On June 10, 2016, the United States Court of Appeals for the Federal Circuit held that Joseph Nacchio (“Nacchio”) could not claim a tax deduction based on a prior court-ordered forfeiture payment of $44 million following a jury verdict that found him guilty on nineteen counts of insider trading.46 Nacchio, the former CEO of Quest Communications, was convicted in April 2007 of insider trading-related counts based on the federal prosecutor’s allegations that he sold $52 million in Quest stock in 2001 when he knew, but did not disclose publicly, that Quest was unlikely to continue to meet its earnings targets. In addition to the forfeiture payment, Nacchio was ordered to pay a criminal fine of $19 million and serve a 70-month criminal sentence.47
In 2009, following his conviction and forfeiture payment, Nacchio filed an amended federal tax return for 2007, claiming a nearly $18 million tax credit under IRC section 1341 based on the forfeiture payment. In January 2011, Nacchio entered into a settlement in connection with a concurrent action brought by the SEC. The SEC settlement required Nacchio to disgorge his $44 million trading profit in Quest stock, but gave him credit for his forfeiture payment to the United States, which satisfied Nacchio’s disgorgement obligation to the SEC. Thereafter, the Department of Justice notified prior participants in private securities class action litigation or SEC civil litigation concerning Quest stock that they were eligible to receive a remission from Nacchio’s forfeiture. In 2012, the chief of the Asset Forfeiture and Money Laundering authorized payment of the forfeited funds to eligible victims of Nacchio’s fraud.
In 2012, Nacchio commenced this action before the Court of Federal Claims seeking a tax credit for his forfeiture payment. The parties agreed to litigate cross-motions for summary judgment prior to discovery. The government argued that: (1) IRC section 162(f) barred any deduction under either section 165 or section 162, and (2) even if the loss caused by the forfeiture was a deductible loss under section 165 or section 162, Nacchio was estopped from seeking the special tax relief authorized by section 1341 because his criminal conviction was conclusive with respect to his state of mind. Nacchio argued that his loss was deductible under both section 165 and section 162 and that the question of whether it appeared that he had an unrestricted right to his trading profits in 2001 was not actually litigated in his criminal trial.
Court of Federal Claims rules for Taxpayer
The Court of Federal Claims denied the government’s motion for summary judgment and granted-in-part Nacchio’s motion for partial summary judgment. The court held that Nacchio’s forfeiture payment was deductible under section 165. The court expressly rejected the government’s argument that deduction of the forfeiture was barred by section 162(f). The court reasoned that, unlike the $19 million criminal fine, which was clearly punitive and was paid from assets unrelated to insider trading, the forfeiture “exclusively represented the disgorgement of Mr. Nacchio’s illicit net gain from insider trading.” 48 In addition, the court found that “Nacchio’s forfeiture was used for a compensatory purpose” because, even if not characterized as restitution, the amounts paid ultimately were returned to victims of Nacchio’s crimes through remission.49 In a footnote, the court rejected Nacchio’s attempt to deduct his forfeiture under section 162 as an “ordinary and necessary business expense.” 50 The court then rejected the government’s argument that Nacchio was collaterally estopped from pursuing special relief under section 1341. The government appealed and Nacchio cross-appealed.
On appeal, the circuit court viewed the relevant question regarding deductibility to be whether Nacchio’s criminal forfeiture was a “fine or penalty” under section 162(f). Following a de novo review, the circuit court held that Nacchio’s forfeiture payment was not deductible because it constituted a fine or penalty under section 162(f).
Forfeiture is Ruled a “Penalty”
First, the circuit court looked to the Tenth Circuit’s holding (Nacchio’s criminal appeal), that Nacchio’s forfeiture should be calculated in accordance with section 981(a)(2)(B), 51 not section 981(a)(2)(A).52 Section 981(a)(2)(B) states that: “[T]he term ‘proceeds’ means the amount of money acquired through the illegal transactions resulting in the forfeiture, less the direct costs incurred in providing the goods or services. . . . The direct costs shall not include . . . any part of the income taxes paid by the entity.” 53 According to the language of the statute, the circuit court concluded that the forfeiture amount does not account for taxes paid on the amount of money acquired through the illegal transactions.
