T.C. Memo. 2010-4
UNITED STATES TAX COURT
PETER D. AND KAREN M. CAVARETTA, Petitioners v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket No. 24823-07. Filed January 5, 2010.
Jeffrey A. Human, for petitioners.
Kevin M. Murphy, for respondent.
MEMORANDUM OPINION
HOLMES, Judge: While working for her husband’s dentistry
practice, Karen Cavaretta billed insurance companies for work he
hadn’t done. After she pled guilty to fraud charges, he repaid
the money and deducted the repayments as business expenses. The
Commissioner agrees that the repayments are deductible, but
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argues that they were restitution, not business expenses. He
also says the Cavarettas were negligent in taking a contrary
view.
Background
Peter Cavaretta opened his dental practice in 1970, and ever
since his wife Karen has kept the books and handled the billing.
The practice served clients of several insurance companies,
including Group Health, Inc. (GHI). Peter treated GHI patients
at agreed rates and then billed GHI, which would send him a
check. If he overbilled GHI, the contract required him to repay
the difference.1 If the practice didn’t pay, GHI could simply
deduct the amount owed from future reimbursement checks.
In 1995, Karen Cavaretta began billing GHI for “planing and
scaling,” a procedure that Peter never performed. She continued
submitting these false claims until January 2001, when a postal
inspector put a stop to it. He also extracted a statement from
Karen admitting to the false claims. Both parties agree that
Peter was unaware of his wife’s enterprise. They also agree that
1
The Commissioner makes much of the fact that the only GHI
contract in the trial record is one from November 2000, toward
the end of Karen’s improper billing scheme. Peter credibly
testified that he had to sign an agreement with GHI before he
began seeing its clients, and that most insurance company
agreements included similar obligations to refund overpayments.
He also credibly testified that he had earlier contracts with
GHI, and we specifically find that he had a contract with GHI
during the years in question and that it required him to repay
overcharges.
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the overcharges went into the practice’s books as revenue--which
the Cavarettas duly reported to their accountant, who included it
on their tax returns.
Once GHI learned of the false claims, it started asking for
repayment. GHI sent a letter in March 2001 to “Dr. Cavaretta”,
with the subject line “Peter Cavaretta, DDS,” the name of the
practice. The letter demanded repayment of more than $1.1
million. A later letter, addressed to Karen’s defense lawyer but
with the same subject line, increased the demand to over $1.6
million. But GHI then backed down from what may have been its
own inflated estimates of the damage it had suffered, and finally
agreed that Karen had submitted $544,216 in false claims that
needed to be repaid.
Karen pled guilty to one count of health-care fraud in
August 2001. United States District Judge Elfvin sentenced her
to 18 months in prison, with two years of supervised release
afterward. He ordered a $100 assessment as required under the
federal sentencing guidelines, but ordered no fine or
restitution.
Judge Elfvin attached to the sentencing judgment a letter
from Karen’s attorney saying that she would pay GHI $600,000 to
“settle all civil claims against the Cavarettas, * * * and
specifically those claims arising from matters dealt with in the
criminal action brought in the Western District of New York.”
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The letter provided that the first payment of $230,000 would be
paid through Karen’s lawyer, and the rest would go directly to
GHI. In return, GHI wrote a letter supporting a home-confinement
sentence.
In December 2001, Karen’s lawyer sent a cashier’s check for
$230,000 to GHI. He included a letter reading, “Due to the
unusual fashion by which Ms. Cavaretta was sentenced, I was
instructed by the probation officer to transmit this directly to
[GHI].” The Commissioner and the Cavarettas stipulated that
Peter made the payment, as well as payments of $165,833 in 2002
and $55,322 in 2003.2
Peter deducted these payments as business expenses of the
dentistry practice on his Schedule C.3 These deductions
2
Although the Commissioner stipulated that Peter made the
payments, he continued to jaw on this point; he claims that the
lawyer’s sending the check, when combined with the lack of
evidence that the Cavarettas kept separate checking accounts,
must mean that Peter was merely transmitting payments owed by
Karen. But the Commissioner signed the stipulation saying “Dr.
