Hackworth v. Commissioner, IRS

UNPUBLISHED
UNITED STATES COURT OF APPEALS
FOR THE FOURTH CIRCUIT
No. 05-1001
EDMAN HACKWORTH; DEBBIE KAY HACKWORTH,
Petitioners - Appellants,
versus
COMMISSIONER OF INTERNAL REVENUE,
Respondent - Appellee.
Appeal from the United States Tax Court. (Tax Ct. No. 02-9786)
Argued: September 21, 2005 Decided: November 16, 2005
Before KING and GREGORY, Circuit Judges, and R. Bryan HARWELL,
United States District Judge for the District of South Carolina,
sitting by designation.
Affirmed by unpublished per curiam opinion.
ARGUED: William Henry Thomas, III, Greenville, South Carolina, for
Appellants. Randolph L. Hutter, UNITED STATES DEPARTMENT OF
JUSTICE, Tax Division, Washington, D.C., for Appellee. ON BRIEF:
Eileen J. O’Connor, Assistant Attorney General, Kenneth L. Greene,
UNITED STATES DEPARTMENT OF JUSTICE, Tax Division, Washington,
D.C., for Appellee.
Unpublished opinions are not binding precedent in this circuit.
See Local Rule 36(c).
PER CURIAM:
This case arises from the denial by the Commissioner of
Internal Revenue of a $152,016 claimed loss deduction under I.R.C.
§ 165 by Edman and Debbie Kay Hackworth (“taxpayers”) on their 1999
income tax return. On February 22, 2002, the Commissioner issued
a tax notice of deficiency to the taxpayers. The taxpayers timely
filed a petition in the United States Tax Court seeking a
redetermination of their liabilities. On July 22, 2004, the Tax
Court issued a memorandum opinion and on October 15, 2004, entered
a final decision determining tax liabilities and additions to tax
against the taxpayers for tax years 1998 and 1999. The taxpayers
filed a notice of appeal on December 21, 2004. We affirm.
I.
The Hackworths are citizens and residents of Greenville
County, South Carolina. Edman Hackworth owned and operated a bar
called the “Sand Trap” in Greenville, South Carolina. In 1997, the
Greenville County Sheriff’s Office began an investigation into
whether the Hackworths were conducting illegal gambling operations
in their house and at the Sand Trap. In 1999, the Sheriff’s Office
began surveillance of the taxpayers’ house and the Sand Trap.
After several months of surveillance, the Greenville County
Sheriff’s Office arrested both Edman and Debbie Kay Hackworth and
charged them with bookmaking and other gambling offenses. In a
2
search of the taxpayers’ residence, the Sheriff’s Office discovered
a betting room with seven telephone lines, tape-recording devices,
two computers, gambling paraphernalia, keys to a safety deposit
box, and $63,589 in cash, all of which were seized. At or about
the same time, the Sheriff’s Office executed a search warrant on
the Sand Trap and seized $10,786. On or about September 8, 1999,
the Sheriff’s Office executed a search warrant on the safety
deposit box, located at Carolina First Bank, and seized $90,900 in
cash. In total, the Sheriff’s Office seized more than $165,000 in
cash.
Following the arrest, the Sheriff’s Office returned some
$13,000 in currency, retaining $152,000 as well as computers and
office equipment. On that same date, Edman Hackworth signed a
“Consent Forfeiture of Monies Derived from Gambling” in which he
agreed “to voluntarily relinquish all rights and ownership” to the
remaining $152,016 in order “to avoid litigation.” That document
also states that he forfeits the money under “[Section] 16-19-80,
Code of Laws of South Carolina (1976), as amended.”
On or about November 22, 1999, Edman pleaded guilty to
“Adventuring in lotteries” in violation of South Carolina Code
Annotated § 16-19-20 (1976).1 He received a citation and paid a
1
Although there is no copy of a plea agreement in the record,
appellants’ counsel indicated to the Court that the Consent
Forfeiture was signed as part of a plea deal.
3
fine of $125. The charges against Debbie Kay Hackworth were
dismissed.