Next, the circuit court looked to Treasury Regulation § 1.162-21(b)(1) which defines “fine or similar penalty” for the purposes of section 162(f) as including, inter alia, “an amount—(i) Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding.” 54 Citing Colt Industries, Inc. v. United States, 55 courts have looked to the Treasury Regulation’s definition of a “fine or similar penalty” in denying deductions a taxpayer sought under section 162(a) for civil penalties paid to a state for violations of the Clean Water Act and the Clean Air Act. In Nacchio, the circuit court concluded that Nacchio’s criminal forfeiture met the definition of a “fine or similar penalty” under Treasury Regulation § 1.162-21(b)(1). Nacchio’s criminal forfeiture was imposed pursuant to 18 U.S.C. § 981(a)(1)(C) and 28 U.S.C. § 2461(c), as part of his sentence in a criminal case. Section 981(a)(1)(C), as amended by the Civil Asset Forfeiture Reform Act of 2000,56 authorizes the forfeiture of “proceeds” traceable to numerous felony offenses, including any offense constituting “specified unlawful activity” as defined by 18 U.S.C. § 1956(c)(7)(A). Section 1956(c)(7)(A), in turn, defines “specified unlawful activity” as any act or activity constituting an offense under 18 U.S.C. § 1961(1)(D), which includes “any offense involving . . . fraud in the sale of securities.” 57
The circuit court further noted that other appellate courts have concluded that forfeitures of property to the government similar to the one at issue are not deductible by the taxpayer because they are punitive.58 For example, in Wood v. United States, the Fifth Circuit denied a loss deduction under section 165 for the civil forfeiture of proceeds from the taxpayer’s drug trafficking activities.59 In non-tax cases, other circuit courts have confirmed that, while restitution is compensatory, criminal forfeiture under section 2461(c) serves a distinct, punitive purpose. The Eleventh Circuit held in United States v. Joseph that a convicted criminal could not offset his restitution by the amount he forfeited under 18 U.S.C. § 981 and 28 U.S.C. § 2461.60
Nacchio argued that his right to deduct his forfeiture payment should follow the Stephens decision.61 The taxpayer in Stephens, like Nacchio, was convicted of whitecollar crimes. At sentencing, the prosecutor recommended that Stephens pay restitution to the company whose funds he had embezzled.62 Stephens was then sentenced to several years in prison and fined, but part of the prison term was suspended “on the condition that he make restitution to Raytheon” 63 in the amount he embezzled plus interest. The Second Circuit held that the restitution was “a remedial measure” to compensate another party, not a “fine or similar penalty.” 64 It thus found the restitution deductible under section 165.
But the circuit court held that Stephens was distinguishable. Unlike Nacchio’s case, the Stephens case “involved court-ordered restitution—imposed as a condition of his partially suspended sentence—which was clearly remedial, as it restored the embezzled funds to the injured party.” 65 The court noted that the payment was so “Raytheon [would] get its money back” and that “Stephens’ payment was made to Raytheon and not ‘to a government.’”66 “Thus, allowing the restitution to be deducted comported with those cases explaining the difference between restitution orders and forfeiture orders.” 67 In Nacchio’s case, by contrast, forfeiture, not restitution, was at issue. The court’s amended judgment specifically provided that the amount of restitution owed was “$0.00” and that restitution was “not applicable.” 68 At the resentencing hearing, the district court judge described Nacchio’s sentence of imprisonment, fine and disgorgement as “three forms of penalty.” 69 The judge further found that “the goal of restitution, sadly [ ] is not applicable here” because “there is no provision in the law for restitution.” 70 Instead, the district court directed that the fine of $19 million “be deposited to the Crime Victims’ Fund” to “help fund state and local victims’ assistance programs[,] . . . And the forfeiture money can be used to assist victims within limitations under the law.” 71
Finally, the circuit court found that the Attorney General’s “post-hoc decision to use the forfeited funds for remission did not transform the character of the forfeiture so that it was no longer a ‘fine or similar penalty’ under section 162(f).” 72 The decision to compensate victims was discretionary, and the forfeited amount was unrelated to the amount of losses suffered by the victims. Accordingly, the circuit court held that the trial court erred in relying that Nacchio may deduct his forfeiture under section 165.
Nacchio recently asked the circuit court to rehear en banc its ruling, arguing that the three-judge panel erred in finding that the forfeiture constituted a penalty or fine. In his petition, Nacchio argues that the panel’s decision erroneously placed form over substance—as it turns merely on the procedural mechanism that prosecutors choose to employ when routing the proceeds of a crime back to victims. The government has opposed the motion.