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Appeals Court Rejects Tax Refund For Former Qwest CEO Nacchio’s $44 Million Forfeiture

Posted on June 15, 2016

An earlier version of this post appeared on the Forbes PT site on June 13, 2016.

Former Qwest CEO Joseph Nacchio is no stranger to lots of attention;  his conviction for insider trading was front page news, and following his release from prison he has been an outspoken critic of the US penal system and the laws with respect to insider trading. While Nacchio has served his time,  the tax consequences of his $44 million in court-ordered forfeiture payments have been the continuing subject of litigation.

A couple of years ago, our Forbes colleague Janet Novack discussed Nacchio’s refund suit at the Court of Federal Claims in Former Qwest CEO Could Score $18 Million Tax Refund For Forfeited Insider Trading Profits and in a follow up US Avoids Trial on EX Qwest CEO’s Claims With $18 Million Tax Refund Deal. In Procedurally Taxing I looked at some of the issues in Insider Trading and Forfeiture of Millions in Stock Gains Runs into Section 1341 and Issue Preclusion.

Last week the Court of Appeals reversed the lower court and held in a precedential opinion that Nacchio is not entitled to deduct the forfeited funds as either a trade or business expense under Section 162 or a loss under Section 165. Because the Court held that Nacchio was not entitled to deduct the forfeited funds, it did not reach the issue under Section 1341. The upshot of the opinion is that Nacchio effectively had to use after tax dollars to pay his the $44 million forfeiture payment.

This is a significant opinion, as the Court of Federal Claims opinion below had looked to the underlying nature of what the US did with the forfeited funds to determine whether it would treat the forfeited amounts as analogous to a nondeductible “fine or similar penalty.” In rejecting that approach the Court of Appeals makes forfeiture payments doubly painful as those funds will have to come from after-tax dollars.

I will briefly summarize the facts, highlight the procedural posture of the case, describe the special relief Nacchio sought, and discuss the main points of the Court of Appeals opinion.

As I described in 2014, while he was CEO in 2001 “Nacchio sold shares and reported over $44 million in net gain from these stock and paid just under $18 million in taxes on the gain. The stock tanked just after the sale. The SEC and Department of Justice came down hard on him. He was convicted on 19 counts of insider trading, and eventually ordered to pay a $19 million fine and to forfeit the $44 million in net profit from the sale of the shares.”

The Court of Federal Claims had partially resolved the case on summary judgment motions that both parties filed. In resolving those motions, it held that Nacchio was entitled to deduct the forfeiture payment as a loss under Section 165, but that he was not entitled to deduct the loss under Section 162. It also held that his criminal conviction for insider trading did not necessarily collaterally estop him from arguing that he was entitled to use Section 1341 to help unwind the inclusion in the year he remitted the forfeited funds, as Section 1341 turned in part on whether he had a subjective belief that he was entitled to the ill gotten gains. It thus kicked the 1341 issue down the road to a trial.

To take advantage of Section 1341 1) the taxpayer must have subjectively believed he had an unrestricted right to the money in the year it was received based on all the facts available that year; and 2)the taxpayer must be entitled “to a deduction (in excess of $3,000) under another section of the Internal Revenue Code for the loss resulting from” repaying the money.

If the taxpayer meets the requirements of Section 1341, then the taxpayer is entitled to either the equivalent of a refund for income tax paid in the earlier year, or a deduction from income in the year of repayment, whichever is more beneficial to the taxpayer.

Nacchio was pushing for the special treatment in Section 1341 that would allow him to get a credit for the taxes he paid in the earlier year when he included in income the funds that he eventually used to forfeit the $44 million in profits.

The 1341 issue was never tried at the Court of Federal Claims. The procedural posture of the case on appeal was somewhat unusual. As the Court of Appeals described,

“[r]ather than proceed to trial on Nacchio’s claim for special relief under I.R.C. § 1341, the government stipulated to the entry of final judgment in favor of Nacchio, waiving its right to challenge Nacchio’s claims under § 1341 on other than deductibility and estoppel grounds; the government expressly reserved its right to appeal the court’s adverse rulings on those issues. Nacchio reserved his right to appeal the court’s adverse ruling as to deductibility under § 162.”

