Kokesh v. SEC: A Tax Case in Sheep’s Clothing?

The Supreme Court recently heard argument in Kokesh v. Securities and Exchange Commission, a case that at first blush raises a straightforward statute-of-limitations question: Can the SEC sue a defendant to disgorge his ill-gotten gains from a securities law violation beyond five years from the date when the claim first accrued? We write as concerned tax lawyers. If the Supreme Court isn’t careful, the answer to this question could result in a multibillion-dollar annual tax hike to U.S. businesses, some of which we represent.

Let’s start with the nontax issue in the case, the one the parties actually briefed. The relevant statute of limitations requires any “action, suit or proceeding for the enforcement of any civil fine, penalty, or forfeiture, pecuniary or otherwise,” to be brought “within five years from the date when the claim first accrued” (28 U.S.C. section 2462). Charles Kokesh, who stole millions of dollars over a period of 12 years from investment funds he ran and marketed to small-time investors, says this statute bars the SEC from disgorging the profits of his illegal activities beyond the five-year limitations period. The government says disgorgement is not a “civil fine, penalty, or forfeiture,” so section 2462 doesn’t impose any limit on the number of years for which Mr. Kokesh should be held to return his ill-gotten gains.

Enter the unforeseen tax complication — a provision in the Internal Revenue Code containing wording reminiscent of 28 U.S.C. section 2462. Section 162(f) of the code prohibits a deduction for a “fine or similar penalty paid to a government for the violation of any law.” Until recently, the consensus view among tax professionals was that disgorgement payments were properly deductible because both the SEC and the federal courts always characterized disgorgement as remedial. The IRS thought so, too, conceding the point in Tax Court and issuing informal guidance to that effect. But last year, a lawyer at the IRS drafted a memo to an IRS audit team in the field (in this instance, classified as a “chief counsel advice”), which concluded that an SEC disgorgement payment should be a nondeductible fine or penalty on the theory that disgorgement is punitive in nature absent special circumstances.

The Supreme Court granted certiorari in Kokesh right as businesses and their tax advisers were digesting the potential impact of the chief counsel advice upon its release under the Freedom of Information Act. Companies facing SEC enforcement actions or accounting for them on their tax returns have now been put in the position of rooting for the government in Kokesh because a pro-SEC opinion from the Supreme Court — which presumably would explain that disgorgement is not punitive in nature, even if in the context of 28 U.S.C. section 2462 — would surely help them rebut the chief counsel advice. And they hope that, if the government loses, the Supreme Court won’t say anything to lend credence to the chief counsel advice’s questionable, yet-to-be-challenged reasoning.

At oral argument, the Justices appeared to have no appetite for raising, much less deciding, whether taxpayers may deduct disgorgement payments. After all, the parties mentioned the tax issue only in passing. But unless the Court is careful, it could end up rewriting the tax law and turning Kokesh’s statute-of-limitations issue into a boon for the federal fisc. From 2010 through 2015, the SEC secured disgorgement awards totaling $20.5 billion, an average of $3.4 billion per year. In 2015 alone, SEC disgorgement awards totaled $4.2 billion. Many of these awards were procured through settlements in which both the companies and the SEC assumed that defendants could deduct them. An overly broad decision in Kokesh could upend those parties’ expectations, in effect unilaterally reopening already agreed-upon settlements.

In hoping that the Court avoids any unintended tax consequences, potentially affected taxpayers will be on the watch for three things.

First, taxpayers will focus on any statement that disgorgement is always and everywhere punitive. Section 162(f) has generally been interpreted to require an assessment of the law obligating the payment in question — if the payment does not serve a punitive purpose or policy, section 162(f) should not bar the deduction. This rule recognizes that, while the IRS might have expertise to determine a taxpayer’s net income, it is no better than anyone else at distinguishing penalties from other kinds of payments. A categorical statement from the Supreme Court that disgorgement is a form of punishment could jeopardize the settled treatment of disgorgement under section 162(f), tilting the scales toward nondeductibility. There is no need to upset tax law in this way, particularly because Kokesh does not require the Court to decide whether disgorgement is punitive in every case.

Second, taxpayers will focus on how the Supreme Court defines forfeiture. One difference between 28 U.S.C. section 2462 and tax code section 162(f) is that section 2462 includes “forfeitures” in addition to fines and penalties, while section 162(f)’s prohibition on deductibility extends only to “fines and similar penalties.” No precedential authority supports the notion that a civil forfeiture is a “fine or similar penalty” under section 162(f). An opinion in favor of Mr. Kokesh that rests solely on the ground that disgorgement is a forfeiture — without addressing whether it is also a penalty — saves the tax issue for another day.

Third, taxpayers will focus on how much weight the Supreme Court gives the chief counsel advice. Mr. Kokesh cites that advice as evidence that disgorgement constitutes a penalty. But a chief counsel advice typically warrants little, if any, weight. It does not represent the considered view of the IRS and may not be used or cited as precedent. Frequently drafted by mid-level IRS employees, chief counsel advices do not require senior management review and may consist of as little as an email drafted in two hours. If a chief counsel advice addresses a specific taxpayer’s case, the facts may be poorly developed, and the taxpayer probably had no opportunity to respond.

Not only is the chief counsel advice here nonprecedential, but its legal analysis is dubious at best. Rather than recite the time-honored rule that deductibility under section 162(f) depends on whether a payment serves a punitive purpose, the chief counsel advice invented a new test. Section 162(f), it said, asks whether the government suffered any specific pecuniary losses for which the taxpayer’s payment is compensation. There is no tax reason to understand the words “fine or similar penalty” in such an odd way. The advice, rather, ignored a number of authorities that permitted deductions of amounts that did not meet its test. It is doubtful that the IRS intended a sea change in how it understood basic section 162(f) principles. We suspect that if it weren’t for Kokesh, with time the chief counsel advice might well be disavowed and forgotten.

The parties did not focus on any of these points. Mr. Kokesh probably wouldn’t care if he couldn’t deduct his disgorgement payment: a deduction wouldn’t be of use to him if he doesn’t have much taxable income, or if, on balance, the years outside the five-year window resulted in a larger disgorgement payment than any deduction would be worth. But disallowing the deduction for disgorgement payments would be a multibillion-dollar matter, and if the Court isn’t careful, it may decide that issue without realizing it.

Sincerely,

Scott M. Levine

Jones Day

Sean E. Jackowitz

Jones Day

April 27, 2017