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Can a Receiver Take Advantage of the Claim of Right Provisions to Benefit Defrauded Consumers?

Posted on Mar. 14, 2016

Today we welcome back David Vendler of Morris Polich & Purdy who discusses a fascinating procedural issue involving the claim of right doctrine in a setting involving a receiver acting on behalf of a group of defrauded consumers who seek recovery of taxes paid by the entity that defrauded them. Les

Section 1341 and the claim of right doctrine occupy an interesting place in tax procedure, essentially allowing the unwinding of a prior inclusion of income when later events demonstrate that the earlier income inclusion was unwarranted. While Les has written about Section 1341 in PT before (see his post on Joseph Nacchio and his efforts to use 1341 to generate a refund on funds forfeited following an insider trading guilty plea), this post discusses a different wrinkle on the issue, namely whether, and to what extent, a receiver appointed on behalf of a defrauded class of consumers can recover from the IRS under Section 1341 taxes that the wrongdoer paid to the IRS from funds obtained from the fraud. There are several thorny issues arising from this question currently pending in the First Circuit Court of Appeals in the case of Robb Evans & Associates, LLC v. US, First Circuit Case No. 15-2540, the resolution of which could have a wide impact on the ability of consumers, such as the victims of such scoundrels as Bernie Maidoff, to recover at least some of their losses from the IRS. (links here to the magistrate report and district court order on appeal).

Section 1341 codifies what is known as the “claim of right” doctrine and derives from equity. Very roughly, it provides that where a taxpayer reported income as being taxable in one year, but then has to repay that money in a future tax year, s/he can deduct in that later year the amount s/he paid back if that amount is over $3,000; alternatively if the deduction does not produce a tax savings equal to the tax imposed on the earlier inclusion, Section 1341 allows a taxpayer to essentially recompute the prior year’s tax and receive a credit based upon the lower tax that would have been imposed in the earlier year without including the proceeds. Courts have held that Section 1341 must be liberally construed to effectuate its underlying remedial purpose. Kappel v. U.S., 281 F.Supp. 426 (D.C.Pa. 1968) (liberal construction of Section 1341 is required because it is remedial in nature and its purpose is to avoid inequities).

The underlying facts in the Robb Evans case are that the original class action plaintiffs obtained a $250 million dollar judgment under the Credit Repair Organizations Act (“CROA”) 15 U.S.C. 1679, et seq. and other theories against Cambridge Credit Counseling Corp., two of its owners, and several of their related corporations. The judgment, which was upheld by the First Circuit in a separate appeal, provided for a constructive trust over all consumer funds and appointed an equity receiver (Robb Evans & Associates) to marshal all of the defendants’ available assets to satisfy the judgment. Because the judgment was largely uncollectable against the various defendants, the receiver brought an action against the IRS, alleging that under the “claim of right” doctrine, the IRS should be compelled to hand over to the receiver under Section 1341 the taxes that the defendants had paid to the IRS in the years in which they had been committing their fraud because those monies properly belonged to the defrauded consumers. The case primarily relied upon by the receiver was Cooper v. United States, 362 F. Supp. 2d 649 (W.D.N.C. 2005). In response to the receiver’s suit, the District Court entered judgment in favor of the receiver. However, the amount of the judgment was not for the roughly $13 million that the fraudsters had paid in taxes, but was limited to roughly $1.1 million, which was the amount that the receiver had already “actually restored” to the plaintiff class from other funds seized by the receiver. Both the U.S. and the receiver have appealed from this judgment.

The appeal will decide several novel issues. The first is whether a court appointed equity receiver should be barred from recovering anything against the IRS under Section 1341 in a case where the taxpayer is found to have committed fraud because the receiver is tarred with the brush of the fraudster’s conduct, i.e. is the receiver in pari delicto. The IRS claims that the receiver should be barred. Relying on Cooper, the district court sided with the receiver on this issue. Cooper stated:

Admittedly, Courts, on public policy grounds, consistently find that persons who receive income as a result of bad acts, and who later repay the money are not entitled to calculation under § 1341 See McKinney v. United States, 574 F.2d 1240 (5th Cir.1978) (same); Wood v. United States, 863 F.2d 417 (5th Cir.1989); see also Revenue Ruling, Rev. Rul. 68–153, 1968 WL 15327 (1968) (holding proceeds from embezzlement activity later repaid, the embezzler not permitted a refund calculated pursuant to I.R.C. § 1341). As such, the Court concedes that if the debtor in this case were the plaintiff seeking a refund, the I.R.S.’s denial of refund computation under § 1341 likely is warranted. In the least, Plaintiff’s summary judgment motion would not survive. However, the debtor is not the plaintiff. The plaintiff, here, is the creditor, represented by the trustee.

Imputing the bad acts of the debtor onto the bankruptcy trustee in the present case renders a categorically inequitable result, that is, the innocent victimized creditors get nothing, and the government gets a windfall.

The second issue raised is whether the “actual restoration” requirement, which has been read into Section 1341 by courts, but which appears nowhere in the actual language of the statute, should apply to an equity receiver. Basically, the “actual restoration” requirement holds that until the taxpayer actually relinquishes dominion of the funds he originally claimed as income, but which later events proved he was not entitled to retain, he cannot seek any refund from the IRS. The rationale for the “actual restoration” requirement is to prevent a taxpayer from receiving a refund from the IRS and then not actually restoring the funds to the person who it turned out had the superior right to them. In short, the requirement is there to prevent the taxpayer from simply keeping the money that is refunded by the IRS. But the receiver’s position is that since there is no danger that a court appointed receiver will keep the money that is refunded by the IRS, the “actual restoration” requirement does not make sense in this context. In fact, it only serves the inequitable purpose of preventing consumers from having their money restored to them by the court pursuant to a lawful judgment and creates a windfall for the IRS. Finally, while Treasury Regulation § 1.1341–1(e) does explicitly include the prior restoration requirement, the drafters of this regulation were clearly not contemplating receivership situations. The district court ultimately sided with the IRS on this issue concluding that Section 1341 implicitly contains the “actual restoration” requirement because the deduction must be “allowable,” and that other provisions of the tax code require taxpayers to make actual restoration before that condition can be met.

The third issue is that all prior Section 1341 cases involve cash basis taxpayers, whereas several of the defendants in the subject case were accrual based. The difference, of course, is that for an accrual basis taxpayer, it is the order to pay the funds back, which, at least from an accounting perspective, makes the deduction “allowable.” So why should actual restoration – which is a cash basis concept – apply to accrual basis taxpayers? The district court, however, sided with the IRS on this issue as well.

It is expected that the First Circuit will issue an opinion on the Robb Evans case sometime in early 2017.

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