On October 20, 2000, taxpayers untimely filed their 1999
individual federal income tax return. On one of the three
Schedules C (Profit or Loss From Business) filed with the return,
they reported $178,236 in gross receipts from gambling activities,
which were referred to as “services” on the tax return. On that
same Schedule C, taxpayers claimed a deduction for “legal and
professional services” in the amount of $152,016 with respect to
the cash forfeited to the State of South Carolina.
In 2002, the Commissioner of Internal Revenue issued a notice
of deficiency to the taxpayers determining, among other things,
that taxpayers were not entitled to a deduction in 1999 for
$152,016 in cash forfeited to the State of South Carolina.
Taxpayers filed a petition in the Tax Court challenging the
Commissioner’s determinations. The taxpayers and the Commissioner
conceded to several issues so that the only issue remaining for
trial was whether taxpayers were entitled to a deduction for the
$152,016 that was forfeited to the State of South Carolina.
Taxpayers argued that they were entitled to deduct the amount
forfeited as a business-related loss under Internal Revenue Code §
165 because it was a loss associated with Edman’s gambling
enterprise. The Commissioner argued against the deduction on the
basis that allowing such a deduction would frustrate the public
4
policy of the State of South Carolina against illegal gambling.
The Tax Court upheld the Commissioner’s denial of the deduction and
this appeal followed.
II.
Whether taxpayers are entitled to a deduction for money
forfeited to the State of South Carolina is a question of law we
review de novo. See Metzger v. Comm’r, 38 F.3d 118, 120 (4th Cir.
1994).
The Hackworths argue that application of the “public policy”
doctrine in denying the deduction of funds seized by the Sheriff’s
Office was erroneous because a civil forfeiture never took place
and that the penalty imposed is illegal and by definition is not a
“fine,” “forfeiture,” or “similar penalty” paid “to the government”
such that the public policy doctrine should apply. Taxpayers also
challenge the Tax Court’s determination that, in this case, they
are attempting a “collateral attack” on the penalty imposed by the
Sheriff’s Office. Finally, taxpayers argue that under the facts of
this case, to disallow the deduction would run afoul of
Congressional intent that only net income be taxed.
Internal Revenue Code § 165(a) provides a deduction for “any
loss sustained during the taxable year and not compensated for by
insurance or otherwise.” Section 165(c) limits the losses
deductible by individuals to those losses incurred in a trade or
5
business, those incurred in a transaction entered into for profit,
and those caused by fire, storm, shipwreck, theft, or other
casualty. The United States Supreme Court has held that rent and
wages paid in the operation of bookmaking establishments are
deductible as ordinary and necessary business expenses within the
meaning of IRC § 23(a)(1)(A) in computing net income for tax
purposes, even though the gambling enterprises were illegal under
state law. See Comm’r v. Sullivan, 356 U.S. 27 (1958).2
A deduction for a state imposed fine or penalty will not be
allowed “if the allowance would frustrate sharply defined national
or state policies proscribing particular types of conduct,
evidenced by some governmental declaration thereof.” Tank Truck
Rentals, Inc. v. Comm’r, 356 U.S. 30, 33-34 (1958). The Supreme
Court has stated that “[d]eduction of fines and penalties uniformly
has been held to frustrate state policy in severe and direct
fashion by reducing the ‘sting’ of the penalty prescribed by the
state legislature.” Id. This “frustration of public policy”
doctrine has consistently been applied to preclude tax deductions
2
That Court stated:
The amounts paid as wages to employees and to the
landlord as rent are “ordinary and necessary expenses” in
the accepted meaning of the words. That is enough to
permit the deduction, unless it is clear that the
allowance is a device to avoid the consequence of
violations of a law . . . or otherwise contravenes the
federal policy expressed in a statute or regulation.
Sullivan, 356 U.S. at 28 (emphasis added).
6
for forfeitures of property to the Government. See e.g., United
States v. Algemene Kunstzijde, N.V., 226 F.2d 115 (4th Cir. 1955).
One reason for the disallowance is that “to allow a deduction . .
. [for a fine or penalty] would have directly and substantially
diluted the actual punishment imposed.” Comm’r v. Tellier, 383
U.S. 687, 694 (1966). See also Wood v. United States, 863 F.2d
417, 421 (5th Cir. 1989) (“It is obvious . . . that the public
policy embodied in this nation’s drug laws is not enhanced by
allowing a tax deduction to offset a forfeiture.”).
