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Buff v. Commissioner of Internal Revenue

decided: April 5, 1974.


Appeal from a decision of the Tax Court, Quealy, Judge, holding that funds embezzled by appellee did not constitute income because appellee had executed a confession of judgment for practically all of the amount embezzled. Reversed.

Moore, Hays and Oakes, Circuit Judges. Oakes, Circuit Judge (concurring).

Author: Moore

Moore, Circuit Judge:

Between January 1 and June 7, 1965, appellee, who was employed as a bookkeeper, embezzled approximately $22,000 from his employer, S & D Meats, Inc. Appellee's crime was discovered by his employer in June, 1965. Appellee immediately confessed. Then, at his employer's insistence, appellee signed an affidavit of confession of judgment for the embezzled amount, plus interest, agreed to continue his employment, and to repay $25 per week from his paycheck. He also borrowed $1,000 from a bank, paying over the proceeds from the loan to his employer. However, in July, 1965, the employer became dissatisfied with this arrangement, discharged appellee, and filed the affidavit whereupon judgment was entered in his favor.

The Commissioner (appellant) determined that appellee, a cash-basis taxpayer, had received as income in 1965 the sum he had embezzled minus the sums he had returned in that year. While there was no doubt that embezzled funds constitute income, James v. United States, 366 U.S. 213, 6 L. Ed. 2d 246, 81 S. Ct. 1052 (1961), the taxpayer contended that since he had agreed to repay the entire amount embezzled, the transaction should be seen to be in the nature of a loan -- his debt exactly equalling his receipts. The Tax Court agreed with the taxpayer, relying in large part on the case of United States v. Merrill, 211 F.2d 297 (9th Cir. 1954). See also J. W. Gaddy, 38 T.C. 943 (1962), reversed in part on other grounds, 344 F.2d 460 (5th Cir. 1965). In the Merrill case, a cash-basis taxpayer received in 1940 from his wife's estate, for his services as executor, an overpayment of $7,500. That same year the error was discovered and "appropriate adjustments were made in his own books and those of his wife's estate. . . ." 211 F.2d at 303-304. Actual repayment of the sum, however, was not made until 1943. The Commissioner assessed income tax on the $7,500 under the claim of right doctrine. North American Oil Consol. v. Burnet, 286 U.S. 417, 76 L. Ed. 1197, 52 S. Ct. 613 (1932). This doctrine holds that monies received by a taxpayer under a "claim of right" are taxable to him as income in the period of receipt even though it is eventually discovered that he was not entitled to the funds and makes restitution in some later period. The court in Merrill held that there had been no taxable income in 1940:

We think there is no warrant for extending the harsh claim of right doctrine to such a situation. In such case [where the error is discovered in the same fiscal year] the Internal Revenue Bureau is not faced with the problem of deciding the merits of the claims to the funds received, for the question has been resolved by the interested parties. No question is here raised as to the bona fides of appellee's 1940 bookkeeping entries relative to the mistaken payments. Good faith is indicated by the fact that the taxpayer's $7,500 obligation to the estate was not only recognized by him in 1940 but was paid in cash in 1943.

211 F.2d, at 304.

The Tax Court in this case analogized the present situation of embezzlement and judgment with the Merrill case:

Where there is "consensual recognition" of indebtedness within the same taxable year, formalized by a confession of judgment, such a transaction does not result in the realization of taxable gain.


Seven judges of the Tax Court dissented from this decision in two opinions. These dissents and the brief of the Commissioner in this court raise three arguments for reversal.

The first broadly attacks the Merrill doctrine as the embodiment of an error in accounting. It is contended that it is improper to allow a cash-basis taxpayer to balance for tax purposes the receipt of income with a promise -- not given in connection with the receipt -- to repay in a later tax period. This argument would have us dispute the validity of such an exception to the claim of the right rule.

The second argues that the criminal nature of the initial receipt in this case should exclude it from the sweep of Merrill. It is claimed that the lack of consensual recognition of an obligation to repay at the time of receipt is the crucial element to consider for the purposes of James v. United States, supra, rather than the presence of that recognition at the end of the pertinent accounting period. James, which, as was stated above, held embezzled funds to be income, distinguished embezzlement from a loan arrangement by stating that, although the embezzler has an obligation in law to repay the misappropriated funds, he lacks the consensual recognition of this obligation. 366 U.S. at 219-20. James, however, is silent as to the precise moment a court should inquire as to the presence or absence of this recognition.

The third attack made on the decision below proposes that the confession of judgment should be viewed as a mere sham. As such it should not be of tax significance and should be given no ...

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