One of the many unresolved issues in the area of compensation clawbacks (in addition to the fact that we don’t have SEC rules on Dodd-Frank Act Section 954 yet) is the tax effect to the executive who must return the compensation. A few of us have addressed this issue, which generally is determined under Code Section 1341, the so-called “Claim of Right Doctrine,” at NASPP and CompensationStandards.com conferences in recent years. However, Section 1341 and the case law and rulings relating to it have not been well-defined.

Now comes a decision out of the U.S. Court of Claims, Nacchio v. United States, granting a partial victory to Joseph Nacchio (and his wife), who was convicted of insider trading in a high-profile 2007 verdict, by allowing them to press their case to deduct the amounts forfeited upon the conviction as a loss under Code Sections 165 and 1341.

Readers may recall that 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 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.

The Court of Claims recognized that to qualify for a tax refund under Code Section 1341, Nacchio must establish both (i) that he believed he had a claim of right to the gain included in his 2001 joint return, and (ii) that he is entitled to deduct the amount forfeited under Code Sections 162 or 165. Like the IRS, the Department of Justice argued that Nacchio did not qualify for Section 1341 relief because his forfeiture was imposed as punishment for insider trading and permitting a deduction would contravene both public policy and the prohibition in Code Section 162(f) against the deduction of a “fine or similar penalty” paid to the United States. The Government also argued that Nacchio could not demonstrate that he believed that he had a bona fide claim to his 2001 trading gains because he was convicted of acting willfully, knowingly, and with the intent to defraud.

The Court cited previous U.S. Supreme Court decisions finding that “the federal income tax is a tax on net income, not a sanction against wronging,” a “principle [that] has been firmly imbedded in the tax statute from the beginning. ... [T]he object of [the income tax] bill is to tax a man’s net income; that is to say, what he has at the end of the year after deducting from his receipts his expenditures or losses. It is not to reform men’s moral characters; that is not the object of the bill at all. ... Only where the allowance of a deduction would [immediately and severely] ‘frustrate sharply defined national or state policies proscribing particular types of conduct’ [has the Supreme Court] upheld its disallowance.”

In other cases, the U.S. Supreme Court upheld the disallowance of deductions claimed by taxpayers for the actual amount of fines and penalties imposed for violating state penal statutes because such deductions “would have directly and substantially diluted the actual punishment imposed.” (Recall that Nacchio had received a $19 million fine as part of his civil and criminal penalties, which he had not attempted to deduct.)

The Court went on to conclude that:

"In the instant case, there is no reason to compound Mr. Nacchio’s criminal punishment with a tax burden Congress has neither expressly nor impliedly directed. As the Government recognizes, Mr. Nacchio’s forfeiture is a loss. The proceeds from Mr. Nacchio’s insider trading evaporated – they were disgorged. Yet, the Government seeks to tax these proceeds not on the ground that they are income, but on an amorphous notion that the public policy against securities fraud must prevent the deductibility of monies that were received due to insider trading even though the monies were disgorged."

Regarding the Government’s argument that Nacchio could not satisfy Section 1341’s requirement that he believed that he had a bona fide claim to his 2001 trading gains because he was convicted of acting willfully, knowingly, and with the intent to defraud, the Court rejected the Government’s claim that Nacchio was barred from litigating whether he believed he had a claim of right to the gain by the doctrine of “issue preclusion” (his “belief” having already been decide in a prior preceding). The Court stated that the issue is not simply whether Nacchio obtained funds unlawfully, but whether it subjectively appeared to him that he had an unrestricted right to those funds. “Although the jury in the criminal trial believed Mr. Nacchio was guilty of willfully engaging in insider trading, this does not equate to a finding of what Mr. Nacchio himself believed. Mr. Nacchio professed his innocence, ... Mr. Nacchio’s subjective belief as to his entitlement to the trading gains in 2001 is a question of material fact that cannot be resolved on summary judgment.”

Readers will understand that we are not celebrating a victory (even partial) for Nacchio; what we want is some degree of certainty for corporations and executives, especially for executives whose compensation is clawed-back through no fault of their own, in the inevitable future clawback cases.

This was not a “clawback” case, of course, and it has not been fully decided. However, the issues and concepts are the same. The majority of future clawback cases are not likely to involve a determination of willful criminal conduct by the executive (although some might). Therefore, the facts and the law will be even more favorable to the executive/taxpayer than in the Nacchio case.