On appeal, the government argued that, despite being a “loss,” the forfeiture is not deductible under § 165 because allowing the deduction would contravene public policy, as codified in § 162(f), which disallows deductions for fines or similar penalties.

In setting up the legal issue, the Court of Appeals recognized the special pain associated with possibly disallowing Nacchio’s refund claim:

We further understand Nacchio’s argument that not being allowed to deduct his forfeited income from his taxes would result in a sort of “double sting”: both giving up his ill-gotten gains and paying taxes on them. But in this case, the relevant statutes, regulations, and body of relevant case law lead us to conclude that Nacchio’s criminal forfeiture must be paid with after-tax dollars, just as fines are paid with after-tax dollars. Specifically, as explained below, the government has demonstrated that Nacchio’s criminal forfeiture is a “fine or similar penalty” within the meaning of § 162(f).

Despite that, the Court held in favor of the government, in part because it felt that “the plain language of the statutory provision [under US Code Title 18] under which the amount Nacchio forfeited was calculated supports the view that Congress intended the forfeiture to be paid with after-tax dollars.” It also looked to the tax regulations under Section 162 (1.162-21(b)(1)), which casts a wide net around “an amount—(i) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding.”

In finding for the government, the opinion also distinguished forfeiture from deductible restitution, which has a compensatory purpose. There are a number of cases allowing deductibility of restitution payments. Recognizing that cases have blessed a tax deduction for restitution, Nacchio argued that in his case the government effectively used the forfeited funds for the same purpose as restitution payments:

Nacchio clings to this last point—the fact that the forfeited funds made their way to the victims of the crimes. He argues that the remission process by which the funds were distributed to the victims is governed by the Civil Asset Forfeiture Reform Act of 2000, which has a compensatory purpose: to restore forfeited assets to victims of the offense giving rise to the forfeiture. He also points out that the remission payments were made to identifiable persons who would have a civil cause of action against Mr. Nacchio to recover those funds. He insists that the forfeiture was tantamount to restitution.

In likely the most significant part of the opinion, the Court explicitly rejects Nacchio’s approach:

Allowing Nacchio to deduct his forfeiture because the AFMLS[the DOJ Asset Forfeiture and Money Laundering Section] decided to distribute it to victims through remission would mean that whether two people convicted of the same crimes could deduct their criminal forfeiture would turn not on their actions, or the statutes governing their sentencings, but on the after-the-fact discretionary decisions of a third party. This is not the law. Instead, “[t]he characterization of a payment for purposes of § 162(f) turns on the origin of the liability giving rise to it.” Bailey v. Comm’r, 756 F.2d 44, 47 (6th Cir. 1985) (citing Middle Atl. Distribs. v. Comm’r, 72 T.C. 1136, 1145 (1979); Uh- lenbrock v. Comm’r, 67 T.C. 818, 823 (1977)). We think Congress could not have intended to create a scheme in which the applicability of § 162(f) would depend upon how the government, in its discretion, later decided to use the funds generated by a fine or similar penalty. (my emphasis).

For good measure, and I suspect not insignificant in why the court came out this way, the opinion also distinguishes the forfeited payments from restitution in the sense that the forfeited amounts have no direct relationship to the losses that the public claims to have suffered as a result of Nacchio’s actions:

While Nacchio forfeited his criminal “proceeds”—about 44 million dollars—the victims claim to have suffered almost 12 billion dollars in cumulative losses. J.A. 513. Though not dispositive, the fact that Nacchio’s forfeiture was pegged to his profits and not to the victims’ losses weighs against a conclusion that Nacchio’s forfeiture was restitution to those victims.


Nacchio has maintained his innocence of the insider trading charges that led to the forfeited amounts (see WSJ article Former Qwest CEO Joseph Nacchio: Tales From a White-Collar Prison Sentence). He has been outspoken following his release from prison regarding the need for prison reform (see his 2015 commentary in CNBC called Six Myths About Prison). No doubt that after this case he will be outspoken about the need to possibly remove some of the limitations on deductibility of forfeited payments.

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