Peter D. Cavaretta made payments to GHI . . .,” and Tax Court
rules are clear that “[a] stipulation shall be treated, to the
extent of its terms, as a conclusive admission,” and says those
admissions will be binding. Rule 91(e). We may allow changes
when justice requires, id., but the Commissioner has not asked
for a change. And we also find that the weight of the evidence
presented is not contrary to the stipulation. (Even if the
payments were made from a joint bank account, it would not change
our holding for reasons explained later.) (Unless otherwise
indicated, all Rule references are to the Tax Court’s Rules of
Practice and Procedure, and all section references are to the
Internal Revenue Code in effect for the years in issue.)
3
According to Schedule C of the tax return the 2003 payment
(continued...)
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generated net operating losses carried back to 1996, 1997, and
1998, for which the Cavarettas got tentative refunds. Sec.
6411(a). But the Commissioner changed his mind after auditing
the Cavarettas’ returns and sent them a notice of deficiency for
all three years.
The parties ask us to decide if Peter’s payments were
deductible as loss carrybacks and, if not, whether the
deficiencies resulting from their disallowance should be subject
to accuracy-related penalties. At the time they filed their
petition, the Cavarettas lived in western New York.
Discussion
We have jurisdiction to hear this case because section
6213(b)(3) lets the Commissioner rescind a tentative refund by,
among other means, a notice of deficiency, which allows a
taxpayer to petition Tax Court, or a math-error notice, which
does not. See Ron Lykins, Inc. v. Commissioner, 133 T.C.
(2009). The Commissioner chose to send the Cavarettas a notice
of deficiency. We can reevaluate the Cavarettas’ treatment of
the payments in 2001-03 even though the notice of deficiency
doesn’t cover those years because section 6214(b) gives us
jurisdiction to review other years or periods “as may be
3
(...continued)
was only $50,000, and the additional $5,322 was for uncontested
business expenses, including telephone, dues and subscriptions,
and outside services. The discrepancy has no effect on the
amount of the carryback.
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necessary correctly to redetermine the amount of such
deficiency.”
This case is unusual in that both parties agree that the
payments were deductible. The Cavarettas say the payments were
deductible under section 162 as a business expense, or under
section 165(c)(1) as a loss incurred in a trade or business, or
under section 1341 as a payment made under a claim of right. The
Commissioner argues instead that the Cavarettas can deduct them
only under section 165(c)(2), as losses incurred in a transaction
(i.e. fraud) entered into for profit.
Lurking behind this dispute is the general rule that a
taxpayer usually can’t have negative income–-if he suffers a very
large loss in one year, he may be limited to reporting zero
income. But section 172 allows taxpayers to sometimes claim a
net-operating-loss (NOL) carryback. Taxpayers with a big NOL in
one year may be able to report zero income in that year and use
the remaining loss to offset other years’ income, possibly even
getting refunds of taxes already paid. But not all losses can be
carried back. Section 172(d) says that most nonbusiness
deductions, like those under section 165(c)(2), can be used only
to reduce income that isn’t from a trade or business and only in
the year incurred–-they cannot be carried back. Sec. 172(b)(2),
(d)(4).
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So our job is to decide whether the Cavarettas’ payments
were business or nonbusiness expenses. The parties frame the
question as asking whether the payments were meant to settle
GHI’s potential contract claim against Peter or to comply with
the criminal plea agreement with Karen.
The Commissioner very much wants us to find that the pay-
ments were Karen’s, that they were “restitution”, and that she
made them as part of her plea deal. We do agree, and find as a
matter of fact, that the payments were restitution. Most of the
documents in the record refer to the payments as restitution, in-
cluding the settlement agreement between GHI and the Cavarettas,
the letter from Karen’s defense attorney to GHI attached to Judge
Elfvin’s sentencing judgment, and the sentencing judgment itself,
which refers to the letter as “the civil restitution agreement.”
The Commissioner thinks that’s enough to win. He argues
that Stephens v. Commissioner, 905 F.2d 667 (2d Cir. 1990), revg.
93 T.C. 108 (1989), makes payments labeled “restitution” never
deductible under section 162 and only sometimes deductible under
section 165. We think this is too blunt a reading of Stephens,
and that labeling a payment “restitution” does not make it
automatically ineligible for deduction as a business expense.4
4
Consider Spitz v. United States, 432 F. Supp. 148 (E.D.
