A New York State Administrative Law Judge has held that a taxpayer cannot claim trade or business losses for embezzled funds that she repaid, and could not receive the benefits of loss carryback provisions. Matter of Hanna Shin, DTA Nos. 822869 and 822992 (N.Y.S. Div. of Tax App., Nov. 24, 2010).
In 2007, the taxpayer pled guilty to grand larceny, and admitted stealing funds from her employer during 2004 through 2006 by created false invoices and diverting payments due the employer to companies controlled by the petitioner or an accomplice. She also kept for her own use additional funds paid by a client and intended for her employer. Under the terms of a plea agreement, she was required to make restitution to her employer, and to file amended federal, state, and local income tax returns for 2005 and 2006, and original returns for 2007. In January 2008, she filed an amended NYS return for 2005, showing additional adjusted gross income and additional tax due. She then filed, in October 2008, a second amended return, seeking a credit or refund and claiming a net operating loss carryback from 2007, based upon “restitution to pay back fees,” as well as increased Schedule C expenses, including expenses for supplies, meals and entertainment, consultants, travel, and formal wear.
The Division denied the refund claim and disallowed petitioner’s deduction of the repayments, finding that she was not entitled to a Claim of Right credit for the repayment of the embezzled funds, and that they were not allowed as business expenses under IRC § 162. The Division also denied the additional business expenses for lack of supporting documentation.
The ALJ upheld the Division’s denials. He noted, first, that petitioner failed to qualify for any Claim of Right deduction under IRC § 1341, which requires a taxpayer to restore in the taxable year an item that was included in a gross income under a Claim of Right in a prior taxable year. Although a taxpayer who embezzles funds must include those funds in gross income under IRC § 61, such income is not included under a Claim of Right for purposes of § 1341.
The ALJ also found that there was nothing in the record establishing that the petitioner was engaged in a trade or business during the years of embezzling. In her plea agreement, she admitted to using the business name she created to submit false invoices to her employer’s customers in order to divert funds to herself, but failed to establish any activity that could be considered the carrying on of a trade or business that would allow her to deduct business expenses under IRC § 162(a). The ALJ also agreed with the Division that the petitioner failed to substantiate the additional claimed business expenses or to explain how the claimed expenses were related to her alleged business.
In order to claim the benefit of the Federal Claim of Right doctrine under IRC § 1341, a taxpayer must restore in the taxable year an item that was included in gross income under a claim of right in a prior year, defined by Treasury Regulation § 1.1341- 1(a)(2) as 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 that it was established after the close of the prior taxable year that the taxpayer did not have an unrestricted right to the item in question and had to make restitution. It does not apply to situations resulting from theft or embezzlement, and the ALJ noted that this “‘claim of wrong’” rule denying the benefits of IRC § 1341 has been applied “in a variety of contexts involving intentional wrongdoing.” Furthermore, since “embezzlement” is not a trade or business, repayment of embezzled funds cannot be deducted as trade or business losses under IRC § 162(c)(1).
In order to claim the benefit of the Federal Claim of Right doctrine under IRC § 1341, a ta xpayer must restore in the ta xable year an item that was included in gross income under a claim of right in a prior year, defined by Treasury Regulati on § 1.1341-1(a)(2) as an item included in gross income because it appeared from all the fa cts available in the year of inclusion that the ta xpayer had an unrestricted right.