I was going to blog today on a great case involving application of the Cohan rule to help a taxpayer establish their basis in property when they had lost their records.  Pak v. Commissioner, T.C. Memo. 2024-86.  I decided not to because Les Book did such a nice job blogging about it here on Procedurally Taxing that I did not feel I would add much value.  However, one result of reducing these Lessons to once-a-month is that I easily found another case to teach a good Lesson.

Today’s lesson is about deductions for criminal activities.  It’s also a lesson about what I call the rule of ‘62’s.  Section 162 allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.”  In contrast, §262 expressly disallows the deduction of “personal, living, or family expenses.”

The key idea behind these two statutes is to distinguish personal from business expenses.  Congress seeks to tax only net income of money made in a trade or business.  Since it takes money to make money, §162 generally permits taxpayers to deduct the money it takes from the money they make.  In contrast, expenses that are not connected to a trade or business activity (or other profit-seeking activity under §212) are not deductible; Congress seeks in such cases to tax the gross receipts of the taxpayer.

But what if the taxpayer’s trade or business is illegal?  Is their income still gross income?  Are their expenses still deductible?  There is a long and rich history regarding these questions, much of it arising from the activities of Chicago mobsters in the 1920’s, who were not always punctilious about their taxes.  The bottom line is that yes, illegal income is gross income and, yes, expenses to produce that income are likewise deductible under §162(a).  In contrast, expenses that are themselves illegal are not deductible, again regardless of the legality of the taxpayer’s trade or business.  §162(c).

Thus income earned by criminals is treated similarly to income earned by law-abiding taxpayers.  That means criminals still have to deal with the rule of ‘62’s.  That is, they must connect their expenses with some activity that amounts to a trade or business.  §162. The expenses cannot be just personal.  §262.  That is the lesson we learn in Jonathan Chang and Wei-Lin Chang v. Commissioner, T.C. Summ. Op. 2024-18 (Sept. 16, 2024) (Judge Panuthos), where the taxpayer sought to deduct the legal expenses he incurred in a criminal trial for wire fraud and money laundering.  The IRS said his criminal activity was not connected to any business, but was merely personal enrichment.  The Tax Court disagreed and allowed a deduction of over $360,000.

\Details below the fold.

Law: Illegal Income As Gross Income
When Congress first revived the income tax in the Underwood Tariff and Revenue Act of 1913, 38 Stat. 114, there was some question of whether income from illegal sources has to be reported as gross income.  Lower courts were conflicted.  Some types of illegal income were taxable, such as ransoms for kidnapping. Humphreys v. Commissioner, 125 F.2d 340 (7th Cir. 1942).  But other types of illegal income were not, such as embezzlements.  Commissioner v. Wilcox, 327 U.S. 404, 409 (1946) (embezzled funds not taxable because taxpayer’s obligation to repay meant taxpayer had no “semblance of a bona fide claim of right”).

In 1961, the Supreme Court settled the issue in James v. United States, 366 U.S. 213 (1961).  Using the idea of accretion to wealth that it had articulated in the sacred text of Commissioner v. Glenshaw Glass Co., 348 U.S. 426 (1955), the Court said that all income was gross income, regardless of how acquired because “the taxpayer has actual command over the property taxed-the actual benefit for which the tax is paid.  This standard brings wrongful appropriations within the broad sweep of gross income."  366 U.S. at 220.

Law: Deductions for Expenses of Producing Illegal Income
Just as there is no explicit distinction in §61 between legal and illegal activities for purposes of calculating gross income, neither is there any explicit distinction in §162 between legal and illegal activities for purposes of determining allowable deductions.

However, federal courts were at one point conflicted about allowing deductions for criminal enterprises.  For example, Al Capone was not the only well-known Chicago mobster to get into tax trouble.  Another well-known mobster was Murray Humphreys.  As I mentioned above, he was tagged for failing to report income, such as a $50,000 ransom he received for kidnapping Robert C. Fitchie, president of the Milk Wagon Drivers Union, as part of the mobsters’ attempt to take over that Union.

