1998 Tax Ct. Memo LEXIS 390 | Tax Ct. | 1998
1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="1" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*390 Decision will be entered under Rule 155.
MEMORANDUM FINDINGS OF FACT AND OPINION
GERBER, JUDGE: Respondent determined a deficiency in petitioner's Federal income tax for 1987 of $ 57,091, additions to tax for fraud under
In the answer, respondent asserted additions to tax for negligence under
The issues for our consideration are: 1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="2" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*391 (1) Whether petitioner is entitled to deduct legal fees or disgorgement payments as business expenses under section 162 or
FINDINGS OF FACT 2
At the time the petition was filed, petitioner resided in Irvine, California. From the fall of 1982 through the spring of 1986, petitioner attended the University of Illinois at Urbana-Champaign, majoring in finance. Petitioner left college after the spring 1986 semester, only nine credits short of his bachelor's degree. In December 1989, he completed the necessary credits and received a bachelor of science 1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="3" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*392 degree in finance with high honors.
Petitioner left college in 1986 to work for Morgan Stanley & Co. (Morgan Stanley), a New York investment banking firm, for a 2- year internship as a junior analyst. Initially, petitioner worked in the Leveraged Buyout Unit of Morgan Stanley's Merchant Banking Department. He was transferred to the Mergers and Acquisitions Department in March 1987 because of unsatisfactory work performance and remained in that department until June 1988. During the course of his employment at Morgan Stanley, petitioner was privy to confidential business information. Some of the information was nonpublic or insider information regarding Morgan Stanley's clients involved in actual and anticipated corporate combinations and other transactions, such as mergers, tender offers, and leveraged buyouts. Petitioner was contractually and statutorily obligated to keep the information confidential and not to use or disclose it for his personal benefit.
In late 1986, petitioner met Mr. Fred Lee, who was then a client of Morgan Stanley. Mr. Lee, a Taiwanese national, owned or had trading authority over a large number of securities and trading accounts with several domestic and foreign1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="4" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*393 brokerage firms. Sometime in 1987, petitioner began selling insider information to Mr. Lee. That information had been obtained in the course of petitioner's employment at Morgan Stanley. Mr. Lee used the insider information to buy and sell corporate securities, earning an overall profit of approximately $ 19 million from June 1987 through June 1988.
Mr. Lee paid petitioner, at minimum, $ 150,000 and $ 50,000 for the insider information during 1987 and 1988, respectively. Petitioner admitted that he and Mr. Lee had discussed petitioner's receiving an additional $ 1 million in compensation. Petitioner received some cash payments directly from Mr. Lee. Petitioner also received payments in the form of deposits to a bank account opened in fictitious or nominee names chosen by Mr. Lee. Petitioner had a power of attorney over the bank account. In 1987, Mr. Lee paid petitioner at least $ 50,000 in cash and $ 100,000 that was deposited by Mr. Lee into the bank account. Petitioner spent the $ 50,000 within a year and did not deposit any of it into a bank account or keep any record of the money. Mr. Lee deposited an additional $ 50,000 into the bank account in1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="5" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*394 February 1988. In 1987, petitioner also sold insider information to Mr. Jerome Cronin, a former University of Illinois classmate, in exchange for $ 4,000.
On June 27, 1988, the Securities and Exchange Commission (SEC) instituted a civil action against petitioner and Mr. Lee in the U.S. District Court for the Southern District of New York for alleged violations of sections 10(b) and 14(e) of the Securities Exchange Act of 1934,
On September 7, 1988, the Federal Government filed a three-count criminal information against petitioner in the U.S. District Court for the Southern District of New York, charging him with one count each of mail fraud,
Petitioner engaged two law firms to represent him in legal matters arising from his insider trading. During 1988 and 1989, petitioner incurred legal fees and litigation costs that totaled $ 110,857.43. Petitioner's father, Stephen S. Wang, Sr., paid petitioner's legal bills in the amounts of $ 60,000 and $ 50,857.43 during 1988 and 1989, respectively. Mr. Wang, Sr., used savings, borrowed money, employer savings plan withdrawals, and vacation time converted to cash in order to pay his son's legal expenses. Before petitioner's incarceration, Mr. Wang, Sr., made out the checks for the legal fees jointly to petitioner and the law firm and gave the checks to petitioner. After petitioner's incarceration, Mr. Wang, Sr., issued his checks directly to the law firm and did not obtain petitioner's endorsement. Although Mr. Wang, Sr., liquidated assets and incurred debt to pay about $ 110,000 of his son's legal expenses, in 1993 he sold stock in a Taiwanese company for over $ 2 million.
