Lucky Break for Sheriff Unauthorized Loan vs. Embezzled Funds

A recent Tax Court opinion sheds light on how unauthorized withdrawals from a jail food account were treated for federal tax purposes.[1] An Alabama sheriff found some unexpected relief when her unauthorized withdrawals, totaling $155,000 from a jail food money account were treated as impermissible, albeit genuine loans, and not embezzled income, subject to taxation.

Background

In Alabama, sheriffs are statutorily mandated to ensure that inmates in county jails receive proper meals.[2] Years before the sheriff (Petitioner) took office, a federal lawsuit led to a detailed consent decree mandating that county inmates receive a nutritionally adequate diet.[3] The sheriff’s immediate predecessor violated the decree by serving substandard meals while personally profiting from the jail food allowance. In response, the court modified the decree such that the then-acting sheriff was prohibited from using funds for anything except inmate meals.[4] Specifically, Paragraph 22 of the Consent Decree in that case required that “County Defendants shall provide a nutritionally adequate diet to inmates.”[5] This Paragraph 22 was ultimately modified following an investigation that found that inmates were being fed things such as corn dogs as a “diet staple” at each meal while the sheriff reaped the benefits in keeping funds from the food allowances. Following an amendment to Paragraph 22 of the Consent Decree, shortfalls were no longer the sheriff’s personal responsibility, as was the case in the past, but noncompliance exposed the sheriff to potential contempt sanctions.[6]

The jail food money account was funded by governmental contributions based on the type and number of inmates in the facility. Specifically, the State of Alabama provided a monthly allowance of $1.75 per inmate, per day, along with additional amounts, conditionally approved, as well as a food services allowance, based upon the number of prisoners in the county jail, for the sheriff’s services in preparing and serving the food.[7] When the Petitioner entered office in 2011, the average daily population for the county jail was approximately 250 inmates, 40 of whom were federal inmates (and thus received a $5 per day food allowance). Over the following years, the blend of inmates and their numbers changed significantly. By 2015, there were up to 500 inmates per day with those numbers projected to continue to increase. Federal inmate numbers stayed consistent.

After taking office in 2011, Petitioner believed – based on consultations with attorneys and colleagues – that the original decree restrictions remained in place only for her predecessor. Convinced she was personally liable for deficits in the jail food money account, the sheriff sought ways to manage a growing inmate population and offset mounting expenses.

Withdrawal and Investment Attempt

After running deficits in the jail food money account in three out of five months (Jan-June 2015), Petitioner began to investigate ways to subsidize the jail food money account. In June 2015, the sheriff withdrew $160,000 from the jail food money account through two cashier’s checks ($150,000 and $10,000).

Relying upon a tip from her boyfriend, Petitioner loaned $150,000 of the funds to a car dealership and title-pawn business named Priceville Partners. There was no promissory note. Things went south quickly. Petitioner was slow to receive responses from the borrower and ultimately was ghosted. She was lured by the promise of a 17% return in 30 days. Unfortunately, the investment turned out to be a Ponzi-like scheme and the dealership soon declared bankruptcy prior to repaying her. Her boyfriend ultimately ended up repaying the funds on behalf of the failing dealership in late 2016 and the funds in the jail food money account were ultimately restored, as Petitioner intended.

The class plaintiffs in the federal action monitoring compliance with the Consent Decree discovered removal of the funds and filed a motion to hold Petitioner in contempt. While she was found in civil contempt, the court merely imposed a nominal $1,000 fine as the money had already been returned. The court also terminated the specific portion of the Consent Decree restricting the sheriff’s use of the jail food money account, effectively signaling that while her actions violated that provision, prospective limits on the account were no longer essential.

Tax Issues and the Government’s Position

For the 2015 tax year, the government took the position that the funds withdrawn from the jail food money account constituted embezzlement income under IRC § 61.[8] The IRS maintained that the funds acquired without authorization and without intent to repay are taxable as an “undeniable accession to wealth.”[9]

Classifying the funds as embezzled income carries some significant consequences. Embezzled proceeds are taxable in the year they are misappropriated, because the wrongdoer gets complete control and dominion without any corresponding liability to repay. This, in turn, would potentially raise the Petitioner’s tax liability for 2015 substantially as well as subject her to penalties, including accuracy-related penalties and failure to pay penalties.

