Tax implication of SEC penalty

In my thinking disgorgement is a repayment of income previously earned. So you can do the claim of right. You can take a deduction or credit, though the credit will mostly likely work better here as his current year income will be low. You will compute an amended return for the prior year, calculate the difference in tax, and claim that difference as a credit on your current year return. The credit is refundable (line 70) so you will get money back, but not with interest as with an amended return.

A previous discussion of claim on right in this newsgroup said that the credit/deduction is not allowed when the money was obtained illegally. I can't find those words in IRC 1341. So I don't really know.

See Stephen S. Wang, Jr. v. Commissioner, T.C. Memo. 1998-389.

It has a detailed discussion on the issue of claim of right and illegally obtained income.

Here's an excerpt that leads into the court's discussion that concluded the referenced Barrett case by the plaintiff was not relevant and Sec.

1341 could not be used by the plaintiff. See the Perez case reference at the end. It's the case that says you can't use Sec. 1341 for earnings that you knew you had no legal right to.

Section 1.1341-1(a)(2), Income Tax Regs., continues with the definition:

"income included under a claim of right" means 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 "restoration to another" means a restoration resulting because it was established after the close of such prior taxable year (or years) that the taxpayer did not have an unrestricted right to such item (or portion thereof).

Section 1341 is titled "CLAIM OF RIGHT", but the statutory language used to describe that concept is that the income item must have been includable because it " appeared " that the taxpayer had an " unrestricted right " to it. (Emphasis added.) The above-quoted regulations, however, again use the term "claim of right" in the process of defining the operative terms of section 1341. The concept of claim of right, accordingly, must be part of our consideration of section 1341 issues.

Respondent contends that petitioner is not entitled to use section 1341 because: (1) Petitioner never included the proceeds of the illegal sale of insider information in his gross income for 1987; (2) petitioner did not have an unrestricted right to the income; i.e., in cases usually involving embezzlement, courts have held that the illegal income is not held under a claim of right; and (3) in general, illegally obtained income does not, per se, give rise to a claim of right. Petitioner disagrees with respondent's contentions and argues that Barrett v. Commissioner [Dec. 47,346], 96 T.C. 713 (1991), a case involving a securities trader who was allowed section 1341 relief, is substantially similar factually and should be followed.

Section 1341 was enacted in 1954 to address the type of situation that existed in United States v. Lewis [51-1 USTC ¶ 9211], 340 U.S. 590 (1951). In that case, the taxpayer repaid, in a later year, part of a bonus received erroneously in a prior year that was closed for tax purposes. Because of those circumstances, the taxpayer lost the benefits of being able to calculate the reduction of income in the year of receipt of the bonus. Those benefits included interest from a refund of the tax paid earlier and differing tax rates between the years of receipt and repayment. Although section 1341 does not address the question of interest, it does address other possible benefits that might have been available from the deduction or computation of the tax in the earlier year.

Respondent contends that section 1341 generally does not apply to circumstances where the income is obtained through illegal means. The cases that have addressed this issue, however, generally involve embezzlement or a similar circumstance where the taxpayer was entrusted with another's cash or assets. 7 We could find only one section 1341 illegal income case that did not involve embezzlement or similar circumstances. On the basis of the embezzlement cases, the court, in that case, decided, that the result in the embezzlement case(s) "cannot be limited only to embezzlers; instead, the statute's `unrestricted right' language must be read to exclude from its coverage all those who receive earnings knowing themselves to have no legal right thereto." Perez v. United States [83-1 USTC ¶ 9106], 553 F. Supp. 558, 561 (M.D. Fla.1982).

Please note that in the case of embezzlement, the courts have held that the CoR method of tax reduction (whether deduction or credit) is denied when the embezzler is CRIMINALLY prosecuted for the embezzlement. There are other (pre-1990) TC cases that have permitted CoR where no criminal prosecution has taken place (but a claim for civil recovery by the embezzled has).