In 1988, petitioner, in connection with the1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="8" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*397 legal expenses, executed three promissory notes to his father totaling $ 115,000 (1988 notes). The first note was drafted by an attorney for Mr. Wang, Sr., and was used as a model for the two subsequent notes. The notes were unsecured, did not require monthly payments, and did not begin to accrue interest until 1993. In January 1993, petitioner executed a note to replace the 1988 notes and extended the maturity date for 5 years, providing for accrual of interest during the extended period. As of the time of trial, petitioner had not made any payments of interest or principal on the replacement note or the 1988 notes.
On his 1987 tax return, petitioner reported gross income of $ 39,521.55, consisting of wages from Morgan Stanley and $ 67 of taxable interest income. He did not report his $ 154,000 insider trading income, $ 150,000 of which was included in his gross income by respondent. On his 1988 tax return, petitioner reported gross income of $ 17,026.85, his wages from Morgan Stanley, and he did not report the $ 50,000 insider trading income included in his gross income by respondent. For 1988, respondent allowed petitioner a $ 125,000 deduction for1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="9" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*398 the disgorgement of his insider trading income, which resulted in no tax deficiency for that year. Respondent determined, however, that the disgorgement deduction was not in connection with a trade or business and, accordingly, did not generate a 1988 NOL that could be carried back to 1987. Under respondent's determination, most (about $ 75,000) of the $ 125,000 disgorgement deduction remained effectively nondeductible.
On January 25, 1994, petitioner executed a Form 872, Consent to Extend the Time to Assess Tax, intended to extend the 1987 assessment period to December 31, 1994. The Form 872 was executed after April 15, 1991, after the normal 3-year period for assessment under section 6501(a) had expired. The Form 872 was executed before April 15, 1994, within the 6-year period for assessment under section 6501(e)(1) (that section applies where substantial omissions from gross income exist). The Form 872, however, did not contain any explanation or indication of whether the period for assessment was then open or under which particular provision it may be open for the 1987 tax year. When he signed the Form 872, petitioner was represented by an attorney who also signed the 1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="10" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*399 form. Subsequently, on or about June 1, 1994, and August 2, 1995, the parties executed Forms 872 to extend the 1987 assessment period to December 31, 1995, and December 31, 1996, respectively. The notice of deficiency was mailed on April 16, 1996.
OPINION
1987 -- PERIOD FOR ASSESSMENT
As a preliminary matter, we consider petitioner's contention that the 1987 assessment period had expired before respondent mailed the notice of deficiency. There was in excess of a 25-percent omission of gross income on petitioner's 1987 tax return, and the 6-year period for assessment is applicable. See sec. 6501(e)(1). Petitioner executed a Form 872 in January 1994, before the 6-year assessment period expired. Petitioner contends that the Form 872 is invalid or without effect because it did not specify that the 6-year assessment period was applicable. Accordingly, petitioner argues that the assessment period expired before the notice of deficiency was mailed.
An agreement to extend the assessment period must be executed before the expiration of the applicable statutory period for assessment or the period agreed upon by the taxpayer and the Secretary in a prior agreement. Sec. 6501(c)(4). There is no1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="11" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*400 requirement, however, that the parties' consent or agreement contain a reference to the applicable statutory provision under which the assessment period remains open.
Additionally, our holding that petitioner filed a fraudulent 1987 return would also permit the tax for that year to be assessed at any time. See sec. 6501(c)(1). Therefore, the 1987 assessment period had not expired at the time respondent mailed the notice of deficiency to petitioner.
WAS PETITIONER'S ACTIVITY A TRADE OR BUSINESS?
