Misappropriated Money Subject to Tax, Even if No Criminal Violation

Published Categorized as Federal Income Tax
Misappropriated Money Subject To Tax, Even If No Criminal Violation
Misappropriated Money Subject To Tax, Even If No Criminal Violation

The proceeds of criminal activities are taxable income. Money that is embezzled from an employer is taxable to the embezzling employee. But what about money transferred between friends with the agreement that one of them will invest the funds, but he instead uses the funds personally and in doing so did not violate a criminal statute? Are the converted funds taxable? The court addressed this in Sun v. Commissioner, No. 16-60270 (5th Cir. 2018).

Facts & Procedural History

The taxpayer is a U.S. citizen. He had a friend in china that wanted to invest in the U.S. The friend sent the taxpayer $19 million to invest. The parties agreed that the taxpayer would invest the funds and then, after several years, they would split the profits.

Of the $19 million, $15 million was sent to the taxpayer’s corporation. The corporation recorded the funds as an officer loan. The remaining $4 million was sent to the taxpayer’s personal accounts.

The taxpayer invested $9 million, held $4 million, and spent $6 million on his personal expenses.

On audit, the IRS concluded that the funds that were paid directly to the taxpayer were taxable as income received from a foreign company and the funds paid to the taxpayer’s corporation were taxable as dividend distributions to the taxpayer.

The U.S. Tax Court concluded that the funds were misappropriated by the taxpayer and, once misappropriated, were taxable as income to the taxpayer. The taxpayer appealed the decision.

Income Taxes on Misappropriated Funds

Our Federal tax laws have long held that misappropriated funds are taxable to the wrongdoer. The idea is that once the funds are used for an unauthorized purpose, the wrongdoers personal financial position has improved. He has had an accession to wealth with no offsetting obligation to repay the debt. This is similar to wages, etc., which increase the wage earners personal financial position with no offsetting obligation to repay the wages. The seminal case is James v. United States, 349 F.2d 625 (1961).

Whose Values Apply in Deciding if there is Wrongdoing?

The James case involved employee embezzlement. The taxpayer in that case was convicted of embezzling money. There was no question of wrongdoing.

While in James the wrongdoing was clear, it was not entirely clear in Sun that there was wrongdoing. The case does not indicate that the taxpayer violated any criminal statute or that charges were pressed against him. Absent a criminal conviction, whose values apply in making this decision?

The foreign friend did not testify that there was any wrongdoing. He may not have believed that there was any wrongdoing.

Some of the money was invested as the parties agreed. Even for the funds that were not invested, it could be that the funds were being held for a better entry point for investments. These events transpired during the mortgage crisis and recession and the markets were in turmoil at the time…. It does not sound unreasonable to keep a cash position during this turbulent time.

The events going on in China and the widely-reported flight of money out of China during this time also seem relevant. Many Chinese citizens were (and still are) looking for ways to get money out of China–be it fear of a Chinese housing bubble, devaluation of the Chinese currency, beliefs about sustainability of the Chinese financial system, or distrust of the Chinese government. The taxpayer’s friend may have fared or believed he fared better by having his funds in the U.S., even with $6 million being spent by the taxpayer personally.

If the foreign friend didn’t believe there was any wrongdoing, should his belief control? After all, it was his money that the IRS was trying to tax. Or is it the court’s own belief as to whether there was wrongdoing?

This distinction is important. One can easily imagine scenarios where we in the U.S. may consider something wrongdoing that a foreigner may not. As a tax attorney in Houston, I have encountered this with other cultures whose value systems place a greater sense of obligation for parents.  These value systems often view the child’s assets as the parents assets, even though legal title belongs to the child.  All assets are family assets ultimately under the parent’s control.  Is this value system sufficient to trigger a tax liability for the parent?

Whose Burden Is it to Prove Wrongdoing?

Typically, the IRS has the burden to show that there is additional income that is subject to tax. To meet this burden, the IRS has to produce evidence. See Portillo v. Commissioner, 932 F.2d 1128 (5th Cir. 1991).

The evidence in this case, consisting mostly of testimony from the taxpayer and his foreign friend, wasn’t all that clear that there was any wrongdoing. The taxpayer’s friend, whose money was being taxed, testified but did not testify that there was any wrongdoing.

The foreign friend’s testimony raised questions as to whether he consented to the taxpayer using his funds personally. He seemed to know that the taxpayer was gambling and losing a significant amount of money.

It also doesn’t seem clear whether the taxpayer’s own funds or the foreign friend’s funds were even being used for the personal expenses, as the taxpayer apparently had his own money.

Does this establish a sufficient record to show that there was enough wrongdoing to result in tax? The courts concluded that it was.

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