Cavaretta v. Comm'r

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
 - 2 -

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.
 - 3 -

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.”
 - 4 -

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...)
 - 5 -

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.
 - 6 -

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).
 - 7 -

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...)
 - 8 -

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.
 - 9 -

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
 - 10 -

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.
 - 11 -

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
 - 12 -

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
 - 13 -

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
 - 14 -

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.”
 - 15 -

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).
 - 16 -

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).
 - 17 -

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.