As part of his litigation, he claimed a deduction of over $2,000 for various expenses that were allowable under §162(a).  Both the Tax Court (then the Board or Tax Appeals) and the Seventh Circuit denied a deduction because of the illegal nature of his activities.  They did not think that an illegal business was a “trade or business” within the meaning of §162.  The Tax Court wrote: “As we have previously stated, we are unable to conclude from the evidence of record that the petitioner was engaged in any legitimate business.”  Humphreys v. Commissioner, 42 B.T.A. 857, 880 (1940).  The Seventh Circuit wrote: “The Board sustained the action of the respondent in disallowing these deductions on the ground that the petitioner was not engaged in any business within the meaning of the statute. We agree and in view of what we have already said in this opinion relative to petitioner's activities, it will not be necessary to discuss the matter further.” 125 F.2d at 343.  This became the consistent position of the IRS: expenses of an illegal activity were not deductible because §162(a) authorized deductions only for legal trade or businesses.

The 1961 James case was about whether embezzled money constituted gross income within the scope of §61.  However, the Supreme Court also opined, in dicta, that “Just as the honest taxpayer may deduct any amount repaid in the year in which the repayment is made, the Government points out that…to the extent that the victim recovers back the misappropriated funds, there is, of course, a reduction in the embezzler's income.” 

The James dicta became the holding in Commissioner v. Tellier, 383 U.S. 687 (1966).  There, the taxpayer was in the business of underwriting securities and of purchasing securities for resale to customers.  He was convicted of 36 counts of fraud, including violating 18 USC 1341.  That’s the mail and wire fraud statute, folks.  It’s a statute so widely used that that one commentator has said “To federal prosecutors of white collar crime, the mail fraud statute is our Stradivarius, our Colt 45, our Louisville Slugger, our Cuisinart-and our true love." Jed S. Rakoff, The Federal Mail Fraud Statute (PartI), 18 Duq. L. Rev. 771 (1980).

Mr. Tellier deducted his $23,000 of legal expenses associated with the criminal case.  The IRS denied the deductions and the Tax Court affirmed that denial.  The Second Circuit reversed the Tax Court, but to do that it had to meet en banc to overrule a prior case authored by the august Agustus Hand.  See Tellier v. C. I. R., 342 F.2d 690 (1965).  The government took the matter to the Supreme Court, where it lost, the Court writing:

“Congress has authorized the imposition of severe punishment upon those found guilty of the serious criminal offenses with which the respondent was charged and of which he was convicted. But we can find no warrant for attaching to that punishment an additional financial burden that Congress has neither expressly nor implicitly directed.  To deny a deduction for expenses incurred in the unsuccessful defense of a criminal prosecution would impose such a burden in a measure dependent not on the seriousness of the offense or the actual sentence imposed by the court, but on the cost of the defense and the defendant's particular tax bracket. We decline to distort the income tax laws to serve a purpose for which they were neither intended nor designed by Congress.” 383 U.S. at 694-95.

In other words, just as §61 does not distinguish between the illegal and legal income, neither does §162(a) distinguish between what deductions are permitted.  In general, §162(a) permits the expenses to be deducted from the taxpayer’s business income when they are: (1) ordinary and necessary; (2) an expense and not a capital investment; (3) sufficiently connected to an identifiable trade or business activity of the taxpayer (whether the activity is legal or illegal).

I call that third requirement the “nexus” requirement.  To avoid the disallowance in evil §262, and to get the deduction under friendly §162, taxpayers must show that the expenses are connected to a business and not simply personal.  That’s the lesson we learned in Classic Lesson From The Tax Court: Twitty Burgers!, TaxProf Blog (Apr. 2, 2018).

To be sure, §162 contains several other subsections that disallow certain expenses that meet those three requirements.  For example, §162(c)(2) prohibits deduction of any payment that “constitutes an illegal bribe, illegal kickback, or other illegal payment under any law of the United States, or under any law of a State (but only if such State law is generally enforced).”  Thus a taxpayer in the business of fencing stolen goods can deduct their reasonable office rents, but not the cost of bribing local law enforcement to look the other way.  If the IRS wants to disallow a deduction under §162(c), however, it bears the burden of persuasion.  §162(c)(2).  In contrast, the usual rule that the taxpayer bears the burden of persuasion to establish an entitlement to a deduction.  Welch v. Helvering, 290 U.S. 111, 115 (1933).

Similarly, §162(f) disallows an otherwise allowable deduction if the expense is “paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.” §162(f)(1).  We learned a lesson about that provision a couple of years ago in Lesson From The Tax Court: Taxpayer Could Not Prove His Way Out Of §162(f), (Aug. 15, 2022).

Today’s case is about the nexus requirement, the need to connect an expense to an actual business activity and not a personal activity.  Let’s take a look.

