The Tax Court held that an Alabama county sheriff’s 2015 withdrawal of a large sum of money from an account containing funds for feeding the inmates of the county jail was an unauthorized loan that was not includible in her income. The court, however, further held that later withdrawals from the account in 2018 to pay legal and accounting expenses the sheriff incurred were includible in her income as other income.
Background
Ana Franklin was the elected sheriff of Morgan County, Ala., from 2011 to 2019. During this time, in Alabama, county sheriffs had a duty to ensure the inmates in their jails were properly fed. To this end, the state, by statute, paid the sheriffs a per–inmate daily allowance and certain other conditionally approved amounts. The federal government also paid sheriffs an allowance for federal inmates held at their jails. After feeding the prisoners in his or her county jail, a sheriff could retain any surplus funds. However, if the funds provided by the state were insufficient, the sheriff was personally liable for the shortfall.
As a result of a 2001 class action lawsuit against Morgan County filed by a class of pretrial detainees held in the Morgan County jail (Maynor v. Morgan County, No. 01–cv–00851 (N.D. Ala. 4/5/01) (complaint filed)), the county entered into a consent decree under which it was required in paragraph 22 of the decree to “provide a nutritionally adequate diet to inmates.” In 2008, a court–ordered investigation revealed Franklin’s predecessor had willfully violated paragraph 22 of the consent decree. This led the court to make changes to paragraph 22, including the addition of a stipulation that the sheriff of Morgan County was required to use all funds provided for feeding inmates exclusively for that purpose. The amended paragraph 22 also provided, however, that the sheriff would not be required to cover any shortfall in the funds provided.
Franklin did not believe that she was covered by amended paragraph 22 of the consent decree, but she believed that she was covered by the original consent decree. To discharge her responsibilities for feeding the inmates at the Morgan County jail, Franklin set up accounts with food vendors and established a line of credit under her own name and Social Security number. She also obtained signatory authority over a checking account used exclusively for the jail food money (the jail food money account), into which Alabama and the federal government deposited the monthly jail food funds.
Things initially went well with Franklin’s operation of the jail food money account and the feeding of the Morgan County jail inmates, and she and her staff managed to feed the inmates with the funds provided by the state and federal government. Although she had deficits in some months and surpluses in others, over time, the balance in the jail food money account gradually increased, and by the beginning of 2015, the account balance was $224,416. However, due to a variety of factors, Franklin found it increasingly difficult to feed the inmates at the jail with the funds provided to her. Consequently, in 2015, she began looking for ways to subsidize the jail food money account.
The way she came up with to earn additional funds for the jail food money account was to make a short–term loan to a local used car dealership/title loan business, Priceville Partners LLC, which promised Franklin a 17% interest rate on the money loaned. To effect this plan, Franklin withdrew $160,000 from the jail food money account in 2015, depositing $5,000 in another personal bank account she set up, putting $5,000 in the jail’s safe as petty cash, and transferring $150,000 to Priceville Partners.
Unfortunately for Franklin, Priceville Partners essentially turned out to be a Ponzi scheme and did not repay the loan. However, the loan had been guaranteed by the person who recommended making it (a Morgan County police officer who was Franklin’s boyfriend at the time), and he repaid the full $150,000 to Franklin on behalf of Priceville Partners in December 2016. Franklin deposited the money in the jail food money account on Dec. 30, 2016.
After hearing what had happened, the representatives of the class members in the Maynor suit filed a motion seeking to hold Franklin in contempt for violating amended paragraph 22 of the consent decree. The court found that, by removing the money from the jail food money account, Franklin violated the terms of the consent decree and held her in civil contempt but only imposed a nominal fine of $1,000.
Franklin’s tax returns for 2015 and 2018 and notices of deficiency
On Dec. 18, 2017, Franklin filed her 2015 income tax return. On it, she reported taxable income of $57,477, mainly from her wages as Morgan County sheriff. She did not report any income in connection with the 2015 withdrawal from the jail food money account on her return.
The IRS examined Franklin’s return for 2015 and in 2021 issued a notice of deficiency for 2015 with a deficiency determination of $46,079. The notice included an adjustment to Schedule C, Profit or Loss From Business (Sole Proprietorship), for gross receipts of $155,000, with the IRS claiming Franklin operated a business for feeding prisoners in 2015 and that the money she withdrew from the jail food money account (less the $5,000 she left in the jail safe as petty cash) was gross proceeds from the business. Related to this, the IRS also included an adjustment in the notice for a net operating loss (NOL) carryback from 2016 of $18,956 arising out of Franklin’s 2016 repayment of funds to the jail food money account and an adjustment for a self–employment tax deduction of $5,224. Franklin filed a petition in Tax Court challenging these adjustments in July 2021.
In Tax Court, the IRS significantly changed its position in its answer to Franklin’s petition. In its answer, it contended that Franklin did not operate a business for feeding prisoners in 2015 and that the $155,000 Franklin withdrew from the jail food money account was not gross proceeds from that business but were instead the proceeds of embezzlement. Consistent with this change in position, the IRS also argued that Franklin was not entitled to the NOL carryback from 2016 or the deduction for self–employment tax allowed in the 2015 notice.
