Vol. 75, No. 2, February 2002

To Catch a Thief:
Civil Strategies for Handling Embezzlement Cases

by Douglas H. Frazer

In the 1955 Hitchcock film To Catch a Thief, Cary Grant plays a reformed cat burglar living on the French Riviera who is trying to clear his name in connection with a recent crime spree. Grace Kelly plays a wealthy and spoiled American traveling the Riviera with her widowed mother. Kelly takes a liking to Grant. But then the mother's jewels are stolen. Guess who's fingered?

In the end, Grant and Kelly get together. They kiss as fireworks explode overhead.

Most lawyers would love to be involved in such a case. With such clients! Unfortunately, most theft cases, including embezzlement matters, are more prosaic.

Like the situation in which Barney Rubble found himself.

Rubble led a successful real estate management firm. He prided himself on hiring well-qualified individuals and delegating responsibility. This strategy liberated Rubble to pursue his passion - prehistoric automobile preservation. "My business runs on cruise control," Rubble would sometimes tell his accountant. "I can drive this business in my sleep."

"Better wake up," the accountant told him one day. "I have discovered that your executive assistant, Fred, has been stealing money for at least five years. He's been writing checks to a dummy vendor that he controls. You're short $250,000."

Rubble and the accountant visited the company lawyer, who listened carefully before laying out the options.

"I don't want Fred to go to jail," Rubble said, "for reasons both personal and practical. I feel bad for Wilma. But I want the money returned."

Embezzlement: The Common Crime

Business owners and tax professionals know that embezzlement in the business world is common. It has its own curious psychopathologies in that the embezzler often is a familiar and trusted employee.

Often, once discovered, the scheme turns out to be uncomplicated. A paper trail usually exists. Embezzlers confronted privately by the employer frequently admit to the act. Those charged criminally usually are convicted. Many confess.

The civil disposition of embezzlement cases, however, is fraught with complications. These matters raise issues different from those involving proof of the act.

Should the employer go to the authorities or work out a private settlement? Should the employer demand repayment? How should repayment be structured? Are there tax implications to the embezzlement loss or the loss repayment?

Then there is the embezzler's interest to consider. What should the embezzler do once exposed? If the employer will consider a private settlement, what should the embezzler propose? What are the tax implications to embezzlement? Are there ways to structure a settlement to minimize the tax effect? Is a settlement with the tax authorities possible if a large amount of tax is owed?

And let's not forget the embezzler's spouse. What should the spouse of the embezzler do? What are the tax implications for the spouse? Is divorce a good idea?

Although not many cases, statutes, or regulations can be found that provide specific guidance on the subject, strategies do exist for dealing with these issues. Here is a primer.

Strategies for the Employer

The employer first must decide whether to go to the authorities with evidence of the crime. The employer has the right, but not the duty, to do so.

This is an important choice. The employer should make this decision carefully with the help of a competent attorney and an accountant.

A few factors commonly influence the decision to not involve the authorities. First, the employer may have a personal relationship with the embezzler. The employer may not want the embezzler to be jailed or tagged with a criminal conviction. Second, the employer sometimes sees the matter as a one-time lapse in judgment and may not want to inflict additional pain on the embezzler or on his or her family. Third, the embezzler may be able to make restitution privately.

In deciding to involve the authorities, different issues factor in. One factor is the insurance policy. To the extent an employer has coverage against embezzlement, the policy may require, either as a general policy term or as a condition for advancing a claim, that the matter be reported to the authorities. A second factor is that the employer may want to see the embezzler punished, repayment matters notwithstanding. Third, the employer may view the criminal justice system as the best means to obtain repayment.1

An employer usually can obtain a restitution order in connection with the criminal disposition of an embezzlement case. Nonetheless, employers often conclude that the chances of being repaid are diminished if the embezzler is forced through the criminal justice system. Why? Because although getting the order may be easy, enforcing it is another story.

The embezzler may be in prison for a stretch - making gainful employment impossible (with the exception of Huber release in state matters). After prison the embezzler's employment prospects may be dim. The embezzler may not then have independent resources to make restitution payments. When the dust settles, the embezzler likely will face a big tax bill from both federal and state tax authorities - and the tax authorities may enjoy a priority lien on the embezzler's assets and income stream.

For these reasons, private settlement of embezzlement cases is common. The employer should secure three documents to memorialize the settlement terms.

The settlement agreement. Language in the settlement agreement should summarize the wrongful conduct, reflect the amount owed, and commit the embezzler to repayment terms. The amount owed can include investigation fees, attorney fees, and accounting fees. The agreement often contains a confidentiality clause that the parties commit to maintain, absent a breach of the agreement or legal compulsion to turn over information (for example, a court order, subpoena, or administrative summons). The settlement agreement also typically contains a release from liability in favor of the employer.

