited money is properly classified as a loss under Sec. 165 ⁸," but that "the loss must be disallowed due to the 'sharply defined national policy against the possession and sale of marijuana.' " (quoting Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 33-34, 78 S.Ct. 507, 510, 2 L.Ed.2d 562 (1958)).

Wood takes issue with this conclusion for three interrelated reasons. First, he relies on James v. United States, supra, which commented on the deductibility to an embezzler if funds were repaid to the victim:

We do not believe that Congress intended to treat a law-breaking taxpayer differently. Just as the honest taxpayer may deduct any amount repaid in the year in which the repayment is made, the Government points out that, "if, when, and to the extent that the victim recovers back the misappropriated funds, there is of course a reduction in the embezzler's income." (footnoted omitted)

366 U.S. at 220, 81 S.Ct. at 1056. Likewise, in McKinney, this court acknowledged that the embezzler was entitled to a loss deduction in the year he repaid the embezzled funds, 574 F.2d at 1241, even though the full benefit of Sec. 1341 was not available to...