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5/19/2016 @ 11:31PM

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Golfer Phil Mickelson To Repay $1 Million In

Gains From Insider Trading- Is It Tax
Deductible?
Golfer Phil Mickelson who once landed in this space by
famously threatening to retire rather than subject his $55
million in annual earnings to rising federal and state tax rates
found himself in the news today, and not in the sports section.
Mickelson was named in a federal insider trading lawsuit by the
Securities and Exchange Commission, in which it is alleged that
the five-time major winner made nearly $1 millionfrom stock
trades in 2012 by using information that was not publicly
available.

PONTEVEDRABEACH,FLMAY13:PhilMickelsonoftheUnitedStatesplayshisshotfrom
thesecondteeduringthesecondroundofTHEPLAYERSChampionshipattheStadiumcourse
atTPCSawgrassonMay13,2016inPonteVedraBeach,Florida.(PhotobySam
Greenwood/GettyImages)

Specifically, Mickelson is named as a relief defendant in the

suit,meaning he has not been accused of any criminal
wrongdoing (a fact that will become very important later). It is
alleged that Mickelson was fed insider information by Billy
Walters, a well-known sports gambler to whom Mickelson owed
a tidy sum of money. Walter,in turn, had received his

informationregarding Dean Foods the owner of Olive Garden

and other chain restaurants directly from Thomas Davis, the
former head ofthe company. BothWalters and Davis arenamed
in the suit.
Mickelson was allegedly encouraged by Walters to use that
information to purchase Dean Foods stock, which the golfer did
in July 2012 to the tune of $2.4 million worth of shares, an
investment that dwarfed the others in Mickelsonstrading
portfolio.When the stock jumped by 40% the next dayafter the
announcement of a successful spin-off of a Dean Foods
subsidiary an announcement the SEC allegesthat Mickelson
had improper advance knowledgeabout via Walters
Mickelson promptly sold the stock, recognizing$932,000 of
gain,with themajority of the profits used to repaygambling
debts owed to Walters.
10 Notorious Tax Cheats
Mickelson has released a statement thathe will repaythe
federal government his $932,000 of ill-gotten gains. This, of
course, raises an interesting tax question: when Mickelson
earned the nearly $1 millionof capital gain in 2012, he paid tax
on the gain at short-term capital gain rates which at the time
topped out at 35% meaning he shelled out $350,000 to the
IRS with his 2012 tax return. Now that he is repaying the $1
millionof gain, shouldnt he be permitted to recover the
$350,000 in tax that he paid?
The answer, as is typically the case in the tax law, is itdepends.
The first hurdle Mickelson faces is found in Section 162(f),
whichbars a deduction for any fine or similar penalty paid to a
government for the violation of any law. Isnt Mickelsons
repayment of his profits derived from alleged insider trading
akin to a fine or penalty paid to the SEC?
Probably not, for a couple of reasons. First, it appears at this
time that the repayment is voluntary rather than forced, thus it
could hardly be coined a penalty. But even if the return of
profits wasrequired by the SEC, the amount would not be
treated as a nondeductible penalty under the precedent
established in Nacchio,a fascinating case with similar facts to
those facing Mickelson.
Nacchiov.U.S.,113AFTR2d20141288(2014).
Joseph Nacchio is the former chairman and CEO of Qwest
Communications who leveraged insider information to sell
Qwest stock for$44 millionin capital gainsin 2001.A more
honest tax filer than businessman, Nacchioproperly reported
his illegal gains on his 2001 tax return and paid the resulting
$18 million tax liability to the IRS.
Nacchio was later tried for his crimes. Throughout the trial,
Nacchio exercised his Fifth Amendment right against selfincrimination and refused to testify. Nacchio was eventually
convicted on criminal charges and sentenced to 70 months in
rich-white-guy-prison. As part of his penance, he was forced to
repay the $44 million in gains in 2007,with the government
tacking on a $19 million penalty for good measure.

