I have always been under the impression that there is one, and only one, federal tax collector – the Internal Revenue Service (IRS). The IRS is the federal agency tasked with assessing and collecting the country’s federal tax revenue. In fact, Congress enacted a law (Section 7401 of the Internal Revenue Code) that mandates that no civil action for the collection or recovery of taxes may be commenced unless the Secretary of the Treasury authorizes such action. However, a very disturbing decision by the U.S. District Court for the Southern District of New York was handed down on June 13, 2013, in which the court held that the Securities and Exchange Commission (the SEC) was not precluded from seeking disgorgement of unpaid tax as part of a securities law enforcement action (SEC v. Samuel Wyly, et. al., No. 1:10-cv-05760 (S.D.N.Y. June 13, 2013)).
The defendants in the case rightly argued that only the IRS can assess and collect federal tax. They also correctly pointed out that calculating the disgorgement amount by reference to unpaid taxes is the substantive equivalent of assessing the tax. Judge Shira Scheindlin saw the world slightly differently. In the court’s opinion the purpose of disgorgement is to deprive violators of their ill-gotten gains and the calculation of the disgorgement amount “need only be a reasonable approximation of profits causally connected to the violation.” The opinion notes that, as a formal matter, an action for disgorgement is a civil action for securities law violations the remedy for which may be measured by the amount of taxes avoided. The court found this to be distinguishable from a civil action for the collection and recovery of taxes which is within the exclusive jurisdiction of the IRS.
The result of this case is intolerable and dangerous on several levels. First, the SEC pursued this never before seen tactic because its original action for penalties was denied as untimely. The transactions in question occurred in 2001 and the original action for remedies was not brought until 2010. The time limit in question did not impact an action for disgorgement. This timing implies the statute of limitations for a normal tax assessment had long since passed as well (absent a finding of fraud). So, on an initial level this case provides the federal government with a method of avoiding the statute of limitations on tax assessments. Second, and perhaps more importantly, if left to stand this opinion will deprive taxpayers of the tax assessment process that is built into the internal revenue code and internal revenue manual. There is an entire due process procedure built into tax assessment and it is not replicated in a securities law disgorgement action. Third, there is that nasty issue of the possibility of a double collection by the SEC and IRS. The court punted on this last point by simply pointing out that such a possibility could be properly dealt with and was no reason to preclude the SEC from pursuing its remedies in this particular case.
This case represents a novel approach by the SEC to extract a penalty from a securities law violation where the act was discovered late, prosecuted late and left the agency with little or no alternatives for recovery. However, this result cannot be permitted to stand. Why have a detailed process and procedure around tax collection within the IRS if the government is free to sidestep such within securities law cases and pursue taxpayers, through the SEC? I sincerely hope the defendants appeal this case and win.