Howard v. Commissioner, T.C. Memo. 1997-473 (1997)
Background. Sometimes a person who embezzles funds will issue a promissory note in an attempt to "excuse" the misdeed. After all, since a promissory note represents a legal obligation to repay the funds, how can embezzlement have occurred? The United States Tax Court addressed this question in a recent ruling.
Facts. An attorney befriended a woman and her three daughters who lived in his neighborhood. The girls called the attorney "Uncle Bill." The attorney drafted the mother's will, which left her estate to her daughters and named the attorney as executor of the estate. A few years later, the mother died in a house fire, leaving an estate valued at $518,000. The attorney was appointed executor and opened a "trust account" at a local bank. He deposited into this account the proceeds of the sale of estate assets. He was the sole authorized signatory on this account. The attorney told the daughters that the estate would be processed in about six months to a year, but that in the meantime they could get cash advances as necessary for important expenses. During the next year, the daughters occasionally requested and received cash advances from the attorney. But about a year after the mother's death, the attorney informed the daughters that the probate judge had "frozen" the assets of the estate, and that they could not get any more money until the estate was settled.
In fact, the attorney was writing large checks from the trust account for his personal benefit, spending the bulk of the daughters' inheritance. Among other things, he used $132,000 to pay down the mortgage loan on his personal residence, $47,000 to pay his personal tax obligations, and $25,000 to settle a lawsuit. He also withdrew funds for the construction of a boathouse and jacuzzi, and for the payment of the salaries for himself and his secretaries. All these expenditures were made without the knowledge or consent of the daughters.
The attorney did execute 28 unsecured promissory notes in which he agreed to pay back to the trust account all of the funds he had withdrawn for his personal purposes, at a rate of 10 percent, when the estate was closed. The daughters were unaware of these notes.
The attorney's scheme was finally uncovered, and he was convicted of grand theft and sentenced to prison. He was also ordered to pay restitution to the daughters in the amount of $516,000 with interest. The attorney was able to pay back only $230 per month in restitution—which was not enough to pay back any of the principal. The attorney also was sued in a civil lawsuit and was ordered to pay the daughters far more than he had embezzled. He was later disbarred.
The IRS became interested in the case and claimed that the attorney owed a substantial amount of back taxes plus penalties as a result of his failure to report the embezzled funds as taxable income. The attorney appealed to the Tax Court, insisting that his issuance of the promissory notes proved that he had received nontaxable loans rather than taxable income.
The court's ruling. The Tax Court ruled that the attorney had embezzled the funds and was liable for back taxes on the unreported income. The Court began its opinion by noting that "it is well established that [taxable income] includes income earned from illegal activity, such as the proceeds of embezzlement." The Court noted that whether the withdrawals were loans "depends ultimately on whether the beneficiaries of the estate were aware of and consented to the distributions at the times they were made," since in order for a distribution of estate funds to be a loan there must be evidence of the beneficiaries' consent. In other words, for the withdrawals to be treated as nontaxable loans, the attorney had to prove "that the beneficiaries of the estate not only were aware of his withdrawals of estate funds, but also consented to them." Since the daughters were unaware of these transactions, the withdrawals could not be treated as loans and had to be regarded as taxable income.
The Court concluded: "[The attorney's] engaging in the solitary activity of writing up promissory notes did not create loans between him and the estate. The promissory notes evidence no more than an intention to repay the amounts [he] withdrew from the estate. Such an intention, even if there was one, cannot transform misappropriations into loans."
What this means for churches
The following two lessons should be understood by any church employee or volunteer who handles church funds:
1. Intent to repay is no defense. Liability for embezzling church funds cannot be avoided by a well-intentioned desire to pay back the funds in the future—even if that intention was reflected in a promissory note that was never disclosed to church leaders. Sometimes church workers having access to church funds are tempted to "temporarily" borrow some of those funds. Because of their conviction that they will return every penny to the church, they often do not view their behavior as improper. Some go so far as to secretly sign a promissory note agreeing to pay back all that they have "borrowed." Good intentions, even if backed up with an undisclosed promissory note, are no defense to embezzlement.
2. Criminal, civil, and tax liability. This case illustrates the three different kinds of liability faced by embezzlers. First, they face criminal liability, which may include prison sentences and court-ordered restitution. Second, they face the threat of a civil lawsuit seeking monetary damages. The damages awarded to the daughters in this case were far more than the amount actually embezzled. Third, they face tax liability, since the IRS will claim that the embezzled funds represent taxable income that was not reported on a tax return.