in defense of embezzlers

No one likes to defend embezzlers.  But some of the case law on the tax repercussions of embezzlement and restitution is unduly harsh.  In some cases, the courts have held that restitution of embezzled funds is not an ordinary I.R.C. §162 deduction, but at most a miscellaneous itemized deduction, e.g. in O’Hagan v. Commissioner, T.C. Memo. 1995-409, which is perhaps one of the harshest cases, given the amounts involved and the AMT effect.  Thus the embezzlement income is taxed in full, but repayment supposedly is only deductible in a limited way.  Apparently, the IRS will hold to this result in many cases even where the embezzlement and restitution occurred in the same tax year.  One cannot help but think of the scene in Theodore Dreiser’s Sister Carrie, where the character Charles Drouet takes company funds from the safe, and while he contemplates embezzlement, the safe door accidentally closes behind him, which means he cannot anonymously put the money back.  In the common IRS view, even if Drouet returns the funds the next morning in full, he has incurred a rather large income tax bill by sleeping with the funds overnight.

The odd thing is that if one ascends this river of case law to its citation source, Yerkie v. Commissioner, 67 T.C. 388 (1976), one finds that the taxpayer in that case made no claim to be in the business of embezzlement, and thereby essentially forfeited the I.R.C. §162 loss claim: “Petitioner does not claim he was engaged in the business of embezzlement.”  67 T.C. at 393.

At some point, a court should hold that a taxpayer can be in the business of embezzlement, and that reimbursement of embezzled funds are a cost of that business, fully deductible under I.R.C. §162.  (A taxpayer generally may be a professional criminal, as a body of case law has established.)  Even the IRS in internal advice has recognized that the Yerkie case law is more of a historical development than a  defensible principle.  “[E]mbezzlement can rise to the level of a trade or business under section 162 of the Code.”  Field Service Advice dated June 1, 1994, available at 1994 WL 1866290.

Of course, whether a taxpayer is in the business of embezzlement is still subject to general trade-or-business analysis under I.R.C. §162.  The taxpayer must pursue the embezzlement with a sufficient profit motive and with sufficient time and energy to establish that there is a business, just as he would have to do with a lemonade stand.  A single act of embezzlement may not qualify as a trade or business.