Petitioner has admitted that he had unreported income in the amounts of $ 154,000 and $ 50,000 for 1987 and 1988, respectively. Petitioner's $ 125,000 deduction claimed for the 1988 disgorgement was allowed, but it only affected the $ 50,000 of the insider information income earned for 1988, because respondent disallowed any carryback to the $ 154,000 earned in 1987. 3 Petitioner also seeks to claim legal expenses of $ 60,000 and $ 50,857.43 paid during 1988 and 1989, respectively. Respondent disallowed those deductions on the grounds that they were not paid by petitioner and/or were not incurred in a trade or business.
1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="12" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*401 The parties advanced several arguments, and the pivotal question for each is whether petitioner was in a trade or business. Although respondent determined that petitioner is entitled to a deduction for the disgorgement, an NOL was disallowed because of the determination that petitioner's activity was not a trade or business, a prerequisite here for a carryback. 4 In that context, we must decide whether petitioner was in a separate trade and/or business of selling insider information or whether the expenses were connected with petitioner's status as an employee.
Petitioner stipulated that he had unreported income of $ 154,000 5 in 1987 from the sale of insider information. Petitioner contends that he is not liable for an income tax deficiency for 1987 because he sustained NOL's for 1988 and 1989 that may be carried back to 1987. In particular, petitioner argues that he is entitled to deduct legal expenses in 1988 and 1989 and the disgorgement of his insider trading profits in 1988 as business expenses. He contends that 1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="13" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*402 the legal fees and disgorgement were related to "his business activities in the securities industry" and, therefore, are deductible business expenses. Respondent maintains that petitioner's expenditures are not business expenses because his insider trading activity was not related to his employment at Morgan Stanley and petitioner was not in a separate trade or business of selling insider information. Respondent has permitted petitioner to deduct the disgorgement under
1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="14" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*403 The first issue for our consideration is whether petitioner's selling of insider information constituted a trade or business. Petitioner asserts that the sale of insider information was in connection with his employment at Morgan Stanley and that his job provided him with the opportunity and means to engage in insider trading. Petitioner also argues that he made the disgorgement to protect his business reputation and future employment. Although petitioner obtained the insider information in the course of his position with Morgan Stanley, his use and disclosure of the information for profit was not within the scope of his employment. Petitioner violated his confidentiality agreement with Morgan Stanley by disclosing and using for his personal gain confidential information that he acquired through his employment.
Respondent attempts to analogize petitioner's actions to those of an employee who embezzles money from his employer. Repayment of embezzled funds is not an ordinary and necessary business expense of being an employee because an embezzler does not act in the course of his employment when taking the money. See, e.g.,
Next we consider whether petitioner is entitled to deduct the disgorgement payment or the legal fees in connection with the separate trade or business of selling insider information. To be a trade or business, a taxpayer's activity must be frequent, regular, and continuous.
It has not been established on this record that petitioner's sales of insider information were continuous and occurred regularly. He obtained insider information and sold it to others until his activities were discovered by the SEC. However, his internship with Morgan Stanley was intended for a limited period, after which petitioner intended to finish his college education. The civil complaint filed by the SEC contained accusations that petitioner sold insider information involving at least 25 companies resulting in $ 19 million in profits in connection with Mr. Lee's trading securities. The criminal charges against petitioner identified five companies about which petitioner sold insider information to Mr. Lee and Mr. Cronin. The criminal1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="17" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*406 information also contained allegations that petitioner had sold insider information with respect to at least 19 companies. The five instances of selling insider information to Mr. Lee and Mr. Cronin as set forth in the criminal charges were separate and occurred over several months. With respect to the other instances alleged in the civil and criminal documents, there is insufficient detail to determine that petitioner's activity was "frequent, regular, and continuous".
On the basis of this record, we conclude and hold that petitioner's sale of insider trading information was sporadic and represented a limited opportunistic transactional relationship with Mr. Lee. Accordingly, petitioner was not in a trade or business in connection with his insider trading activities.
