Appeal from a judgment of the tax court that the taxpayer realized taxable income when he made unauthorized withdrawals of corporate funds. Reversed.
Lumbard and Feinberg, Circuit Judges, and Albert W. Coffrin, District Judge.*fn*
The taxpayer Edward M. Gilbert appeals from a determination by the tax court that he realized taxable income on certain unauthorized withdrawals of corporate funds made by him in 1962. We reverse.
Until June 12, 1962, Gilbert was president, principal stockholder, and a director of the E. L. Bruce Company, Inc., a New York corporation which was engaged in the lumber supply business. In 1961 and early 1962 Gilbert acquired on margin substantial personal and beneficial ownership of stock in another lumber supply company, the Celotex Corporation, intending ultimately to bring about a merger of Celotex into Bruce. To this end, he persuaded associates of his to purchase Celotex stock, guaranteeing them against loss, and also induced Bruce itself to purchase a substantial number of Celotex shares. In addition, on March 5, 1962, Gilbert granted Bruce an option to purchase his Celotex shares from him at cost. By the end of May 1962, 56% of Celotex was thus controlled by Gilbert and Bruce, and negotiations for the merger were proceeding; agreement had been reached that three of the directors of Bruce would be placed on the board of Celotex. It is undisputed that this merger would have been in Bruce's interest.*fn1
The stock market declined on May 28, 1962, however, and Gilbert was called upon to furnish additional margin for the Celotex shares purchased by him and his associates. Lacking sufficient cash of his own to meet this margin call, Gilbert instructed the secretary of Bruce to use corporate funds to supply the necessary margin. Between May 28 and June 6 a series of checks totalling $1,958,000 were withdrawn from Bruce's accounts and used to meet the margin call. $5,000 was repayed to Bruce on June 5. According to his testimony in the tax court, Gilbert from the outset intended to repay all the money and at all times thought he was acting in the corporation's best interests as well as his own.*fn2 He promptly informed several other Bruce officers and directors of the withdrawals; however, some were not notified until June 11 or 12.
On about June 1, Gilbert returned to New York from Nevada, where he had been attending to a personal matter. Shortly thereafter he consulted with Shearman, Sterling & Wright, who were outside counsel to Bruce at the time, regarding the withdrawals. They, he, and another Bruce director initiated negotiations to sell many of the Celotex shares to Ruberoid Company as a way of recouping most of Bruce's outlay.
On June 8, Gilbert went to the law offices of Shearman, Sterling & Wright and executed interest-bearing promissory notes to Bruce for $1,953,000 secured by an assignment of most of his property.*fn3 The notes were callable by Bruce on demand, with presentment and notice of demand waived by Gilbert. The tax court found that up through June 12 the net value of the assets assigned for security by Gilbert substantially exceeded the amount owed.*fn4
After Gilbert informed other members of the Bruce board of directors of his actions, a meeting of the board was scheduled for the morning of June 12. At the meeting the board accepted the note and assignment but refused to ratify Gilbert's unauthorized withdrawals. During the meeting, word came that the board of directors of the Ruberiod Company had rejected the price offered for sale of the Celotex stock. Thereupon, the Bruce board demanded and received Gilbert's resignation and decided to issue a public announcement the next day regarding his unauthorized withdrawals. All further attempts on June 12 to arrange a sale of the Celotex stock fell through and in the evening Gilbert flew to Brazil, where he stayed for several months. On June 13 the market price of Bruce and Celotex stock plummeted, and trading in those shares was suspended by the Securities and Exchanges Commission.
On June 22 the Internal Revenue Service filed tax liens against Gilbert based on a jeopardy assessment for $3,340,000, of which $1,620,000 was for 1958-1960 and $1,720,000 was for 1962.*fn5 Bruce, having failed to file the assignment from Gilbert because of the real estate filing fee involved,*fn6 now found itself subordinate in priority to the IRS and, impeded by the tax lien, has never since been able to recover much of its $1,953,000 from the assigned assets.*fn7 For the fiscal year ending June 30, 1962, Bruce claimed a loss deduction on the $1,953,000 withdrawn by Gilbert. Several years later Gilbert pled guilty to federal and state charges of having unlawfully withdrawn the funds from Bruce.
On these facts, the tax court determined that Gilbert realized income when he made the unauthorized withdrawals of funds from Bruce, and that his efforts at restitution did not entitle him to any offset against this income.
The starting point for analysis of this case is James v. United States, 366 U.S. 213, 6 L. Ed. 2d 246, 81 S. Ct. 1052 (1961), which established that embezzled funds can constitute taxable income to the embezzler.
When a taxpayer acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition, "he has received income which he is required to return, even though it may still be claimed that he is not entitled to the ...