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Crime doesn't pay ... but it may save taxes.

However desirable the tax advantages of a particular transaction may be, it is important to remember that they should be kept in perspective; the "tax tail should not wag the economic dog." The paradox presented in a recent case may give tax professionals pause to consider a new twist to this advice, namely, to encourage clients not to let "the tax tail wag the criminal dog."

In Accardo, 7th Cir., 1991, aff'g 94 TC 96 (1990), the taxpayer and several other individuals were indicted under the Racketeer Influenced and Corrupt Organizations Act (RICO) for their involvement in certain labor union affairs. The taxpayer and three other defendants were acquitted, while eight defendants were convicted and sentenced. On his 1981 and 1982 tax returns, the taxpayer deducted the legal fees of his successful defense to the RICO charges. The IRS denied the deduction and was upheld by the Tax Court. On appeal, the Seventh Circuit, noting that the case presented a "somewhat paradoxical situation in which the IRS treats convicted taxpayers more favorably than acquitted taxpayers," affirmed.

The paradox referred to by the court arose because the eight defendants found guilty were (as conceded by the Service on brief) entitled to deduct the legal fees they incurred in unsuccessfully defending against the RICO charges under Sec. 162(a), while the legal expenses incurred by those defendants who mounted a successful defense were nondeductible personal expenditures under Sec. 262. The legal expenses of the convicted defendants were deductible because they were incurred in the trade or business of racketeering--an illegal business, but, under the Code, a business nevertheless. Conversely, by proving his innocence, the taxpayer apparently was precluded from arguing that he was engaged in a business (racketeering or otherwise), leaving the taxpayer with the argument that the legal fees could only be deductible under Sec. 212(2).

Sec. 212(2) allows individuals to deduct expenses incurred to conserve or maintain income-producing property. As part of the RICO indictment, the IRS sought forfeiture of all proceeds from the alleged racketeering activities and of all interests in property acquired with such proceeds. Consequently, to support his deduction under Sec. 212(2), the taxpayer argued that in defending the RICO charges, he was not only seeking to prove his innocence, but was also attempting to prevent forfeiture of three certificates of deposit (CDs) totaling $1.5 million.

Focusing on the "origin and character of the claim" rationale generally applicable in determining the deductibility of legal fees, the court found that the taxpayer's legal fees were nondeductible personal expenditures; they were incurred solely to defend against the RICO criminal prosecution, and not directly for the purpose of avoiding the forfeiture of property. The forfeiture provisions of RICO permitted the government to seize only property acquired with proceeds derived from racketeering activities. Because the Tax Court had determined as a factual matter that the taxpayer's CDs were not acquired with the fruits of any racketeering activities, these CDs were, in fact, never subject to forfeiture. Thus, the Seventh Circuit concluded that the taxpayer had not incurred legal fees to conserve or maintain his income-producing property within the meaning of Sec. 212(2). (The IRS, it should be noted, had unsuccessfully attempted to persuade the court to find that, even if the CDs were in fact forfeitable, the legal fees were nevertheless not incurred to conserve or protect those assets within the meaning of Sec. 212(2); the court left this issue for another day.)

The court also rejected the taxpayer's equitable estoppel argument. The taxpayer contended that the government's position in the criminal trial, i.e., that the taxpayer was engaged in racketeering, placed the taxpayer in the same position as his co-defendants who were convicted of RICO violations--for tax purposes, in the business of racketeering--and that the IRS was, therefore, estopped from asserting the contrary. The court simply reiterated its earlier position that Sec. 212(2) did not support a deduction when the subject assets were not in fact forfeitable. (The court also noted the taxpayer's "unwavering denial" in the RICO trial of any involvement in racketeering activities.)

Perhaps the taxpayer could have successfully argued, because the burden of proof in a criminal trial is heavier than in a civil trial, that despite the acquittal by the criminal court, he was nevertheless engaged in some business activity that would have supported a Sec. 162 deduction. The issue was apparently not before the Accardo court, however, since the taxpayer asserted his Fifth Amendment privilege when questioned about his occupation.
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Author:Cohen, Robert L.
Publication:The Tax Adviser
Date:Dec 1, 1991
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