Petitioner contends that the legal expenses paid for his defense in civil and/or criminal litigation that arose in connection with his sale of insider information are deductible under section 162. Respondent, however, argues that petitioner is not entitled to a deduction because the legal expenses were paid by his father. Petitioner maintains that his father lent him money to pay his legal expenses and argues that he1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="18" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*407 intended to repay his father as evidenced by promissory notes. Alternatively, petitioner argues that he is entitled to deduct the legal fees because his father paid his legal expenses as a gift to petitioner. Because we have decided that petitioner was not engaged in a trade or business in connection with his sales of insider information, it is unnecessary to decide whether he paid the legal expenses. That is so because respondent has already allowed the deduction of the disgorgement under
A taxpayer engaged in a trade or business may be entitled to carry a resulting NOL deduction to other taxable years. An NOL is the excess of deductions over the taxpayer's gross income, subject to certain modifications specified in
We hold that petitioner is not entitled to carry back an NOL deduction from 1988 or 1989 to the year in controversy in this case (1987).
DOES
Having decided that petitioner is not entitled to an NOL carryback to 1987, we consider his alternative1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="20" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*409 argument that
"income included under a claim of right" means an item included in gross income because it appeared from all the facts available in the year of inclusion that the taxpayer had an unrestricted right to such item, and "restoration to another" means a restoration resulting because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="21" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*410 to such item (or portion thereof).
Respondent contends that petitioner is not entitled to use
Respondent contends that
In a memorandum opinion of this Court, the generalized holding of Perez was relied upon in circumstances where a lawyer converted his client's trust fund to his own use.
Any analysis of the "claim of right" concept in conjunction with embezzlement cases must focus on a line of cases surrounding
When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, "he has received income which he is required to return, even though it may still be claimed that he is not entitled to retain the money, and even though he may still be adjudged liable 1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="25" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*414 to restore its equivalent". * * * Citation omitted.
The requirement to report embezzled funds for tax purposes even though the embezzler/taxpayer may not have had a claim of right to the funds was analyzed in
Here, petitioner's1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="26" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*415 and Mr. Lee's activities were illegal in every respect. Petitioner's act of obtaining the insider information, his sale of insider information to others, and the use of the information by others were all illegal acts. Although Mr. Lee did not place any restrictions on use of the funds paid to petitioner, under securities laws petitioner did not have a claim of right or the appearance of an unrestricted right to the money. He had then knowingly committed a crime, and he was subject to criminal penalties and to the SEC's remedy of disgorgement. 8 In 1988, petitioner's disgorged profits were placed in a receivership fund to be used as restitution for investors who could show a loss due to petitioner's and/or Mr. Lee's illegal actions. Under these circumstances, we hold that petitioner does not pass the
1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="27" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*416 Petitioner argued that his circumstances were similar to those of
Although Barrett is factually similar to the case under consideration, the holding in that case concerned
Accordingly, petitioner does not qualify for
ADDITIONS TO TAX FOR FRAUD UNDER
The next issue for our consideration is whether petitioner is liable for additions to tax for fraud under
1998 Tax Ct. Memo LEXIS 390" label="1998 Tax Ct. Memo LEXIS 390" no-link"="" number="30" pagescheme="<span class=">1998 Tax Ct. Memo LEXIS 390">*419
The existence of fraud is a question of fact to be resolved upon consideration of the entire record.
From the record in this case, we hold that petitioner's 1987 return was fraudulent. He pled guilty to securities, mail, and wire fraud in connection with his acquisition and sale of insider information. He failed to report any of the income he received from the sales in either 1987 or 1988. Reporting the illegal income would have increased the risk that petitioner's illegal activities would be detected. Reluctance to report illegal income because of the chances that the illegal source of the income will be discovered does not preclude a tax evasion motive.
Petitioner argues that he did not have fraudulent intent because he did not consider whether or not to report the illegal income. Petitioner's argument is unpersuasive. He is a well-educated and knowledgeable taxpayer. In college, he took a number of business courses, including a class on Federal income tax accounting. Petitioner does not deny that he knew that illegal income was taxable and was aware of his reporting obligations. In addition, petitioner understood that he received cash; he did not use his own name on the bank account to avoid detection of his illegal activity and income. We are satisfied that respondent has proven by clear and convincing evidence that petitioner had a fraudulent intent. Petitioner is liable for the additions to tax for fraud under
ADDITION TO TAX UNDER
The final issue for our consideration is whether petitioner is liable for a
Decision will be entered under Rule 155.