Nacchio then attempted to deduct the repayment of the $44

million repayment. The IRS denied the claim, first arguing that
it represented a nondeductible fine or penalty under Section
162(f). The Court of Federal Claims sided with Nacchio,
however, differentiating between the $44 million of profits
Nacchio repaid which was a disgorgement of previously
earned profits from the $19 million fine levied by the SEC,
which was punitive in nature, stating, Unlike the fine, which
was clearly punitive and was paid from assets unrelated to
insider trading, the forfeiture exclusively represented the
disgorgement of Mr. Nacchios illicit net gain from insider
trading.
As a result, Nacchio was not barred from deducting the payment
by Section 162(f), andwas permitted to deduct the payment as a
loss under Section 165. Under similar reasoning, so should
Mickelson.
But theres a catch. Because the original income was capital gain
albeit short-term capital gain subject to ordinary rates the
repayment must be deducted as a capital loss. And depending
on his specific facts, taking a $1 millioncapital loss in 2016 may
not do Mickelson a whole heck of a lot of good. After all, under
Section 1212, an individual may only deduct capital losses to the
extent of capital gains for the year; any excess losses are only
allowable to the extent of $3,000, the rest must be carried
forward. Thus, unless Mickelson has $1 millionof capital gain
lying around and waiting to be harvested, he may not derive a
tremendous benefit from deducting the repayment in 2016.
It would behoove Mickelson to, instead, simply remove the gain
from income when it was recognized back in 2012, as if it never
happened. But he cant do that, because the gain didhappen in
2012, and it wasnt repaid until 2016. And one of the
fundamental principles of the tax law is that each year stands on
his own. So what is Mickelson to do?
Fortunately for Phil, there is a little known provision of the tax
Code Section 1341 that may be of tremendous benefit in his
current situation. Should Mickelson qualify to avail himself of
Section 1341, it will effectively allow him to in 2016 pretend
as if he had never included his ill-gotten gains in income back in
2012, thus allowing him to fully recover the taxes he paid on the
income.
Section1341,InGeneral
Section 1341 provides that if the facts are right, a taxpayersuch
asMickelson who is required to repay amounts previously
included in income can compute their tax consequences on a
best case scenario basis. The statute permits the taxpayer to
either:
1. Deduct the payment in the year of repayment
(2016 in our scenario), or
2. Compute the hypothetical reduction in tax that
would have resulted from excluding the repaid
income in the year it was originally received
2012 before applying that reduction to decrease
the current years tax bill (without deducting the
repayment in the current year).

To illustrate,when Mickelson repays the $1 millionto the SEC

in 2016, he could opt to simply deduct therepayment as a
capital loss on his tax return, but as stated above, unless he has
enough capital gains to shelter the loss, he will not receive a full
tax benefit from the repayment.
IfMickelson qualifies to use Section 1341 a big if, as well
soon see he canopt instead to go back to the year he
recognized theincome (2012)and perform a hypothetical
computation (he does not actually amend the previous years
returns,which may beclosed by statute, anyway) in which he
redetermines the tax liability for2012 by excluding the $1
millionof income that has subsequently been repaid. If the
result of this computation is a total decrease in previous years
tax of $350,000 ($1 million repayment * 35% maximum federal
tax rate for the year at issue),Mickelson is permitted to treat the
$350,000 reduction in previous years tax as an estimated
payment on his 2016 tax return, generating a $350,000 federal
refund in the process.
While that sounds like a perfect ending to a bad situation,
unfortunately for Mickelson, Section 1341 is rife with
requirements that must be met before a taxpayer can take
advantage of the retroactive reach of the provision. Lets take a
look
RequirementsofSection1341 In order to avail himself of
Section 1341,Mickelson must satisfyfour tests.
First,thededuction must be allowable under another provision
of theCode. Section 1341 does not grantadeduction; rather, it
simply allows for an alternative tax benefit analysis in certain
situations providedthedeductionisotherwiseallowable. As
discussed above, in Mickelsons case, because the payments
relate to previous capital gains, and because Section 162(f) does
not bar a deduction for his repayment of those gains, he is
permitted a deduction under Section 165.
As asecond requirement, the deduction must exceed $3,000.
Thats not going to be a problem.
Next, and this is where things begin getting tricky,the income
must have been originally included in Mickelsons income
becausehebelievedhehadanunrestrictedrighttotheincome.
This requirement poses a major hurdle because it requires us to
look at Mickelsons mindset at the time he initiallygenerated
the capital gains based on information that he shouldnt have
been privy to.Did he genuinely believe that he had done nothing
wrong and deserved the income? Or did he know that the
income was ill-gotten, and that he was at risk of getting caught
by the SEC?
Fortunately for Mickelson, Nacchio once again provides the
precedent he needs. In that case, once the court decided
thatthe repayment of $44 million in capital gains proceeds was
not disallowed as a deduction by Section 162(f), the IRS moved
on to the argument that Nacchio could not avail himself of
Section 1341, because he could not have believed he had an

