Tax Court Holds Form Over (Controlled) Substance

I am again both proud and honored to be co-author with Richard Wise on this article, which first appear in the St. Louis Bar Journal. Any errors are mine alone. Readers who want the full version, complete with footnotes, should check out the original published by the Bar Journal.

In 2017, Lonnie Wayne Hubbard, a pharmacist from Kentucky, was found guilty by a jury on multiple charges of distributing a controlled substance. The indictment included a forfeiture provision with respect to the pharmacist’s listed property, more specifically an Individual Retirement Account held at T. Rowe Price. Following the defendant’s jury trial, his IRA was condemned and forfeited to the United States.

T. Rowe Price issued Hubbard a Form 1099–R: Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc., for the 2017 tax year, reporting an early taxable distribution in the amount of $427,518.00. For 2017, Hubbard did not file an income tax return, thus failing to report the $427,518.00 IRA distribution which was forfeited.

The Internal Revenue Service via its Automated Substitute for Return Program, authorized by § 6020(b) of the Internal Revenue Code, prepared a substitute tax return on behalf of the taxpayer.

In 2020, the IRS sent a notice informing Hubbard of an income tax deficiency for the 2017 tax year of $165,353, an addition to tax of $37,204.00 for failure to file a timely tax return, an addition to tax of $28,937 for failure to timely pay, and an addition to tax of $3,959 under for failure to make estimated tax payments for 2017. In 2021, Hubbard timely filed a notice of petition with the Tax Court contesting the tax deficiency.

Hubbard’s argument was that since the funds were directly transferred to the government, he never constructively received the funds. Furthermore, he argued that he had reasonable cause for not filing his tax return, as he was incarcerated at the time the tax return was due. Lastly, he argued that his wife (now his ex-wife) never forwarded him the Form 1099-R received from T. Rowe Price.

Constructive Receipt

Section 61(a) of the Code provides that gross income includes “all income from whatever source derived.” This includes all accessions to wealth, clearly realized, and over which the taxpayer has complete dominion. Pensions and IRA distributions are generally taxable as income.

Gross income under § 61(a) includes items of income that the taxpayer has constructively received. Under the constructive receipt doctrine, funds or property which are subject to a taxpayer’s unfettered command and which they are free to enjoy at their option are constructively received whether they see fit to enjoy them or not.

Where a taxpayer’s funds are criminally forfeited to the United States to satisfy a forfeiture judgment, the taxpayer is not relieved of the income tax consequences that would have attached to the funds without such forfeiture. By forfeiting the funds, the taxpayer has realized the benefits of the funds, and must recognize the funds as gross income to the same extent as if they had been physically received.

The courts have held that a discharge by a third person of an obligation is equivalent to receipt by the person taxed.

In addition, the courts have previously held that IRA funds constitute gross income as an involuntary distribution when forfeited to a third party. A taxpayer constructively receives the IRA distribution when the distribution is made from the taxpayer’s IRA to satisfy a fine or restitution related to criminal conviction.

In the present case, there were undeniable accessions to wealth, clearly realized, and over which Hubbard had complete dominion. The mere fact that the payments were extracted as punishment for his unlawful conduct did not take away from their character as taxable income to him.

Excuses Not to File Petitioner’s Tax Return

Sections 6651(a)(1) and (2) of the Code provide that additions to tax may be reduced if petitioner can establish that his failure to timely file or failure to timely pay was due to reasonable cause and not willful neglect. Hubbard argued that he had reasonable cause not to file his tax return because he was incarcerated.

This argument failed, as the Tax Court held that Hubbard knew that he had a duty to file his tax returns. The Tax Court took judicial notice that Hubbard had filed his tax returns in previous years, and that he was aware of the criminal forfeiture. The Tax Court relied on Commissioner v. George, in which it was held that incarceration is not reasonable cause for the failure to file an income tax return.

Lastly, the court addressed Hubbard’s claim that he did not know that he had to file an income tax return because he did not receive the Form 1099-R from T. Rowe Price. Failure to receive tax documents does not excuse taxpayers from the duty to report income, and the courts have held that non-receipt of a tax document does not constitute reasonable cause to prevent the application of a § 6662(a) accuracy-related penalty.

Conclusion

In conclusion, Hubbard had no better luck in his proceedings in Tax Court than he did in his unlawful distribution of controlled substances.

This piece originally appeared in the St. Louis Bar Journal blog.