Footnotes
1. Unless otherwise indicated, all section references are to the Internal Revenue Code for the year in issue, and all Rule references are to the Tax Court Rules of Practice and Procedure.↩
2. The stipulation of facts and the attached exhibits are incorporated herein by this reference.↩
3. Because of respondent's allowing $ 50,000 of the $ 125,000 disgorgement deduction against the $ 50,000 of unreported income, no deficiency was determined for 1988. Because respondent determined that petitioner was not in a trade or business, no part of the $ 75,000 difference that was not deductible in 1988 could be carried to other taxable years.↩
4. Respondent did not argue or determine that the deduction for the disgorgement or the allowance of a net operating loss (NOL) was against public policy.↩
5. In the deficiency notice, respondent determined unreported income of $ 150,000. Respondent did not seek to amend the answer, but at trial and on brief sought an increased deficiency and additions to tax. Petitioner's admission that he had unreported income of $ 154,000 caused the issue to have been tried by consent of the parties. See Rule 41(b).↩
6. The disgorgement of petitioner's profits is governed by
sec. 165(c)(2) . The distinction between losses and expenses is found primarily in the nature and occasion of the expenditure. It is well settled that deductions for cash forfeitures and confiscations, if allowed at all, are normally allowed as loss deductions undersec. 165 .Holt v. Commissioner, 69 T.C. 75">69 T.C. 75 , 69 T.C. 75">78 (1977), affd. per curiam611 F.2d 1160">611 F.2d 1160↩ (5th Cir. 1980).7. One case involved the misappropriation of a lawyer's clients' trust funds, which in all material respects is the same as embezzlement, especially with respect to the question of whether a taxpayer has a claim of right (appearance of an unrestricted right) with respect to the item in question. See
O'Hagan v. Commissioner, T.C. Memo 1995-409↩ .8. Disgorgement is used as a deterrent and is intended to make the improper use of security information unprofitable.
Hateley v. SEC, 8 F.3d 653">8 F.3d 653 , 8 F.3d 653">655 (9th Cir. 1993);SEC v. Rind, 991 F.2d 1486">991 F.2d 1486 , 991 F.2d 1486">1490 (9th Cir. 1993);SEC v. Wang, 944 F.2d 80">944 F.2d 80 , 944 F.2d 80">85 (2d Cir. 1991). The amount disgorged must be reasonable; i.e., approximately equal to the violator's profits.8 F.3d 653">Hateley v. SEC, supra at 656↩ .9. Respondent determined additions to tax for 1987 under
sec. 6653(b)(1)(A) and(B) , the version ofsec. 6653(b) that applied to petitioner's 1987 return. See Tax Reform Act of 1986 (TRA), Pub. L. 99-514, sec. 1503(a), 100 Stat. 2085, 2742. In the answer, respondent incorrectly alleged that the fraud additions for 1987 should have been asserted undersec. 6653(b)(1) and(2) , a prior version ofsec. 6653(b) . Similarly, in the answer, respondent asserted alternate additions to tax for negligence for 1987 undersec. 6653(a)(1) and(2) , a prior version ofsec. 6653(a) . The version ofsec. 6653(a) applicable to taxable year 1987 issec. 6653(a)(1)(A) and(B) . TRA sec. 1503(a).With respect to the fraud additions to tax, the deficiency notice cited the version of
sec. 6653(b) applicable to the year in issue and properly informed petitioner of respondent's determination. Respondent's assertion in the answer of a prior version ofsec. 6653(a) and(b) for the additions is an error in form only and does not have a substantive effect on this case. In any event, citation of a prior version ofsec. 6653(a) and(b)↩ is immaterial to the outcome of the case because respondent bears the burden on both the fraud and negligence additions to tax. See Rule 142.