The “Unclean Hands” Principle in Tax Disputes

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There are a number of legal principles that apply when it comes to civil litigation. Some of these rules apply in tax disputes and others do not. And tax disputes add other legal principles that are unique to tax.

For example, our Federal tax system is premised on a concept of sovereign immunity where the IRS cannot be sued except in limited circumstances. It is based on a framework for the burden of proof that starts with the IRS’s audit or collection determination is presumed correct. And then there are the concepts of economic substance, substance-over-form, and the tax benefit rule that can result in taxpayers not being able to get the benefits promised to them in the tax code. There are fraudulent transfers and transferee liability concepts that can put liability on taxpayers where one would not think that liability would normally exist. And there are even a few of these concepts that can help taxpayers. Equitable recoupment and the mitigation provisions are an example.

Other civil law concepts, such as latches, do not apply. But what about the “unclean hands” principle? Does it apply to tax disputes with the IRS? The court recently addressed this in Kim v. Commissioner, T.C. Memo. 2023-91, which involved a large cryptocurrency loss.

Facts & Procedural History

This case involves a taxpayer who bought and sold virtual currency through Coinbase.

The IRS received information reports from Coinbase for the tax years 2013 to 2016, reporting the proceeds of the taxpayer’s Bitcoin (“BTC”) transactions. In 2017, Coinbase reported proceeds from virtual currency transactions, including BTC, Litecoin (“LTC”), and Etherium (“ETH”).

The taxpayer did not report these transactions on his tax returns for 2013 to 2016. However, on his 2017 tax return, the taxpayer reported gross proceeds from virtual currency transactions but offset the amount against claimed basis, resulting in a reported short-term capital gain.

The IRS selected the taxpayer’s returns for audit. The IRS agent reconstructed the gains and losses using records from Coinbase on a “first in, first out” basis. The IRS agent determined that the taxpayer had realized short- and long-term capital gains and losses from transactions in BTC, ETH, and LTC for the years 2013 to 2017.

Based on the IRS agent’s calculations, the taxpayer had short-term capital loss carryforwards at the beginning of 2015, 2016, and 2017. The RA determined taxable gains for 2013 and 2017, with no taxable gains for the years 2014 to 2016.

The IRS issued a notice of deficiency in 2021. This was well into the COVID-19 pandemic when many businesses were still shut down. Litigation ensued in the U.S. Tax Court.

The taxpayer agreed that he owed taxes from 2013 and 2017. His only contention seemed to be the unfairness of the crypto gain and tax he has to pay in 2017 when he had a crypto loss from 2020 that he could not use. The taxpayer’s argument was based on the “unclean hands” principle.

About Capital Gains

Before getting into the “unclean hands” principle, we have to first pause to consider the capital gain rules as they apply to the sale of crypto assets to better understand the nature of the taxpayer’s argument as to the IRS having unclean hands.

The term “capital gain” refers to the profit made from selling or exchanging a “capital asset.” Capital assets are generally investments and personal assets, such as stocks, real estate, and bonds. They also include crypto.

The gain is the positive difference between the selling price and the original purchase price of the asset.

Capital gains are classified as short-term or long-term based on the duration of ownership. Short-term gains (held for less than a year) and long-term gains (held for more than a year) are taxed at different rates, with long-term gains often taxed at lower rates.

Investors can use “harvesting tax losses” to offset capital gains. This involves strategically timing the market to realize losses on certain assets and using those losses to reduce the taxable amount of gains, potentially lowering overall tax liability. This is possible as the wash sale rules, which apply to securities like stocks and bonds, do not apply to cryptocurrencies (and no mark-to-market election is needed). If they did, they would prevent investors from claiming losses if they repurchased substantially identical assets within a specific period.

There is a limitation on the amount of capital losses that can be deducted against ordinary income in a single tax year, set at $3,000. Excess losses can be carried forward to offset future gains or income in subsequent years. Moreover, capital losses generally cannot be carried back to prior years or generate net operating losses (“NOLs”) for individual taxpayers. NOLs, if generated, can only be carried forward and used partially each year.

In applying these rules to the facts in this case, it sounds like the taxpayer had a large tax liability due to a capital gain on his crypto in 2017. He then had a large tax loss, which was a capital loss in 2020. The capital loss could not be used except for $3,000 against his other non-capital income, and the loss could not be carried back to prior years. If the taxpayer’s 2020 losses whipped out his capital investment funds, he may not have the funds to re-invest to use up the capital loss carryforward from 2020 any time soon. The tax loss might be large enough that he may never use it up.

About Unclean Hands

The “unclean hands” legal principle is often raised in civil lawsuits as a defense.

The basic idea behind the unclean hands doctrine is that a party who seeks a favorable judgment or equitable relief from a court must come to the court with “clean hands,” meaning they must have acted ethically and honestly in the matter related to their claim.

Based on this, if a party’s actions are tainted with dishonesty, wrongdoing, or unfair conduct regarding the subject matter of the case, they may be deemed to have “unclean hands.” As a consequence, the court may refuse to grant the requested relief or may deny the party’s claim, even if they have a valid legal right on the merits of the case.