South Carolina law provides that “[a]ll and every sum or sums
of money staked, betted or pending on the event of any such game or
games as aforesaid are hereby declared to be forfeited.” S.C. Code
Ann. § 16-19-80 (1976). The statute permits the forfeiture of
property that is “‘an integral part of’ or ‘fruit of’ a gambling
operation.” South Carolina v. Petty, 241 S.E.2d 561, 562-563 (S.C.
1978). The Tax Court reasoned that, as a result of these statutes,
“South Carolina had a sharply defined policy against illegal
gambling in 1999 as expressed in its statutes and enforced by the
[Greenville County Sheriff’s Office].” (J.A. 190.) The forfeiture
was clearly a part of South Carolina’s enforcement of its public
policy against illegal gambling. Appellants do not contest that
the State of South Carolina has such a policy.
Appellants argue that the forfeiture was invalid and,
therefore, the deduction cannot be denied on the grounds of public
7
policy. The Tax Court observed that, by questioning the validity
of the forfeiture, the Hackworths were attempting to collaterally
attack the forfeiture, a matter which the Tax Court had no
jurisdiction to hear. Appellants argue that their deduction was
proper because no proper civil forfeiture took place under South
Carolina law. Rather, they argue that the alleged property has
been illegally retained by the Greenville County Sheriff’s Office
and that the illegal retention of the monies is not a government
sanctioned penalty under state law. However, Edman Hackworth
voluntarily signed a form entitled “Consent Forfeiture of Monies
Derived from Gambling” which stated that the $152,016 had been
seized as a result of Edman’s arrest for violation of the South
Carolina gambling statutes. (J.A. 279.) The Consent further
stated that the parties were entering into “a compromise settlement
to avoid litigation” and that the $152,016 seized was being
forfeited pursuant to South Carolina Code § 16-19-80.
Taxpayers argue that the consent form is “incomplete” and,
consequently, ineffective, because it is not signed in the space
provided for an assistant solicitor or a judge to sign. However,
they have not provided any legal authority to demonstrate that
Edman Hackworth’s signature, along with his conviction for
adventuring in lotteries, is insufficient to effect a consent to
forfeiture. Before the Tax Court, Lieutenant Robert L. Gillespie,
with the Greenville County Sheriff’s Office, testified that he
8
understood the consent to be effective upon conviction without a
judge’s signature. (J.A. 155.) While the taxpayers assert that
this is only Gillespie’s interpretation of the law, they point to
no legal authority that would render his understanding of the law
to be erroneous.
Appellants argue that no forfeiture took place because no in
rem action took place. See Ducworth v. Neely, 459 S.E.2d 896, 899
(S.C. Ct. App. 1995) (an action for forfeiture is an action in rem
against the property itself ). Relying on Petty, 241 S.E.2d 561,
they assert that an in rem action was necessary to determine, among
other things, whether Edman’s consent was knowledgeable. However,
that case does not discuss a situation where, as here, there was a
consent forfeiture.3 Importantly, in the instant case, the Consent
provides that it is a “compromise settlement” entered into for the
express purpose of “avoid[ing] litigation.”
Appellants also rely on the case of Moore v. Timmerman, 276
S.E.2d 290 (S.C. 1981), which they characterize as a case that
requires a forfeiture hearing to be held even where the statute in
3
In that case, pursuant to a search warrant, SLED agents found
and seized cash and checks totally $23,549.58, in the same room
where gambling paraphernalia was discovered. Petty pled guilty to
South Carolina Code § 52-15-10 and the State subsequently
petitioned to have the seized monies and checks forfeited to the
state pursuant to South Carolina Code § 16-19-80. Petty appealed
the forfeiture on the grounds that the evidence was insufficient to
support a finding that the monies and checks found were “staked,
betted or pending” within in the meaning of § 16-19-80 in that
there was no direct showing that the money was involved in
gambling. Petty, 241 S.E.2d at 562.
9
question provides for an automatic forfeiture.4 In that case, the
South Carolina Supreme Court determined that the criminal defendant
was charged with hunting deer at night and the criminal trial
provided the due process necessary to support the statutory
forfeiture of the guns in his possession at the time of his arrest.
