The First Circuit Court of Appeals determined that a District Court went beyond the law in attempting to mitigate an unfair result in the case of Robb Evans & Associates, LLC v. United States, CA1, Case Nos. 15-2540 & 15-2552.

The case involved the always confusing concept of a claim of right under IRC §1341. This rule provides that if a taxpayer included an item in gross income in a prior year because it appeared the taxpayer had an unrestricted right to the item that is more than $3,000, and the amount is repaid in a later year, the taxpayer can, on the return for the year of repayment, either take a deduction for the amount repaid or claim a credit for the amount of additional tax paid when the item was originally included in income.

In the case at hand, the items included in income were fraudulently obtained by an organization claiming to provide assistance to financially strapped individuals. Eventually a suit was filed against the organization and the name plaintiff in this case was appointed as receiver of the organization to collect judgments against those organizations.

The receiver had limited success in obtaining funds for the individuals who had been harmed and who had a judgment. So the receiver, who now as filing returns on behalf of the organization, attempted to take a credit for the taxes paid on the ill-gotten gains of the organization under the claim of right statute.

The IRS argued that this claim could not meet the requirements for a claim of right credit since a taxpayer who receives funds via fraud cannot reasonably believe he/she had an unrestricted right to the funds. And, as the appellate panel notes, that position has been upheld by the courts:

The law is clear, though, that it cannot be said to appear to an embezzler or fraudster that he has an unrestricted right to his ill-gotten gains (notwithstanding the fact that he is obligated to report those gains in his annual gross income). See Culley v. United States, 222 F.3d 1331, 1335-36 (Fed. Cir. 2000); Kraft v. United States, 991 F.2d 292, 299 (6th Cir. 1993); McKinney v. United States, 574 F.2d 1240, 1243 (5th Cir. 1978). In short, section 1341(a)’s “unrestricted right” language excludes all income reaped by taxpayers who know at the time of receipt that they have no right to the income. “When a taxpayer knowingly obtains funds as the result of fraudulent action, it simply cannot appear from the facts known to him at the time that he has a legitimate, unrestricted claim to the money.” Culley, 222 F.3d at 1335. It follows inexorably that if the taxpayers acquired the funds at issue by fraud, they could not have thought that they had an unrestricted right to those funds.

But the District Court, agreeing in general with the above concept, found that this case should be treated differently to avoid an unfair result. In the view of the trial court, since the provision was inserted in the law to prevent inequalities, the “fair” result in this case should not block the receiver, who was acting on behalf of the defrauded individuals, from obtaining a refund due to the bad faith of those that previously controlled the organization and had defrauded those who would receive the funds.

The appellate panel concluded the District Court went too far in crafting this remedy, noting:

After careful consideration of these appeals, we conclude that the district court erred: that Congress, in the spirit of fairness, tailored a statute to iron out a wrinkle in the Internal Revenue Code does not give a court license to make the application of the statute wrinkle-free. This conclusion leads us to apply the luminously clear language of the statute as written, sustain the government’s appeal, reject the cross-appeal, reverse the judgment below, and remand for entry of judgment dismissing the tax-refund suit.

Specifically, the appellate panel found:

This finding of pervasive fraud was affirmed on appeal, see Zimmerman IV, 613 F.3d at 62, and the class action judgments against the taxpayers have become final. Thus, the Receiver is collaterally estopped from challenging the finding. And because it has been conclusively determined that the taxpayers procured the funds at issue through fraud, the taxpayers could not have thought that they had an unrestricted right to the funds. See Culley, 222 F.3d at 1335. Consequently, the Receiver, standing in their place and stead, is collaterally estopped from asserting that the taxpayers satisfied the requirements of section 1341(a).