In March 2014, I blogged on an Illuminating Case on the Tax Effect of Forfeitures and Clawbacks. In Nacchio v. United States, the U.S. Court of Claims allowed Mr. Nacchio to continue his case to deduct compensation amounts that he later forfeited upon his conviction for insider trading, under the so-called “Claim of Right Doctrine.” At the time, I expressed hope that the decision in would be helpful toward developing the regulatory and case law under Code Sections 165 and 1341, before the effective date of the compensation clawback rules of Dodd-Frank Act Section 954. Unfortunately, last month the Federal Circuit Court of Appeals, in Nacchio v. United Sates, No. 2015-5114, 2016 BL 185348 (Fed. Cir. June 10, 2016), reversed the holding of the Court of Claims and denied Mr. Nacchio the ability to claim the amount of compensation he reported as income in 2007 and forfeited in 2011, as a loss, deductible on his 2011 tax return.

The Federal Circuit Court acknowledged that Section 1341 provides special relief to a taxpayer who is required to restore funds to a third party where the taxpayer included the funds in his income in a prior taxable year in which it “appeared that the taxpayer had an unrestricted right” to the funds. However, the Court found that a taxpayer who knowingly obtained funds by fraudulent means could not later argue that from the facts known to him at the time he had a legitimate, unrestricted claim to the funds. The court also found under Code Section 165, a taxpayer cannot deduct a loss where its allowance “would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.”

This was not a “clawback” case, but the issues and concepts were similar, and Section 1341 and the case law and rulings relating to it had not been well defined. To refresh your recollection, Nacchio served as the CEO of Qwest Communications from 1997 to 2001 and received a substantial number of stock options during that period. In April 2001, when Qwest opened a “trading window” pursuant to company policy to allow its officers to sell Qwest stock, Nacchio exercised his options and sold 1,255,000 shares of Qwest stock. On May 16, 2001, Nacchio entered into an automatic sales plan under Rule 10b5-1 to sell his Qwest stock and continued to sell his stock until May 29, 2001, when its price fell precipitously. Nacchio reported $44,632,464.38 in net gain from these stock sales in his 2001 joint tax return and paid $17,974,832 in taxes on this gain. However, a series of civil and criminal action resulted in the courts sentencing Nacchio to 70 months in prison, a $19 million fine, and a $44,632,464.38 forfeiture. On their joint income tax return for the 2007 tax year, following the forfeiture, Nacchio claimed a $17,999,030.00 credit pursuant to Code Section 1341. The IRS disallowed the credit, stating that Section 1341 “can be invoked only after a valid deduction is claimed pursuant to another Code section.” Because Nacchio’s forfeiture was a penalty for violating the law, it was “not remedial in nature” and a deduction was not permitted under any section of the Code. The IRS Appeals Office also denied Nacchio’s refund claim citing the same grounds and the case landed in the U.S. Court of Claims.

I have labeled this result as “unfortunate,” not because I am of fan of Mr. Nacchio or insider trading, but because the case added some much-needed clarity to the application of the Claim of Right Doctrine under Code Section 1341 (and Section 165). The majority of future clawback cases are not likely to involve a determination of willful criminal conduct by the executive. However, the IRS could attempt to apply the broad reasoning of the Federal Circuit’s decision to more routine compensation clawback cases, which would make a bad situation worse.