unrestricted right to the $44 million in gains when he initially

earned them, as he was fully aware that his insider trading was
illegal.
The court, however, noted one very important fact. While
Nacchio was convicted for his crimes, heneveractuallypled
guilty.As the court put it:
AlthoughthejuryinthecriminaltrialbelievedMr.Nacchio
wasguiltyofwillfullyengagingininsidertraining,thisdoes
notequatetoafindingofwhatMr.Nacchiohimselfbelieved.
Mr.Nacchioprofessedhisinnocence,andnothinginthis
Courtsrecordfromthecriminalproceedingshedsanylighton
thebonafidesofMr.Nacchiosbelief.
So insummary, Nacchio was convicted of insider trading and
servedjailtime,but because he never admitted his guilt, was
permitted by the court to make the argument that at the time he
generated the ill-gotten gains, he genuinely believed he had an
unrestricted right to the income. This precedent would make
any argument set forth by Mickelson who has not been
charged with a crime and not admitted any guilt that he too
believed he had an unrestricted right to his insider trading
proceeds in 2012 a fairly easy victory.
Compare the facts in Nacchioand Mickelson with those facing
another famous athlete, disgraced cyclist Lance Armstrong. In
2015, Armstrong, who had previously been stripped of all seven
Tour de France titles and banned from cycling for his role in the
most sophisticated doping program in sports history, was
required by a court to repay $10,000,000 in prior bonus
winnings. Unlike Nacchio and Mickelson, Armstrong will likely
notbe able to use the provisions of Section 1341 to recompute
his tax liabilty for the years he included the $10,000,000 in
income, because unlike those two gentlemen, Armstrong felt
compelled to sit down with Oprah Winfrey and confess his guilt.
As a result, he can no longer make the argument that when he
received the bonus winnings, he believed he had an unrestricted
right to the income, because he knew they had been earned with
the benefit of cheating and would be lost should he get caught.
So is Mickelson in the clear? Can he go back to 2012 and reduce
his capital gains by $1,000,000, generating a $350,000 refund,
which he will promptly lay on the Cavs to win the NBA finals at
7-5?
Well, there is one more hurdle found in Section 1341, and while
this requirement didnt pose a problem to Nacchio or
Armstrong, it could prove fatal to Mickelson.
In order to use Section 1341, the repayment of the prior income
must be involuntary.The taxpayer must be required, as a result
of a discovery madeafter the payment was originally included in
income, to have not had a rightto the incomewhen received.
At first blush, this sounds like bad news for Mickelson, because
the statement issued by the golfers attorneycertainly sounds as
ifMickelson has simply made the decision to repay the amounts
to the SEC of his ownvolition, and has not been required to do
so. The statement explained, Phil has no desire to benefit from
any transactions that the SEC sees as questionableunless, of
course, it enableshim to pay off his bookie. OK, I added that

last part.
It would appear, however, that once again, Mickelson has eerily
identicalprecedent on his side, and that the courts afford a
great deal of flexibility to therequirement that the repayment
beinvoluntary.
InBarrettv.Commissioner,the taxpayer was a shareholder in a
stock brokerage firm who used insider trading to generate
$187,000 of capital gain.Barrett was soon contacted by the
SEC, with the agency threatening to remove his brokerage
license and to refer his case to the Department of Justice for
criminal prosecution if he didnt cooperate. After Barrett
testified, both the SEC and the United States Attorney declined
to prosecute him for insider trading or anything else.
Barrett was not in the clear, however; two groups of option
brokers filed civil lawsuits against him and several other
brokers, seeking $10,000,000 in damages. Hoping to avoid a
jury trial, Barrett settled with the suing group by repaying
$54,000 of the profits he had received as a result of insider
trading.
Barrett sought to use Section 1341 to his advantage by removing
the $54,000 from income in the year he originally recognized
the gains, but the IRS denied the claim, arguing that Barretts
repayment was not involuntary,because he had not been
required by anyone to repay the amounts. Instead, because he
settledhis suit, rather than made payment pursuant to a
judgment, the payments were purely voluntary.
The Tax Court disagreed, however, finding the argument made
by the IRS that the payment was voluntary ludicrous. The
court noted that the SEC had initiated proceedings in which it
presumably sought to compel a restoration of the ill-gotten
gains. In addition, Barrett had been sued for $10,000,000 by
other brokers, and had settled based on the advice of his
attorney because the prospects for victory in a jury trial were
grim. All of these facts indicated to the court that the settlement
was made in good faith, at arms length, and had the same
effectas a payment made pursuant to a legal judgment.
As a result, it appearsMickelson will satisfy all four
requirements of Section 1341, and will be permitted to
recompute his 2012 tax by omitting the $932,000 of income
previously recognized and taking the reductionin tax as a
refund on his 2016 tax return. This would guarantee a full tax
benefit for the repayment, even in the absence of any offsetting
capital gains in 2016.
Because two of the four requirements appear to carry some
element of risk, however, Mickelson would be wise to engage the
services of a strong tax advisor in order to fully support his
position for using Section 1341. Fortunately for Mickelson, one
of his sponsors is KPMG, the Big Four accounting firm, so
finding some tax talent shouldnt prove problematic. If it is,
however, Phil knows where to find me.
follow along on twitter @nittiaj
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