Al Capone apparently said, “they can’t collect legal taxes from illegal money.” He later learned that they can. Last week, the Fifth Circuit provided a reminder that stolen money is income, just like money obtained through honest means. Sun v. Comm’r, No. 16-60270, 2018 U.S. App. LEXIS 1187 (5th Cir. Jan. 18, 2018).
A foreign friend sent Jerry Sun $19 million dollars to invest on his behalf in a loose arrangement that was not committed to writing. Sun spent $6 million on personal expenses, parked $4 million in the accounts of a company he controlled, and invested the balance in his own brokerage accounts where it was intermingled with his own funds. Sun, 2018 U.S. App. LEXIS 1187 at *1. The tax consequences were hotly disputed:
- The IRS offered two different theories why Sun owed tax on the entire amount. at *5.
- Sun argued that there was no income because the money was a loan. at *6.
- The Tax Court held that the entire $19 million was taxable because Sun misappropriated it. at *6-*7.
On appeal, the Fifth Circuit commenced its analysis by noting that funds acquired through embezzlement or misappropriation were a form of income, as the Supreme Court recognized in James v. United States, 366 U.S. 213, 219 (1961). The Court of Appeals then considered Sun’s main argument, which was the funds were not income because he was obligated to repay them. While recognizing the principle that an obligation to repay the funds might preclude them from being income, the court concluded that Sun’s case did not fall within its scope. Specifically, it concluded that there was only “[a] vague understanding that some money will be returned at some undefined time” and that such a vague understanding “is not the mutual recognition of an obligation to repay in full that James contemplates.” Sun, 2018 U.S. App. LEXIS 1187 at *10.
The Fifth Circuit observed that James was drawing a distinction between the proceeds of a loan, which are not income because of the obligation to repay the loan, and the proceeds of a theft, which are income. Id. at *11. Against that background, the Fifth Circuit explained that the Tax Court’s finding concerning the loose arrangement that resulted in Sun’s receipt of the money had none of the earmarks of a loan. The Tax Court had concluded that there was no loan because there was no written agreement, Sun provided no collateral, and the parties did not agree to a schedule for repayment. Id. at *12. In the view of the Court of Appeals, those findings precluded a determination that the funds provided to Sun were a non-taxable loan. Id. at *13-*14. The court bolstered its analysis by noting that courts had frequently refused to treat even properly documented arrangements as loans if there was substantial doubt about the prospect for repayment. Id.
Instead, the Fifth Circuit concluded that the agreement to return some funds at an indefinite time in the future was consistent with the idea that he was holding the funds to invest them, as a trustee would. Id. at *14-*15. The court indicated that no particular formalities were required. Instead, the question is whether someone who is holding funds for another stops using the funds to benefit their owner and instead uses them for his own economic benefit. Id. at *15. Since Sun clearly did this by paying personal expenses, using funds to benefit a company he controlled, and intermingling the remainder in his personal brokerage account, the Fifth Circuit affirmed the Tax Court’s holding that the funds represented income. Id. at *15-*16.
Mr. Sun’s argument was clever, but the Fifth Circuit was plainly correct: The IRS can “collect legal taxes from illegal money.”