As a complicating matter, Petitioner failed to file her 2015 return on time, leading to an additional concern under IRC § 6651(a)(i) (failure to file). That section imposes incremental monthly penalties (5% per month) for failing to file a timely return, up to 25% of the unpaid amount. Petitioner pleaded guilty following criminal charges for willful failure to file the 2015 return.

Sheriff’s Defense and Court Reasoning

Surprisingly, the Tax Court rejecting the IRS’ contention that the money withdrawn constituted embezzlement proceeds. The central question was whether the sheriff had “consensual recognition” of an obligation to repay the withdrawn funds at the moment she took them.[10] The Tax Court also noted that under the terms of the Amended Paragraph 22 of the Consent Decree, Petitioner was not authorized to use the funds in the manner that she did. Thus, in circumstances where misappropriations do not enrich or benefit the misappropriator, and there is a consensual recognition of an obligation to repay the funds, income does not arise.[11]

Seemingly crucial to the Court’s analysis was the Petitioner’s apparent good-faith belief that the borrowed amount would be returned with interest. She took the funds specifically to earn a quick 17% gain for the benefit of the jail food money account, immediately endorsing the cashier’s check over to Priceville Partners, keeping no portion for her own personal use. Even though the terms were not memorialized in writing – an omission typical of more formal lending arrangements[12] – the Court found no evidence that she intended to enrich herself permanently and her ultimate repayment in late 2016 further reinforced the idea that such was an outstanding debt.

Conclusion

The Petitioner’s lucky break here reflects the importance of carefully analyzing whether contested funds represent income or merely a debt. It should be emphasized here that this situation presented itself with extremely unique facts not usually present in cases involving taxpayers. Usually, lack of documentation and the mere words and later-actions of a taxpayer are not persuasive. Here however, the stars aligned for the Petitioner. The situation and facts made sense for the ruling given. Nonetheless, one could only imagine how differently this case may have gone had the sheriff used some of the money for her own benefit or if the money had not been repaid.

For local authorities, government officials, and any parties managing restricted funds, this case underscores that processes for disbursing and tracking funds should align with both legal mandates and best accounting practices. Even unauthorized use, if proven to be a loan with a bona fide repayment obligation, may spare a taxpayer from having to count that money as taxable embezzlement income. But the dangers of misunderstanding complex consent decrees and ignoring deadlines can be far-reaching, with criminal and civil consequences lurking in the background.

[1] Franklin v. Comm’r, T.C. Memo 2005-8.

[2] Ala. Code § 14-6-60.

[3] Maynor v. Morgan County, No. 01-cv-00851 (N.D. Ala. filed Apr. 5, 2001).

[4] See Ala. Code § 36-22-17 for prior law pertaining to the sheriff’s right to keep the excess funding.

[5] Consent Decree Applicable to the Plaintiff Class and the County Defendants, Maynor, No. 01-cv-00851 (N.D. Ala. Sept. 25, 2001), ECF No. 45.

[6] The terms of Amended Paragraph 22(a)(i) provided, in relevant part, that the Sheriff of Morgan County “shall immediately establish and implement a procedure whereby all funds provided by any source for the feeding of inmates, including funds from the State of Alabama, any municipality, and the federal government, will be used exclusively for the feeding of said inmates incarcerated in the Morgan County Detention Facility.

[7] Ala. Code § 14-6-42; Ala. Code § 14-6-43.

[8] See also James v. U.S., 366 U.S. 213, 219 (1961).

[9] Id.

[10] See James, 366 U.S. at 219 providing that a taxpayer has income when she “acquires earnings, lawfully or unlawfully, without the consensual recognition, express or implied, of an obligation to repay and without restriction as to their disposition.

[11] Hobson v. Comm’r, T.C. Memo. 1992-312, at *8; see also Beasley v. Comm’r, T.C. Memo. 1989-173.

[12] Lack of memorializing transactions contemporaneously can be extremely problematic for taxpayers and our firm has written on this subject numerous times.

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