An earlier version of this post originally appeared on the Forbes Procedurally Taxing site on October 18, 2016
When Tyco was synonymous with greed, Mark Swartz and his boss Dennis Kozlowski were vilified as all that was wrong with corporate America. Swartz and Kozlowski were both released on parole in the last couple of years. Swartz, Tyco’s former CFO and Kozlowski’s right-hand man, has had a long-simmering dispute with the IRS over the tax consequences of $12.5 million he helped himself to back when he and Kozlowski were raiding the corporate coffers. This past week the Tax Court in Swartz v Commissioner resolved in favor of the IRS a partial summary judgment motion relating to the $12.5 million, and I will briefly describe it below.
Back when Tyco was flying high, Swartz was participating in Tyco’s key executive loan program. The receipt of loan proceeds, however, is not gross income. The problem for Swartz was that he took steps that suggested he had no intent of repaying some of those proceeds:
In August 1999, a handwritten journal entry in Tyco’s accounting records mysteriously reduced Mr. Swartz’s outstanding loan balance by $12.5 million. Swartz did not make any payments on this loan to Tyco during the year at issue. He also did not include the $12.5 million on his Form 1040 (for example, as cancellation-of-debt income), and Tyco did not include the amount on Mr. Swartz’s W-2.
Tax Court Judge Mark Holmes, in his direct style, describes the hot water that Swartz found himself in:
In 2001, Mr. Swartz became a member of Tyco’s board of directors. Not too long afterward, the directors learned that Kozlowski was the target of a criminal investigation for possible state sales-tax violations by the district attorney in Manhattan. Kozlowski was indicted only a few days after this information surfaced and promptly resigned from the board. His replacement — John Fort — immediately retained a law firm to undertake a full and complete investigation of Tyco’s business including compensation and transactions between Tyco and its officers and directors. This led to a conversation (the details of which are unknown on this motion) between the law firm and Swartz about the mysterious 1999 journal entry. And the conversation led to the reversal of the journal entry. Mr. Swartz then repaid the money with interest.
Kozlowski and Swartz were the subject of a multi-count indictment, including one that alleged that Mr. Swartz stole the $12.5 million from Tyco and another that alleged the conduct amounted to grand larceny under New York law.
At trial, Swartz argued that he thought the $12.5 million loan reduction was part of his bonus; after a hung jury in the first trial a second jury found Swartz guilty of those counts (and others) and sentenced him to 8 to 25 years.
What of the tax consequences of the $12.5 million? It is black-letter law that ill-gotten gains are gross income. In the tax dispute, Swartz took a different approach than what he argued in the criminal trial. In Tax Court he argued that his eventual repayment of the proceeds and Tyco’s actions in 2002 showing after the fact that a repayment obligation existed meant that his actions back in 1999 were null and void and thus there was no gross income in the first instance.
He did not raise this argument in the criminal trial, and IRS sought to use the doctrine of collateral estoppel to prevent him from arguing it in Tax Court.
The order lays out the general conditions for collateral estoppel:
- an issue of law or fact in the second case is the same as one in the first case;
- there has been a final judgment in the first case;
- the party to be precluded is the same or in privity with a party in the first case;
- the issue that is precluded was actually litigated in the first case; and
- the controlling facts and legal principles are unchanged.
Swartz argued that there was no identity of issue or actual litigation because he did not make the argument he wanted to make in Tax Court in the criminal case. There was no dispute about elements 2 and 4. The focus was on whether the issue was the same in both matters. Finding in favor of the IRS, the order notes that “a party’s failure to make an argument about an issue in the first case doesn’t mean that he gets a do-over in the second.”
As the Restatement (Second) of Judgments, §27cmt.c (Am.LawInst.1982), concisely summarizes “if the party against whom preclusion is sought did in fact litigate an issue of ultimate fact and suffered an adverse determination, new evidentiary facts may not be brought forward to obtain a different determination of that ultimate fact. . . . And similarly if the issue was one of law, new arguments may not be presented to obtain a different determination of that issue.”
The order notes that there are some cases which suggest that a thief’s agreement to return stolen property in the same year as the original taking can serve as an exception to the general rule that ill-gotten gains are gross income. It was possible that the argument Swartz sought to make may not have mattered for state law purposes but in fact may have mattered for tax purposes. Yet, the order notes that as a matter of law Swartz’s position did not address that narrow exception, as there was no agreement to return the funds to Tyco until 2002, “after he was caught.” If there were allegations that the facts may have led to a material difference under federal tax law, I suspect the order would have concluded differently.
Often the government argues that a conviction should serve to collaterally estop a taxpayer from arguing that the ill-gotten gains were not gross income. Keith discussed the somewhat unusual case of Senyszen v Commissioner where the Tax Court looked at the impact of a tax evasion conviction on the amount of the civil liability owed by the taxpayers and held that the IRS cannot use collateral estoppel to impose a liability where it otherwise does not exist. As that case makes clear, courts have discretion to not apply it even when the basic conditions are satisfied. Moreover, sometimes embezzlement type convictions do not have the specificity in terms of the amount at issue, which could generate a separate dispute. Here as Judge Holmes notes, the amount itself was specific in the indictment, and Swartz is left to face the tax consequences of that conviction, though his later repayment of the $12.5 million may generate a deduction that perhaps will soften the blow somewhat.