Wis. 1977), in which the taxpayer was convicted of theft by a
contractor and ordered to pay $5,000 in restitution. The court
found that the restitution was not a fine or penalty made
(continued...)
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The salient facts in Stephens are simple: Stephens had
criminally defrauded Raytheon, and part of his sentence was
suspended on condition that he pay $1 million in restitution. He
had also been sued by Raytheon, and settled in part by agreeing
that Raytheon could empty his Bermuda bank account holding
$530,000 to partially satisfy the restitution order. Stephens
then tried to deduct that payment.
When Stephens was in our Court, we asked whether that pay-
ment--sort of a cost of stealing from Stephens’s perspective--was
deductible under either section 162 or 165. We first noted that
restitution, “such as is involved herein,” wasn’t an ordinary and
necessary business expense and could be deducted only under sec-
tion 165, if at all. Stephens, 93 T.C. at 111 (citing Mannette
v. Commissioner, 69 T.C. 990, 992-94 (1978)). We then held, for
public-policy reasons, that the payment was not even deductible
as a loss resulting from a transaction entered into for profit
under section 165(c)(2). Id.
The Second Circuit reversed, but it didn’t hold that all
restitution is automatically deductible or nondeductible. It
carefully distinguished punitive from compensatory restitution,
even in criminal cases, and reasoned that Stephens’ restitution
4
(...continued)
nondeductible by section 162(f), because it was “an amount due
and owing”, and there was no public policy against allowing the
deduction. Id. at 149-50.
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payment had both law-enforcement [punitive] and compensatory
purposes, but that it was “primarily a remedial measure to
compensate another party.” Stephens, 905 F.2d at 672. The court
held that it was more compensatory than punitive because the
sentencing judge had stressed “‘that Raytheon must get its money
back,’” and added the suspended jail sentence to ensure that
Stephens paid. Id. at 673. The court held it important that the
sentence included jail time, a fine, and restitution, so that the
restitution was compensatory while the jail time and fine were
punitive. Id. at 674. It distinguished Bailey v. Commissioner,
756 F.2d 44 (6th Cir. 1985), in which a taxpayer tried to deduct
payments made to satisfy a restitution order that had previously
been a fine. Stephens, 905 F.2d at 674. It therefore held that
it would not be against public policy to allow deductions for
this type of restitution. Id.
It also touched--albeit lightly--on the issue of whether
restitution payments could be business expenses under section
162. On the facts in Stephens, this might have been dicta,
because Stephens and the Commissioner agreed that the
deductibility of the restitution was governed by section 165.
Id. at 670. The Second Circuit nevertheless quoted with approval
the part of our opinion where we held that “a restitution
payment, such as is involved herein, is not an ‘ordinary and
necessary’ business expense as required by section 162(a) but
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rather gives rise to a loss in a ‘transaction entered into for
profit’ under section 165(c)(2).” Id. The Commissioner urges us
to elide the phrase “such as is involved herein,” and read
Stephens as a general bar on deduction of restitution payments as
business expenses.
We decline to do so. The restitution in Stephens and
Mannette was for criminal fraud or embezzlement without any
connection to a separate business, where the taxpayer seeking the
deduction was also the wrongdoer. (In Mannette, the taxpayer
tried to convince the Court that embezzlement was an integral
part of an alleged securities business. Mannette, 69 T.C. at
993.) This is hardly the case here.
In this case, the Cavarettas are very much disagreeing with
the Commissioner about whether the restitution payments are
deductible under section 162. On the assumption that some
restitution payments are nondeductible under that section,5 we
first ask whether the restitution here was punitive. If it was,
the deduction may be barred; if it wasn’t, then we will need to
ask whether it is an otherwise ordinary and necessary expense of
5
We held in Waldman v. Commissioner, 88 T.C. 1384, 1389
(1987), affd. 850 F.2d 611 (9th Cir. 1988), that the exclusion
from deductibility of fines and penalties under section 162(f)
sometimes bars restitution paid to private parties. The Second
Circuit questioned this in Stephens, 905 F.2d at 674, but we
haven’t revisited Waldman, and need not do so here--we’ll just
assume that punitive restitution is nondeductible under section
162.
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Peter’s dentistry business. But we do agree at the outset with
the Cavarettas’ claim that Stephens doesn’t say all restitution
is nondeductible.
