Assume you commit a crime and receive a financial windfall. Then you get caught and have to repay the windfall in the form of restitution. Further assume that you have three options when it comes to reporting and paying tax on the illegal income: (1) you file tax returns to report the income and you pay the taxes, (2) your file tax returns but fail to report or pay tax on the income, or (3) you fail to file tax returns and don’t pay tax on the income.
Should the tax liability be the same regardless of which option you pursue? Or maybe our tax law should provide some incentive for you to go with option one? Would you be surprised to find out that the first option may result in more taxes being paid than the other options? The court recently addressed the option one in Gross v. United States, No. 2:20-CV-00192 (S’D. Tex.–Corpus Christi 2022), which provides an opportunity to consider all of these options.
Facts & Procedural History
The taxpayer was a psychiatrist in West Texas. The government indicted the taxpayer alleging that from 2009 to 2014, he “submitted claims to Medicare and Medicaid for services not rendered in the manner billed, which included for services that were allegedly rendered after patients had died.”
The taxpayer pleaded guilty in 2015. As part of a criminal settlement, the taxpayer reimbursed to Medicare $1.8 million and nearly $300 thousand to private insurance companies. These payments were made as restitution ordered as part of his criminal sentence. Presumably these payments were made in 2016.
The taxpayer earned $1.8 million and reported and paid taxes on this amount (i.e., option one described in the intro to this article). The taxpayer filed a refund claim in 2016 to recoup the taxes he paid on the amounts he paid back to the government and insurance companies.
The IRS denied his refund claim and litigation ensued.
Taxes and Restitution
Before getting into the tax law, its helpful to pause to consider what restitution is for. Restitution is a payment to make a victim whole or to restore the victim to where they were prior to the criminal event. Restitution also involves a punishment. This punishment may include jail time, restrictions on one’s liberties, additional fines, etc. The punishment aspect is thought to be a way society is repaid for criminal acts. The end result is that the wrongdoer, the victim, and society are all put back to where they were. Conceptually, the status quo is restored in some way.
In our example and the fact pattern in this case, the wrongdoer paid on the ill gotten gains. When the tax benefit the Federal government received is factored in, other than the costs of prosecution, the Federal government may be in a better position than it was. To complete the circle, it would seem that the Federal government should reverse the tax on the income that was later repaid as restitution. This brings us to the claim of right deduction.
The Claim of Right
The “claim of right” affords a tax deduction in the current year for amounts repaid in a later year for certain amounts that a taxpayer included in income and subject to tax in a prior year.
This tax deduction is needed as there is a strict time limit to file a refund claim. The refund period is generally three years from the date the original tax return was filed. If the taxpayer cannot file a refund claim in this time period given the circumstances, there would be no way for the taxpayer to recoup the taxes paid in the prior years outside of the claim of right deduction.
A typical example of how this deduction applies includes an error an employer makes in paying wages to an employee. The employee may report the wages on his tax return and then, more than three years later, his employer may notice the discrepancy and require the employee to repay the income. The taxpayer may be entitled to a claim of right deduction in the year he repays the income. This puts the employer, the individual, and the government back in the same position they would have been if the error was not made.
Unrestricted Right to Income
To qualify for the claim of right deduction, one has to believe that they had an “unrestricted right” to the item of income.
According to the courts, an employee who embezzles funds cannot have an “unrestricted right” to the income as they cannot have a belief that they have an restricted right to the income. This makes sense for an embezzlement case as the employee is acting outside the scope of their job duties and the proceeds are received in the pursuit of the criminal act.
But what about proceeds received in a non-criminal act? The taxpayer raised this argument in this case. He noted that the proceeds were reimbursements for psychiatric services. Providing psychiatric services is not a criminal act. And there is a gap of time between the provision of services, the time the application for reimbursement was submitted, and the later repayment by Medicaid or insurance. That time gap can be lengthy between each of these steps. Given these factors, could the taxpayer have had a belief that he had an unrestricted right to the income at the time the income was received?
The court considered a prior court case involving embezzlement. The court equated the Medicaid and insurance over-payments with embezzled funds and held that “because the funds were improperly obtained, it could not appear to Gross that he had a right to the funds, much less an unrestricted right to them.” Thus, the taxpayer who reports ill gotten income and pays tax on it, cannot benefit from the claim of right deduction.
Tax on Illegally Obtained Income
Knowing that the claim of right deduction isn’t available, we get to the question presented in at the start of this article. Should a taxpayer like the one in this case simply fail to file or pay the tax on illegally obtained income?
There are criminal consequences for not filing a tax return that correctly reports income. There can also be criminal consequences for not paying taxes. So the answer to the question is, yes, the taxpayer should file and pay.
But let’s focus on just the financial aspect. If the taxpayer did not file tax returns for these years, he could still do so later as there would be no time limit on filing the returns. In doing so, he would still have to report the income received as our tax laws say that illegally-obtained income has to be reported and triggers tax. But with the benefit of hindsight, this presents an opportunity to argue that the amounts received were loans and not income. Loans are not considered income and not subject to tax. It might be argued that the facts presented in this case present a non-taxable loan. Medicaid reimbursements are subject to clear audit and refund rules. They are frequently audited and refunds are common. So they are more akin to milestone payments that are subject to being clawed back by the government. By not timely filing, the taxpayer may preserve the ability to make this argument if the IRS actually audited his late-filed tax returns. The IRS might not even audit the late filed tax returns.
The result would be the same if the taxpayer filed tax returns and did not report the income as there would be an unlimited period for the taxpayer to file refund claims given the previously fraudulent tax returns. The taxpayer could, in theory, file amended tax returns at any time to correct the prior returns. The taxpayer would have to disclose the fraud to get the IRS to process the late-filed refund claims, which would likely trigger the IRS examining the amended tax returns. But the taxpayer would again have the opportunity to present the idea that the income was really a non-taxable loan that was repaid.
It is not clear whether the result would be the same if the taxpayer filed tax returns and reported the income but did not pay the taxes. If the criminal complaint included a criminal charge for non-payment, the unpaid taxes could be included as restitution in the criminal sentence (which would not draw interest or penalties). If there was no criminal tax charge, the taxpayer may be able to submit an offer in compromise to settle the unpaid taxes for less. The IRS would likely accept a reasonable offer after a criminal conviction as the restitution and disruption and stigma from the criminal conviction mean that the IRS probably wouldn’t be able to collect from the taxpayer before the statute expires. Thus, the taxpayer might avoid paying the tax.
The outcome for these options seems to be better than the outcome where the taxpayer reported the income and paid the taxes, as in this case. The taxpayer is then left with the claim of right deduction, which, according to the court, does not apply.
The claim of right deduction could provide a way to ensure that all parties, including the Federal government, are put back in the position they would have been absent the criminal act. As evidenced by this case, the law does not currently provide for this in many cases. While it may not be politically popular, the claim of right deduction could be changed so that those who are trying to get their lives back in order and who have repaid their debt to society are not denied a deduction that others benefit from. Absent a change in the law, those who receive income illegally have to make difficult decisions on how to report the income and whether and when to pay the taxes on the income.