Herman E. And Mary E. McKinney v. United States
574 F.2d 1240 (1978)
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Rule of Law:
The tax relief provided by 26 U.S.C. § 1341 for the restoration of a substantial amount held under a claim of right is not available to a taxpayer repaying embezzled funds, because an embezzler never holds such funds with the requisite appearance of an unrestricted right.
Facts:
- Herman E. McKinney was an employee of the Texas Employment Commission.
- Over a period of years, McKinney embezzled a total of $91,702.06 from his employer.
- In 1966, McKinney reported the embezzled funds as 'miscellaneous income' on his federal income tax return and paid the corresponding taxes.
- Subsequently, the embezzlement was discovered by authorities.
- McKinney was convicted in state court for the crime of embezzlement.
- In 1969, McKinney repaid the entire $91,702.06 to the Texas Employment Commission.
Procedural Posture:
- On his 1969 tax return, Herman E. McKinney claimed a deduction for the repayment, resulting in a net operating loss which he sought to carry back to 1966.
- Alternatively, McKinney filed a claim with the Internal Revenue Service for a tax refund, asserting he was entitled to relief under 26 U.S.C. § 1341.
- The IRS denied the § 1341 claim.
- McKinney sued the United States in federal district court (the trial court) seeking a tax refund.
- The trial court ruled in favor of the United States, holding that McKinney was not entitled to § 1341 relief.
- McKinney, as the appellant, appealed the trial court's judgment to the United States Court of Appeals for the Fifth Circuit.
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Issue:
Does an embezzler, who reports illegally obtained funds as income and subsequently repays them, qualify for the special tax computation under 26 U.S.C. § 1341, which requires that it 'appeared that the taxpayer had an unrestricted right' to the funds in the year they were received?
Opinions:
Majority - Tuttle, Circuit Judge
No. A taxpayer who repays embezzled funds is not entitled to the tax relief provisions of § 1341 because such funds are not held under a claim of right. The plain language of the statute requires that in the year of inclusion, it 'appeared that the taxpayer had an unrestricted right to such item.' An embezzler, by definition, knows they have no right to the funds, so it cannot appear to the taxpayer that they have an unrestricted right. The Supreme Court's decision in James v. United States, which held that embezzled funds are taxable income, did so on the basis of the taxpayer's control and economic benefit, not by concluding that such funds are held under a claim of right. The James decision made the 'claim of right' doctrine immaterial for the definition of gross income, but it did not eliminate the doctrine as a statutory requirement for relief under § 1341. Furthermore, § 1341 was enacted when Commissioner v. Wilcox was law, which held embezzled funds were not income precisely because they were not held under a claim of right; therefore, Congress could not have intended for the statute to apply to embezzlers.
Analysis:
This decision clarifies the narrow scope of § 1341 and reinforces the distinction between what constitutes taxable income versus what constitutes income held under a 'claim of right.' The court establishes that while illicit gains are taxable under the broad definition of income from James v. United States, the statutory relief for repayment is reserved for taxpayers who had a good-faith, albeit mistaken, belief in their right to the funds. This precedent effectively bars thieves and embezzlers from benefiting from a tax provision designed to correct inequities arising from honest mistakes. It solidifies that the subjective belief of the taxpayer is critical for invoking § 1341, creating a 'clean hands' element for this specific form of tax relief.
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