Facts
The year at issue was 2019.  In the years prior, going back to 2001, Mr. Chang was an employee of a company called VIA Technologies, Inc., and was on the Board of Directors of another company, S3 Graphics, Inc., which apparently eventually merged into, or was absorbed by, VIA.  Both of those were indisputably businesses within the scope of §162.

The criminal indictments stemmed from Mr. Chang’s activities and involvement in two organizations other than the two businesses listed above.  The first organization was a §501(c)(3) charity named HOC Associates, Inc., formed in 2004.  The acronym HOC stands for “Home of Christ.”  Mr. Chang was an elder in his religious organization, called “Home of Christ Church” in Saratoga, CA.  As indicated by its acronym, the charity’s purpose was to “support religious activities” such as evangelical missions.  The second organization was a for-profit limited liability company called HOC Associates, LLC, also formed in 2004.  It’s stated purpose was to acquire and rent property.  Mr. Chang was the sole member of the LLC.  After receiving a $3m loan from S3 Graphics (the company where Mr. Chang was on the Board), it did apparently acquire one rental property in 2006 and received rents from it.

In 2019 Mr. Chang was convicted of violating the wire fraud statute, 18 USC §1341.  Like Mr. Tellier, Mr. Chang incurred legal expenses, paying almost $366,000 in 2016.  Defending against criminal charges has gotten a lot more expensive, however.  Mr. Tellier spent $23,000 on his defense in 1956.  That would be about $200,000 in 2016 dollars.  So even taking into account time value of money, Mr. Chang spent a lot more.

Mr. Chang spent his money from his personal accounts, not the bank accounts of either HOCA Inc. (the charity) or HOCA LLC (the rental business).  Despite that, Mr. Chang deducted the legal expenses on the Schedule C for HOCA LLC.

The IRS disallowed the deduction.  Mr. Chang petitioned the Tax Court.  And we get our lesson.

Lesson: Criminal Activity Must Be A Business, Not Personal
While this case is similar to Tellier, it is also different.  In Tellier the Supreme Court noted that there was “no serious question that the payments deducted…were expenses of his securities business.” 383 U.S. at 689.  That case was not about the Rule of ‘62’s.  Thus, Judge Panuthos explains that when evaluating the deductibility of expenses defending a criminal charge, it does not matter whether the activity of the taxpayer was legal or illegal.  What matters is whether the criminal charge originates from the taxpayer’s business activity or personal activity.  Writes Judge Panuthos: “The deductibility of legal fees…depends on the origin and character of the claim for which the expenses were incurred and whether the claim bears a sufficient nexus to the taxpayer’s business or income-producing activities.”  Op at 5.

Mr. Chang argued that the expenses were deductible because the criminal case was one “involving” HOCA Inc. and HOCA LLC.  Op. at 4.

The IRS gave three reasons why it disallowed the deduction.  First, while the criminal case involved the HOCA entities, the criminal charges were against Mr. Chang personally because he was the one doing the criminal acts, apparently using his role as an elder in his church to facilitate the fraud.  Second, the IRS argued that HOCA, LLC, was not a bona fide trade or business but was merely a shell in Mr. Chang’s scheme to enrich himself through fraud.  Third, the fees were paid from Mr. Chang’s personal account, not the accounts of either HOCA Inc., the charity, or HOCA, LLC, the business.  So they were a personal expense.

Judge Panuthos rejected the first two reasons for the same reason: he decided that Mr. Chang operated the two HOCA entities as a criminal enterprise.  First, Judge Panuthos noted that the criminal charges “involve transactions that were made between the HOCA entities and Mr. Chang.”  Judge Panuthos then finds that "at least part of Mr. Chang’s business activities in HOCA LLC were to defraud donors and others for his personal financial benefit.”  Judge Panuthos therefore concludes that “the origin of petitioner’s legal fees stem from Mr. Chang’s business activities as the director of the HOCA entities.”

Judge Panuthos also rejected the third reason, noting that Mr. Chang had shown the Court his criminal defense attorney’s retainer agreement which required him to pay all fees and expenses from “sources that have no connection to the criminal charges.”  That would be his personal account and not either of the entity accounts.

Bottom line:  If you are going to commit fraud and launder money, make it your business.  That way you can at least take deductions for your ordinary and necessary expenses, including legal fees. 

Bryan Camp is the George H. Mahon Professor of Law at Texas Tech University School of Law.  He invites readers to return on the first Monday of each month (or Tuesday if Monday is a federal holiday) to TaxProf Blog for another Lesson From The Tax Court.

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