John Smith is the majority stockholder of ABC Corp. In 2007 ABC pays Smith a $1M bonus. In 2012 the minority stockholders win a judgement ordering Smith to repay the bonus plus interest as misappropriation.
Since it is too late to amend the 2007 return can Smith get his tax payment back. Can he deduct the repayment from his 2012 return? (were he to have the income...) Will the repayment be income to ABC? What does ABC do about their 2007 return where they deducted it?
This sounds like a Repayment.
If the repayment of income declared and taxed in an earlier year is not more than $3000, that amount can be claimed as a Schedule A Misc deduction subject to reduction by 2% of AGI.
But if more than $3000, it is subject to recovery under the Claim of Right doctrine.
Under the CofR doctrine, taxpayer may chose one of two methods to recover:
a) A Schedule A Misc deduction Not subject to 2% reduction, or b) Calculate and recover as a tax credit the difference between tax paid in the earlier year assuming no income corresponding to the repayment amount, and actual tax paid.
See IRS Pub 525 for a longer discussion on Repayments and how to calculate the tax credit due to asserting the Claim of Right.
Since the repayment was in a later year, there is no amended return even if SOL is still running.
I read through 525. Is the credit refundable? If not, can it be carried forward or backward?
Presumably the interest ordered to be repaid is simply lost.
Believe it or not, yes. It is a line 71 refundable tax credit.
I would certainly assume so.
Could it be a misc deduction subject to 2%?
Believe it or not, yes. It is a line 71 refundable tax credit. =============The authority (as a credit) for such is IRC Section 1341(b)(1). The credit does not carry.
=============The deduction version (if selected) does carry as an NOL - 1341(b)(4)(A).
I would certainly assume so. ============= I wouldn't make that assumption so quickly. If one can show that he was "in the trade or business of embezzlement," he might get a deduction as business interest.
Note: As misappropriation is effectively embezzlement, there is case law to consider: The claim of right deduction or credit is available ONLY when the transaction is a civil matter. A criminal conviction for embezzlement procludes CoR treatment. [The conviction implies there was no right to take in the first place.]
As to the company, it follows the usual "recovery rule" of Section 111 as to the taxability of the amount recovered, which first goes against the amount wrongfully taken before any excess is applied as taxable interest income. Therefore, they will see income on the stolen amount only if they deducted a casualty loss for its theft.
Is there are IRS statute that prohibits deductions for illegal activities? For example, there is 280E which disallows deductions for illegal sale of controlled substances (ie. drugs).
Is there are IRS statute that prohibits deductions for illegal activities? For example, there is 280E which disallows deductions for illegal sale of controlled substances (ie. drugs).
=================== The payment of interest is not an illegal transaction unless the interest exceeds 25%.
I'm confident that interest payments made in support of an illegal activity will be classified as non-deductible personal interest upon IRS audit.
280E is the only section that I am aware of that denies business expense deductions against income derived from an illegal activity (sale of controlled of substances). E.g., a bookie operating his/her business contrary to the law can take ordinary and necessary business expenses against income. Obviously, you don't usually see criminals declaring their ill-gotten gains. However, if they did, they would get the deduction. Also obviously, they open themselves up to an audit of their income and expense. This is why, we have money launderers.
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