The employer must be careful when wording the agreement and obtaining the embezzler's acceptance of the terms to avoid any suggestion that it is engaging in conduct that resembles extortion. Extortion, in general terms, is the act of compelling or exacting something wrongfully through threat or intimidation. In this context the law could be read to prohibit the employer from coercing the terms of a civil settlement based on the threat of criminal prosecution. A rule of professional conduct, Wisconsin Supreme Court Rule 20:3.10, explicitly governs this situation. The rule states that "[a] lawyer shall not present, participate in presenting or threaten to present criminal charges solely to obtain an advantage in a civil matter."

The embezzler's independent statement. The second document is an independent statement that the embezzler executes that acknowledges and describes the embezzler's wrongful conduct.

The promissory note. The third document is a promissory note evidencing the terms of the debt and repayment. The note might be accompanied by a security agreement or mortgage if the embezzler is able to offer the collateral.

In the event of a breach of the agreement or a default, the employer would not have to disclose the settlement agreement (and its terms) to a third party. The employer can enforce the settlement agreement, or disclose the wrongful conduct, with documents consistent with but apart from the agreement itself.

If the matter is handled correctly, the employer is in the driver's seat. Most embezzlers want to avoid prosecution and therefore will agree to any reasonable private settlement terms.

Strategies for the Embezzler

The embezzler's overriding concern is avoiding criminal charges. Either federal or state authorities can bring such charges (or both - although it is uncommon for both federal and state authorities to prosecute the same transaction or occurrence). Sometimes the matter is unavoidable - the employer believes it should or must go to the authorities with evidence of the misconduct.² In other instances, however, a contrite embezzler can persuade the employer to handle the matter privately.

In the event of a private settlement, the embezzler should keep certain things in mind.

The first is employer over-aggressiveness. If the embezzler has facts to support the inference that the employer is engaging in extortion in connection with settlement terms, those facts can sometimes give the embezzler leverage in obtaining better terms.

Tax Implications. The second is the tax law. It's important because the tax implications of embezzlement often guide the strategies the parties consider.

As a general rule, gain from an illegal transaction, including embezzlement, is includable in gross income in the year it is received.³

Embezzlement income, like other income subject to tax, is required to be reported on a tax return. (This does not happen often.) Joint returns, of course, bring with them joint and several liabilities for the taxes owed. Therefore, in our example, if Wilma knows of or has reason to suspect the embezzlement, Wilma might be able to shield herself from tax liability arising from the income by filing a separate return.

This technique, however, may not work if Wilma participated in the wrongful act or materially benefited from it. Then the income might be construed as community income⁴ or the tax debt as a family purpose obligation under Wisconsin marital property law for which both spouses are liable⁵ - separate returns notwithstanding.

Likewise, Fred might be able to shield Wilma by insisting on filing a separate return. Most embezzlers, however, will not do this. Absent some special consideration, married couples filing joint returns usually pay less tax than those filing separate returns. Embezzlers typically do not share with their spouse the "special consideration" as to why a separate return might be a good idea.

If embezzlement proceeds are reported as income, embezzlement restitution payments, whether court ordered or privately arranged, are a deductible loss in the year paid⁶ but are treated as a miscellaneous itemized deduction subject to a 2 percent floor.⁷ This deduction cannot create a net operating loss (one that can be carried over to another year).⁸ Thus, to the extent that there is insufficient taxable income against which the deduction can be offset, the deduction is lost. To maximize the tax benefit of the deduction, the restitution payer will want to match the restitution payments in a tax year to taxable income.

Also, because the deduction is a miscellaneous itemized deduction subject to the 2 percent floor, the deduction is an item that might expose the taxpayer to the alternative minimum tax (AMT).⁹ Such a result could cost an embezzler more tax than the embezzler would have paid if he or she did not take the deduction at all. Thus, careful tax accounting projections are needed to determine the best tax outcome for matching income and restitution payments in a given tax year.

An employer may recognize a theft loss deduction for the full amount of the loss in the year the loss is discovered.¹⁰ If an employer takes such a deduction, however, the employer is required to report restitution payments as recovery income in the year received - at least up to the amount deducted in prior years.¹¹

As touched upon previously, it is to the embezzler's advantage to match restitution payments with taxable income from other sources (with an eye toward avoiding a diminished or negative tax outcome on account of the AMT) so that the embezzler can maximize the tax benefit arising from the repayment deduction. This strategy may involve an attempt to negotiate a repayment schedule with the employer that carries into future years. The advantage of being able to recognize the deduction in full likely would offset the disadvantage of having to pay a reasonable rate of interest (or other consideration) for the privilege of extending the repayment stream for several years.