On the question of whether the restitution here is punitive,
Stephens is controlling. Its logic makes the Cavarettas’ case
for deductibility even stronger than Stephens’s, because it isn’t
at all clear that the restitution here was part of Karen’s
criminal sentence. Judge Elfvin’s only specific mention of
restitution was on the page titled “Special Conditions of
Supervision,” where he noted, “The defendant shall comply with
the civil restitution agreement . . . .” (Emphasis added.) In
the criminal sentencing paperwork, Judge Elfvin noted a “None” in
the line marked “total amount of restitution” and on the page
entitled “Criminal Monetary Penalties” the Restitution column
contains a zero.
But even if we swallowed the Commissioner’s argument, and
assumed Judge Elfvin had somehow bollixed the distinction between
criminal and civil restitution, the Cavarettas’ obligation to pay
restitution was in addition to the sentencing of Karen to prison
and supervised release. Stephens says this fact weighs in favor
of finding that the restitution--even if part of a criminal
sentence--was compensatory, not punitive.
The amount of the restitution also suggests that it was
meant to make GHI whole, and not meant to punish--the payments
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totaled $600,000 on a claim worth $550,000. But the claim had
accrued over six years, and would have given rise to at least
$50,000 in interest, meaning that the amount of the payments
closely approximates (or even underestimates) what GHI was owed.
So we have little trouble concluding that the payments are
noncriminal, compensatory restitution. But are they business
expenses, deductible under section 162? On this question, the
Commissioner pokes around for another argument, and contends that
the payments can’t be business expenses because they were
expenses of committing fraud, and Dr. Cavaretta’s business is
dentistry, not fraud. The Cavarettas brush this argument aside.
They first contend that the payments were ordinary and necessary
for Peter as a dentist. The Cavarettas are clearly right that
the payments settled a contract claim. And payments in
settlement of a contract claim usually qualify as ordinary and
necessary business expenses under section 162. Old Town Corp. v.
Commissioner, 37 T.C. 845 (1962). This is true even when no
litigation has commenced, as long as the business felt the claim
had some possibility of success, made the payments to avoid the
damages or liability, and had an objectively reasonable belief
that the expense was necessary. See id. at 858-59. Peter
credibly testified that he would have lost his business if he had
not settled the matter with GHI. We also believed him when he
said that the installment agreement he worked out with GHI was
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less onerous than a potential court-ordered lump-sum payment. We
therefore find that the payments were ordinary and necessary to
his business.
This was not an ordinary contract claim, of course, but one
that arose specifically because of Karen’s wrongdoing. And even
if we ignored Peter’s contractual obligation to repay GHI, we
would again agree with the Cavarettas that the payments were
deductible--businesses can sometimes deduct payments made to
satisfy claims against a third party. See, e.g., Lohrke v.
Commissioner, 48 T.C. 679 (1967). Lohrke and similiar cases are
usually about expenses that “originated with another person and
would have been deductible by that person if payment had been
made by him.” Id. at 685 (citing nine other cases). And Karen
could not have deducted these as business expenses herself,
because (as the Commissioner is right to emphasize) taxpayers who
procure illegal income can’t claim they were in the trade or
business of fraud or embezzlement, and Karen doesn’t have another
business to attribute the payments to. See Mannette, 69 T.C. at
992. (“Embezzlers generally have been prohibited from carrying
back losses arising from repayments of embezzled funds.”)
From Peter’s perspective, though, the situation is a lot
like the one that we saw in Musgrave v. Commissioner, T.C. Memo.
1997-19, where a business repaid a client after one of its
employees had embezzled money from him. We held that the
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repayment was an ordinary and necessary expense of the business.
We stressed that deductibility depends on the relation of the
payment to the business claiming the deduction; in other words,
don’t look at the situation from the perspective of the
embezzling employee, but from that of the business actually
claiming the deduction and see if there is a reasonable business
purpose for repayment. The Commissioner tries to distinguish
Musgrave as arising only from a civil liability, not criminal
restitution. But as we’ve already explained, that only helps the
Cavarettas, because Judge Elfvin ordered no criminal restitution
--he just required the Cavarettas to abide by the civil
restitution agreement they had negotiated privately with GHI.
