A recent opinion issued by the U.S. Court of Claims could provide relief to individuals who agree or are ordered to return wages, gains or other income in connection with criminal or civil prosecution, or per compensation clawback provisions, for actions that led to the income. The income tax implications of this class of activity are highlighted in Nacchio v. U.S. (Fed. Cl. Mar. 12, 2014).

You may recall the tales of Joseph Nacchio:

• He served as the CEO of Qwest Communications from 1997 to 2001 and received a substantial number of stock options during that period.
• In April 2001, Qwest opened a “trading window” pursuant to company policy to allow its officers to sell Qwest stock.
• He exercised his options and sold 1,255,000 shares of Qwest stock.
• On May 16, 2001, Nacchio entered into an automatic sales plan under Rule 10b5-1 to sell his Qwest stock, and he continued to sell his stock until May 29, 2001.
• The stock tanked almost immediately afterwards.
• Nacchio was convicted of insider trading and was named in several civil actions pursuing parallel paths for compensation.
• He ultimately was sentenced to 70 months in prison, to pay a $19 million fine, and to disgorge profits of slightly more than $44.5 million (which was paid into a fund to compensate victims of his actions).

Following is the untold story about the opposing tax positions Nacchio (with his wife) and the Internal Revenue Service took regarding the stock gains and the subsequent forced disgorgement.

• Nacchio reported those gains on his 2001 tax return and paid nearly $18 million in taxes thereon.
• On the 2007 tax return, he claimed an almost identical tax refund for the amount disgorged (but not for the fine).
• He turned to section 1341 of the Internal Revenue Code for that position, which is a unique provision intended to address situations of improper tax assessment on income thought to be reportable in one year only to be proven later it was not includible at all.

The IRS disallowed the credit, stating that section 1341 “can be invoked only after a valid deduction is claimed pursuant to another code section.” According to the tax agency, Nacchio’s forfeiture was a penalty for violating the law; therefore, no deduction was available by reason of the prohibition against deductions for penalties and similar fines under section 162(f). The IRS also argued that because Nacchio had been found guilty of willfully violating the insider trading rules, he could not claim the stock gains were income in 2001.

As the U.S. Court of Claims recognized, to qualify for a tax refund under section 1341, Nacchio had to establish that:

• He believed he had a claim of right to the gains he had included in his 2001 joint return.
• He is entitled to deduct the disgorged amounts under sections 162 (business expense) or section 165 (loss).

Unbowed by the Department of Justice’s assertions for a strict reading of section 162(f), the court referred to previous U.S. Supreme Court opinions that found “the federal income tax is a tax on net income, not a sanction against wronging,” a “principle [that] has been firmly imbedded in the tax statute from the beginning. … [T]he object of [the income tax] bill is to tax a man’s net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men’s moral characters; that is not the object of the bill at all. … Only where the allowance of a deduction would [immediately and severely] ‘frustrate sharply defined national or state policies proscribing particular types of conduct’ [has the Supreme Court] upheld its disallowance.”

The court went on to conclude that “[i]n the instant case, there is no reason to compound Mr. Nacchio’s criminal punishment with a tax burden Congress has neither expressly nor impliedly directed. As the Government recognizes, Mr. Nacchio’s forfeiture is a loss. The proceeds from Mr. Nacchio’s insider trading evaporated – they were disgorged. Yet, the Government seeks to tax these proceeds not on the ground that they are income, but on an amorphous notion that the public policy against securities fraud must prevent the deductibility of monies that were received due to insider trading even though the monies were disgorged.”

Regarding the government’s argument that Nacchio could not satisfy Section 1341’s requirement that he believed that he had a bona fide claim to his 2001 stock gains because he was convicted of acting willfully, knowingly and with the intent to defraud, the court rejected the government’s claim that Nacchio was barred from litigating whether he believed he had a claim of right to the gain by the doctrine of “issue preclusion.” The court stated that the issue is not simply whether Nacchio obtained funds unlawfully, but whether it subjectively appeared to him that he had an unrestricted right to those funds. “Although the jury in the criminal trial believed Mr. Nacchio was guilty of willfully engaging in insider trading, this does not equate to a finding of what Mr. Nacchio himself believed. Mr. Nacchio professed his innocence, … Mr. Nacchio’s subjective belief as to his entitlement to the trading gains in 2001 is a question of material fact that cannot be resolved on summary judgment.”

Nacchio may ultimately lose his case under the “unrestricted right” element; however, the U.S. Court of Claims has now provided well-needed guidance to defense teams and compensation experts who advise clients on disgorgement and clawbacks. Two critical facts in Nacchio were:

1. The report by the victims’ fund administrator that the disgorged gains would go to those victims.
2. The separate amount had been paid as a fine (as well as the imprisonment). The U.S. Court of Claims easily determined the disgorgement was remedial in nature (under existing tax jurisprudence) and thus not precluded by section 162(f). In addition, the court determined that issue preclusion was inapplicable to the factual issue of whether Nacchio had an unrestricted right to the stock gains in 2001. (Another court may not take the same view on this issue of first impression.)

The decision highlights the proposition that tax advisory planning is critical to reducing the sting of additional economic loss from a profit, income or compensation disgorgement or clawback proceeding. Adopting proactive tax positions at the beginning of the proceeding can allow for better tax consequences once the dust has settled and amounts are to be repaid, forcibly or by contract. Also, because the U.S. Court of Claims is a national court, its opinion in Nacchio is now important in forum selection for litigating tax claims.

Please contact Padric Kelly O’Brien or any other member of Taft’s Tax group with comments or remarks associated with this briefing.