Id. at 292. The South Carolina Supreme Court held that the only
hearing required, when there is an automatic forfeiture, is one to
allow an innocent third party claiming an interest in one of the
forfeited guns to be heard. Id. at 292-293. In the instant case,
there is no third party claiming an interest in the monies
forfeited and, consequently, Moore is inapplicable. The taxpayers
have presented this Court with no legal authority to support their
argument that a consent to forfeiture does not permit the State to
forego an in rem proceeding when that consent specifically states
that it is signed to “avoid litigation.”
Appellants also argue that, shortly before the trial before
the Tax Court, Edman “revoked” his consent to the forfeiture.
Appellants have failed to address whether the attempt to revoke his
consent, long after the forfeiture had been completed, could have
any legal effect. Regardless, the Tax Court found the argument
4
Appellants concede that there are South Carolina decisions
that have found an automatic forfeiture upon conviction of a crime
or from the possession of contraband, but assert that those cases
were not pursuant to the gambling statute used in the instant case.
See Ducworth, 459 S.E.2d 896; South Carolina v. Coin-Op. Video Game
Mach., 525 S.E.2d 872 (S.C. 2000).
10
that Edman revoked his consent to forfeiture to be “uncorroborated
and unpersuasive.” This Court defers to a trier of fact on a
question of credibility. McCrary v. Runyon, 515 F.2d 1082, 1086
(4th Cir. 1975); see also Anderson v. City of Bessemer City, N.C.,
470 U.S. 564, 575 (1985).
Appellee asserts, and the Tax Court agreed, that appellants
are attempting to collaterally attack the forfeiture of the
gambling funds. Appellants contend that they are not attacking
whether the funds should be retained by the Greenville County
Sheriff’s Office, an issue they concede is not within the Tax
Court’s jurisdiction. Rather, appellants assert that the issue is
whether a deduction should be allowed as a business loss. Appellee
asserts that whether or not the forfeiture was valid under South
Carolina law is an issue between the taxpayers and the Greenville
County Sheriff’s Office. This Court agrees. If the taxpayers
believe that the forfeiture was invalid, the proper remedy is for
them to sue the Greenville County Sheriff’s Office and seek return
of the funds. Appellants’ counsel indicated at oral argument that
the taxpayers were, in fact, now trying to challenge the forfeiture
in the South Carolina state courts, but that such challenge may
prove to be untimely. Regardless of whether that action is timely,
the Tax Court has no jurisdiction to determine whether a forfeiture
was valid or invalid and until it is determined to be invalid the
retention of the $152,016 by the Greenville County Sheriff’s Office
11
is a “forfeiture” paid “to the government” rather than a “business
loss” (as appellants now argue) or payment for “legal and
professional services” (as they claimed on their Schedule C).
Appellants argue that the result in this case violates the
“principle” that only net income should be subjected to tax. A
taxpayer generally is not taxed on the gross income of his
business, but rather is allowed to deduct the ordinary and
necessary business expenses that are incurred. See I.R.C. § 162.5
Appellants argue that they should be able to deduct the monies
retained by the Greenville County Sheriff’s Office for “reasons
analogous to a theft or casualty loss.” The appellants point out
that the United States Supreme Court has allowed a gambler to
deduct business expenses or losses. See Sullivan, 356 U.S. 27.
While the Court in Sullivan specifically acknowledged that a
deduction for “ordinary and necessary expenses” will ordinarily be
permitted, such a deduction will not be permitted if “the allowance
is a device to avoid the consequence of violations of a law.” Id.
at 28. The taxpayers in Sullivan were seeking a deduction for
wages and rent, not for the forfeiture of funds as in the instant
case. Such a deduction would run contrary to the public policy and
laws of the State of South Carolina.
5
As discussed above, appellants are seeking a deduction under
§ 165 rather than § 162.
12
We are of opinion the Tax Court correctly decided, as a matter
of public policy, that the Hackworths are not entitled to a
deduction for the $152,016 forfeited to the Greenville County
Sheriff’s Office. The judgment of the Tax Court is accordingly
AFFIRMED.
13