The unclean hands doctrine is rooted in the principles of fairness, equity, and good conscience. It prevents parties from taking advantage of their own misconduct or wrongdoing to gain an advantage in a legal dispute. By requiring parties to act with integrity and avoid wrongful behavior, the doctrine promotes the notion that the legal system should not be used as a tool for injustice or rewarding improper actions.

The Relationship to the IRS’s Improper Conduct

The court noted that the alleged improper conduct by the government in response to COVID-19 was not related to the tax liability in 2017:

When relevant, the “unclean hands” defense applies only to conduct immediately related to the cause in controversy. See Seller Agency Council, Inc. v. Kennedy Ctr. for Real Estate Educ., Inc., 621 F.3d 981, 986-87 (9th Cir. 2010). The Government’s actions in response to the COVID epidemic have no relationship whatever to the determination of petitioner’s 2013 and 2017 tax liabilities. Those governmental actions occurred in 2020, three years after petitioner had realized the most recent gains in question.

Those who were investing in crypto in 2020 may not agree with the court on this.

The COVID-19 pandemic unleashed widespread economic uncertainty and reshaped financial markets worldwide. Among the assets impacted, cryptocurrencies experienced a significant crash in March 2020. The Federal government’s response to the pandemic played a crucial role in this market downturn.

The economic uncertainty triggered risk aversion among investors, prompting them to seek safer assets. Cryptocurrencies, being volatile and speculative, suffered as investors turned to traditional safe-haven options like gold and U.S. Treasury bonds. Additionally, the massive stimulus packages introduced by governments to mitigate economic fallout raised concerns about inflation and currency devaluation. Investors sought to hedge against these risks by turning to what were perceived to be safer assets.

At the same time, many crypto investors held most of their assets in crypto leading up to the 2020 crash. This is particularly true for those who were actively trading crypto. As their investments grew in value leading up to 2020, the crypto gains triggered taxes, which were due each year, yet the underlying asset continued to be invested in cryptocurrencies. When the March 2020 crash happened, many investors had to finally sell out of their positions to cover margin loans, etc.-triggering very large tax and cash losses. This is the relationship that the taxpayer, in this case, was probably considering and arguing for as he had a sizeable gain and is required to pay tax on it in 2017 when his loss in 2020 for the same asset (which was a tax loss that he probably could not use) was caused in part by the government.

Nevertheless, the court did not find the relationship to be close enough for the unclean hands principle to apply in this case.

Unclean Hands for Applying Tax Laws

The court also noted that the unclean hands principle does not apply in situations where the IRS is simply following its mandate to assess taxes:

the “unclean hands” principle is designed to withhold equitable relief from one who has acted improperly. See Stafford v. Rite Aid Corp., 998 F.3d 862, 865 (9th Cir. 2021). Respondent is not seeking equitable relief but is endeavoring to recover taxes determined to be due from petitioner under the Internal Revenue Code.

This is consistent with prior court cases. For example, in United States v. Denkers, No. C 09-03403 WHA (N.D. Cal. Mar. 29, 2010), the court held that the unclean hands principle did not apply to the IRS’s denial of an offer in compromise to settle an unpaid tax debt. In that case, the court noted that the IRS has rules set out for processing and returning unprocessable offers submitted by taxpayers. Thus, according to the court, the IRS could not have unclean hands for following its own policies in returning the offer to the taxpayer as unprocessable.

The court did cite other cases in which the unclean hands principle did apply. The court cited the Schuster v. Commissioner, 312 F.2d 311 (9th Cir. 1962) case, for example. The taxpayers in that case was a bank that argued that the IRS should be estopped from asserting transferee liability against it because of the IRS’s earlier determination that there was no estate tax deficiency. They claimed that they relied on this initial determination and, as a result, the bank had distributed the trust corpus to the beneficiary. The court recognized that there may be rare situations where the doctrine of estoppel could be applicable against the government. In this case, the court found that the bank had suffered significant prejudice due to the IRS’s earlier determination. The bank had distributed the trust corpus based on the understanding that it was not taxable, but later the IRS changed its position and asserted transferee liability against the bank. As a result, the bank would be forced to bear the liability out of its own pocket, which the court deemed grossly unfair, considering that the bank never enjoyed the use of the corpus and only acted as a trustee.

These court cases show that unclean hands can apply in tax disputes involving the IRS, but generally, it has to be in situations where the IRS is seeking tax from a party after reaching a contrary determination, and after the party detrimentally relied on the IRS’s prior determination. The present facts do not necessarily rise to this level, at least the facts as stated in the court’s written opinion.

The Takeaway

As this court case shows, those investing in or holding crypto should understand the nuances of the capital gain tax rules. By proactively applying these rules over time, investors and others who hold crypto can strategically manage their tax positions and potentially minimize tax liabilities. This can be much more effective than waiting for a substantial loss from cryptocurrencies and then scrambling to find ways to offset it or mitigate the tax consequences. The unclean hands principle may be viable in some situations, but generally, one may need to show improper conduct by the IRS combined with detrimental reliance by the taxpayer or a third party.

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