The Commissioner next suggests that the payments aren’t
deductible because they were Karen’s alone. We, however, find
that both Cavarettas were obliged to make them. The first
letters from GHI demanding refunds were addressed to Peter at his
place of business, even though Karen had by then admitted to the
scheme. The letter attached to the sentencing judgment stated
that the payments were to “settle all civil claims against the
Cavarettas.” (Emphasis added.) And when GHI issued its final
release of claims, it released “Karen Cavaretta and Dr. Peter
Cavaretta, jointly and severally.” Peter credibly testified that
he viewed the term “restitution” to mean “paying back money that
was overpaid to me.”
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A potentially more important difference between Musgrave and
the Cavarettas’ case, however, is that the business taxpayer in
Musgrave was not filing a joint return with the misbehaving
employee. This strikes a nerve with the Commissioner, who
bristles at seeming to give Karen a tax benefit. And we agree
with him that Karen could probably not get carryback-generating
deductions if she were filing by herself. But the Supreme Court
has said, “The deductions to which either spouse would be
entitled would be taken, in the case of a joint return, from the
aggregate gross income.” Helvering v. Janney, 311 U.S. 189, 191
(1940). We have interpreted this to mean that one spouse may
take a deduction on the joint return even if the other spouse
would be prohibited from taking the same deduction. DeBoer v.
Commissioner, 16 T.C. 662 (1951) (loss on sale to wife’s grandson
deductible by husband, despite prohibition on recognition of
losses to family members, because husband not himself related to
grandson),6 affd. 194 F.2d 289 (2d Cir. 1952). So even though
Karen could not deduct the payments as business expenses on the
Cavarettas’ joint return, we hold that Peter is not similarly
barred. And the Cavarettas were right to combine their
deductions to calculate their NOL. Sec. 1.172-3(d), Income Tax
Regs. (“In the case of a husband and wife, the joint net
6
The statute covering joint returns at issue in these cases
has been repealed, and joint returns are now covered in section
6013(d)(3).
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operating loss for any taxable year for which a joint return is
filed is to be computed on the basis of the combined income and
deductions of both spouses”).
The Commissioner’s final salvo is that the Cavarettas would
somehow get a double deduction if we allowed a carryback. It is
true that the Cavarettas offset business expenses against illegal
income in those years, but sections 172 and 6411 governing NOL
carrybacks are unconcerned with the source of income in the year
of the carryback.
That leaves only the penalty that the Commissioner asserts
for the Cavarettas’ alleged negligence.7 While this obviously
disappears with the part of the deficiencies that we hold does
not exist, we do specifically find that, even if we’re wrong on
the substantive issue of characterizing the payments as
deductible business expenses, the facts of this case are so
unusual and their legal treatment so uncertain that we would not
find the Cavarettas to be negligent for taking the position they
did.
The Commissioner is, however, asserting the negligence
penalty against more than the payments we’ve just discussed. He
also rejected some Schedule C and E deductions for 2001 and 2002
7
We don’t need to analyze the Cavarettas’ other arguments
that these payments might be deductible under section 1341, the
claim-of-right deduction; or that any deduction not prohibited
under section 162(f) should be allowed under section 165(c)(1).
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unrelated to those payments, which also affect the amount of the
NOL available for a carryback. The Cavarettas don’t contest
these adjustments, worth $39,282. They also presented no
evidence or argument that these smaller disallowed deductions
shouldn’t be subjected to the accuracy-related penalty. We
therefore sustain the Commissioner’s determination of a penalty
on any deficiency owed due to their disallowance.8
Decision will be entered under
Rule 155.
8
We point out for the parties’ Rule 155 computations (and
so we don’t end up back here to redetermine interest in a section
7481 proceeding) that the Commissioner calculated interest on the
deficiencies starting when the original returns were due (e.g.,
in April 1997 for the 1996 return), rather than in the years the
returns claiming carrybacks were filed. Section 6601(d) says a
carryback will not affect the computation of interest for any
period before the net operating loss arises, and section
301.6601-1(e)(3), Proced. & Admin. Regs., provides when a
carryback gives rise to an overpayment, interest runs from the
last day of the year in which the loss arose. The parties may
wish to consider whether interest should be calculated from the
last day of each year in which Peter made a payment.