The effort to fully recognize the deduction is important even in the context of court ordered restitution. A court typically will approve just about any repayment agreement worked out between the parties if the court views the terms as reasonable.

Voluntary Disclosure Programs. In virtually all cases the embezzler has not reported the embezzlement proceeds on his or her tax return. Therefore, in connection with both private and nonprivate resolutions of embezzlement matters, the embezzler needs tax counsel concerning how to deal with the issue. It is in the embezzler's interest not to be charged with tax crimes in addition to, or in the case of private settlements, in lieu of, embezzlement-related crimes.

The best opportunity is for the embezzler to take advantage of the voluntary disclosure programs offered by the Internal Revenue Service and the Wisconsin Department of Revenue. While these programs differ in specifics, the basic premise of each is that if, before being contacted by the agencies or being alerted to the likelihood or inevitability of an audit, a taxpayer comes forward voluntarily with information that would materially change and correct a filed return, the tax authorities will give weight to that fact in deciding whether to investigate or charge the taxpayer criminally.

The IRS voluntary disclosure program explicitly is not a guarantee of immunity from criminal prosecution and does not confer substantive or procedural rights. It is, rather, a means by which a taxpayer may win a no-prosecution recommendation.¹² In practice the IRS, at least in Wisconsin, most often elects not to criminally investigate - or recommend charges against - an embezzler for a tax offense if that person has come forward under the voluntary disclosure rules.¹³

The Wisconsin Department of Revenue (DOR) voluntary disclosure program, on the other hand, explicitly confers substantive benefits. The DOR states that provided the program conditions are met, "civil and criminal penalties will not be imposed on additional taxes or excessive credits voluntarily disclosed."¹⁴

These programs are sensible and forward thinking. Embezzlers should most often take this opportunity and, if they do, use a carefully crafted letter that serves as a program "enrollment."

The next step is preparing and submitting amended federal and state tax returns that reflect the previously unreported income. Rather than accept the amended returns as filed, the tax authorities frequently will elect to open an examination of the subject years based on the information on the returns.

Thought should be given to procedural order. After voluntary disclosure program "enrollment," it often is advantageous to deal with the tax authorities consecutively rather than concurrently. This strategy eliminates the possibility of simultaneous and inconsistent adjustments. In most cases, one tax authority will "piggy-back" off the audit results of the other.

Because the DOR and the IRS have different limitation periods, it is often best to deal with the DOR first. For persons who make incorrect returns with the intent to defeat or evade tax, the DOR may assess the additional income whenever discovered.¹⁵ The IRS, on the other hand, has a three-year statute of limitation¹⁶ (six years in the case of understatement of more than 25 percent of reported gross income and an open statute in the case of a fraudulent return - although the IRS does not always invoke the broader limitation periods even when it may have sufficient facts to do so). By the time a taxpayer is finished with the DOR, the IRS limitation period for one or more of the years at issue may have expired.

Keep in mind that the civil arms of the IRS and the DOR share information. This sharing usually occurs after the final disposition of a matter by one agency or the other. Therefore, it is unrealistic to expect that the IRS or DOR will miss the tax consequences of the embezzlement.

Very often the embezzler lacks the financial resources to pay the tax. The problem is compounded by the accrual of penalties and interest on top of the principal amount of tax owed. In this event, the attorney should evaluate the embezzler as a candidate for a settlement under the IRS Offer in Compromise program and the DOR Petition for Compromise program.

Although the programs work differently, both offer the opportunity for a reasonable and final settlement for less than the full amount of the liability. It can be a good deal for the embezzler and for the tax authorities. The embezzler can settle his or her accounts up front and without the hassle of enforced collection activity (for example, tax liens, wage levies, bank levies) or long-term payment arrangements. The tax authorities can secure money up-front and close the account.

If sufficient time has passed, bankruptcy might be another avenue for relief. Generally, an income tax liability is subject to discharge if the assessment occurs more than three years before the date the bankruptcy petition is filed.¹⁷ An exception to discharge, however, exists if the debtor made a fraudulent return or willfully attempted in any manner to evade or defeat such tax.¹⁸ It is likely, although not certain, that the tax authorities would object to the discharge under this exception.

Strategies for the Embezzler's Spouse

Like other spouses in her situation, Wilma was left holding the pebbles. She had signed joint returns for years in which embezzlement income was omitted. Thus, absent some kind of relief, Wilma was jointly and severally liable for the unpaid tax.

The most important principle for a spouse is that from the moment a spouse learns of the embezzlement activity, that spouse should not sign a joint return.

The spouse should consider petitioning for innocent spouse relief for the years of embezzlement activity for which joint returns were filed. Congress changed and somewhat liberalized the innocent spouse law in 1998 through the enactment of 26 U.S.C. section 6015. Although the new law is not as elastic as many taxpayer advocates had hoped, it does provide some chance that an innocent spouse in embezzlement matters can be relieved from the taxes arising from the omitted income.

Wisconsin law contains an innocent spouse provision that incorporates by reference the federal statute.19 If the IRS grants innocent spouse relief, the DOR usually will grant relief as well. The reverse may not always be the case. This is because IRS application of the innocent spouse statute is screened for consistency on a national level.

The spouse may also seek a divorce. While a spouse probably should not get a divorce solely for tax reasons, the sad fact is that embezzlement can cause such a rupture that the spouse elects to end the marriage. The property settlement agreement (incorporated into the divorce judgment) in connection with the divorce typically contains language requiring the embezzler to indemnify and hold harmless the spouse for any tax arising from the embezzlement activity that the spouse will have to pay. The problem is that the tax authorities are not parties to the proceeding and are not bound by the terms. The tax authorities can thus attempt to collect from the spouse. In our story, Wilma would then have to collect from Fred.

A partial solution exists. A well-crafted property settlement agreement might contain language consistent with Wis. Stat. section 71.10(6m)(b). This provision states that if a divorce judgment apportions Wisconsin state income tax liability to the former spouse of the taxpayer (Fred) and the taxpayer (Wilma) includes with her tax return a copy of the portion of the divorce judgment that relates to the apportionment of tax liability, then the DOR may not collect from Wilma the tax so apportioned.

In other words, if the divorce court allocates the Wisconsin income tax arising from the embezzlement to Fred, the DOR cannot collect it from Wilma.

By virtue of the supremacy clause of the U.S. Constitution, the IRS is not bound by Wisconsin statutes and is free to collect the federal tax liability from the spouse, Wis. Stat. section 71.10(6m)(b) notwithstanding.

Conclusion

A lawyer can play a constructive role as counselor to a Barney, Fred, or Wilma caught in the web of embezzlement exposed. The client will appreciate the effort - even if the matter doesn't end, à là Cary Grant and Grace Kelly, under fireworks on the French Riviera.

Endnotes

1 Court-ordered restitution, however, usually is limited to the repayment of the money taken. While permitted to do so, courts do not routinely order the repayment of attorney fees, accounting fees, investigation expenses, or consequential damages.

2 In this context, the timing of the return of the stolen funds can make a difference in sentencing. The federal sentencing guidelines provide for a credit to the extent that the embezzler returns the stolen funds before discovery by the employer or the government agency. United States Sentencing Commission, Guidelines Manual § 2B1.1(e), comment (Nov. 2001).

3 26 U.S.C. § 61(a); James v. United States, 366 U.S. 213, 218 (1961).

4 Wis. Stat. § 766.31(4).

5 See Wis. Stat. § 766.55(1).

6 26 U.S.C. § 165(c)(2).

7 26 U.S.C. § 67(b).

8 Olken v. Commissioner, 54 T.C.M. (CCH) 1172 (1987).

9 See 26 U.S.C. § 56(b)(1)(A)(i).

10 26 U.S.C. § 165(e).

11 26 U.S.C. § 111(a).

12 Internal Revenue Manual § [9.5] 3.3.1.2.1 (Apr. 9, 1999). IRS News Release IR-92-114 (Dec. 7, 1992) indicates that legal source income is a further eligibility requirement for the voluntary disclosure program. The news release, however, appears to address only nonfiler situations. Taken together, these IRS pronouncements reflect uncertainty on the issue whether legal source income is a condition of acceptance into the voluntary disclosure program.

13 A word of caution. If a lawyer believes that the IRS already may have initiated an inquiry likely to lead the criminal investigators to the taxpayer, before doing anything else the lawyer should try to confirm the activity. Most taxpayers who already are under criminal investigation will not wish to participate in the voluntary disclosure program. Such taxpayers probably will be better served by preserving their constitutional rights.

14 Wisconsin Tax Bulletin 101, April 1997, p. 25.

15 Wis. Stat. § 71.77(3).

16 26 U.S.C. § 6501.

17 11 U.S.C. § 507(a)(8).

18 11 U.S.C. § 523(a)(1)(C).

19 Wis. Stat. § 71.10(6)(a).

Wisconsin Lawyer