Franklin timely filed a 2018 income tax return reporting taxable income of $58,197, again with the primary source of income being her wages as Morgan County sheriff. However, unlike her 2015 return, her 2018 return included a Schedule C, on which she listed her business as “Sheriff’s Jail Food Account.” On the Schedule C, she reported gross income of $44,967 and legal and professional services expenses of $44,967, resulting in zero net profit. The $44,967 of income and expenses represented funds that Franklin withdrew from the jail food money account during 2018 and paid to lawyers and accountants to resolve her ongoing legal and tax issues.
In January 2022, the IRS issued a notice of deficiency for Franklin’s 2018 tax year in which it determined a deficiency of $15,900. Franklin timely filed a petition in Tax Court challenging the IRS’s determinations in the notice. In Tax Court, in conformity with its answer to Franklin’s 2015 petition, the IRS argued that Franklin did not operate a Schedule C business during 2018 and was not subject to self–employment tax. The IRS also reclassified the legal and accounting expenses as nondeductible miscellaneous itemized deductions.
In 2022, the Tax Court consolidated Franklin’s 2015 and 2018 cases for trial, briefing, and opinion.
The Tax Court’s decision
The Tax Court held that the money that Franklin withdrew in 2015 was an unauthorized loan from the jail food money account that was not includible in her income. It further held that Franklin’s operation of the jail food money account in 2018 was not a trade or business. Thus, the money she withdrew from the jail food money account to pay her legal and accounting expenses in 2018 was other income, and the expenses she paid were nondeductible miscellaneous itemized deductions.
2015 tax year: Sec. 61(a) defines gross income as “all income from whatever source derived,” and the Supreme Court stated in Glenshaw Glass Co., 348 U.S. 426, 431 (1955), that it includes all “accessions to wealth, clearly realized, and over which the taxpayers have complete dominion.” On the other hand, loan proceeds are excluded from gross income because the benefit of income is offset by a corresponding obligation to repay.
The IRS argued that Franklin’s withdrawal from the jail food money account was a misappropriation of funds from the account and conversion of those funds for personal use in violation of Alabama law and amended paragraph 22 of the Maynor consent decree and, as such, was embezzlement. In the IRS’s view, the withdrawal had the three characteristics of income set out in Glenshaw Glass, and, therefore, the amount withdrawn should be included in Franklin’s income as other income.
Franklin countered that the withdrawal was a loan from the jail food money account that she had intended on repaying with interest. She contended that, as signatory authority on the jail food money account, she always had dominion and control over the funds in the account and that she received no accession to wealth when she withdrew the funds because she created a corresponding obligation to repay the funds. Thus, she contended, the funds withdrawn were not income under the Glenshaw Glass definition.
The Tax Court explained that although Franklin was not authorized to use the funds in the manner that she did, it has long distinguished between unauthorized loans and embezzlement. In the case of embezzlement, there is no consensual recognition by the person receiving the funds of an obligation to repay them, while in the case of an unauthorized loan, there is a consensual recognition by the person receiving the funds of an obligation to repay them.
For genuine indebtedness to be present, the Tax Court found that there must be a good–faith intent on the part of the borrower to repay the debt and good–faith intent by the lender to enforce payment of the debt. After reviewing the evidence in the case and the trial testimony, the court concluded that the funds Franklin withdrew from the jail food money account were a loan. As the court explained, while Franklin’s withdrawal of the funds failed to adhere to certain formalities such as a written instrument, the lack of such formalities was not conclusive, and Franklin’s credible testimony and other evidence showed that her intent was that the withdrawal was a loan. The court stated that Franklin showed “poor business judgment, both in withdrawing the funds and in lending them to Priceville Partners, but [her] poor judgment is not a factor in determining her intent.”
The Tax Court also found that although the court in Maynor held that the withdrawal was made in violation of the consent decree from that suit, it did not alter the fact that Franklin intended to return the funds to the jail food money account. The court noted that Franklin was never charged with, much less convicted of, embezzlement or theft of the funds. Instead, the Maynor court ruled that she was not authorized to use the funds in the manner she did.
Based on its findings, the Tax Court held that the $155,000 withdrawn from the jail food money account in 2015 was an unauthorized loan that was not includible in income. Thus, Franklin’s restoration of the funds in 2016 constituted a loan repayment rather than a repayment of embezzled funds, so Franklin was also not entitled to the NOL carryback from 2016 that the IRS originally included in its 2015 deficiency notice.
2018 tax year: For 2018, the Tax Court found that Franklin was not engaged in the trade or business of operating the jail food money account and that, instead, she did so in the course of her employment as sheriff of Morgan County. To determine whether a trade or business exists, the Tax Court examines the facts and circumstances, focusing on whether: (1) the taxpayer undertook the activity intending to earn a profit; (2) the taxpayer is regularly and actively involved in the activity; and (3) the taxpayer’s activity has actually commenced.
In Franklin’s case, the court found that she did not separately or independently undertake the operation of the jail food money account with the intent to make a profit but rather was specifically obligated to do so in her position as sheriff. It also found that Franklin would have not been able to operate the jail food money account but for the fact that she was sheriff, so the activity was inextricably connected with that position. In addition, the court determined that she did not operate the jail food money account as a separate trade or business. Accordingly, the court held that Franklin operated the jail food money account as a duty of her employment, not as a trade or business, and therefore sustained the IRS’s determination that the income Franklin reported on Schedule C of her 2018 return was other income and not gross receipts from a trade or business.
Regarding the legal expenses Franklin included on her 2018 Schedule C, the Tax Court found that since it had determined that Franklin operated the jail food account as part of her duties as sheriff, the expenses could only be deducted as employee business expenses if they were related to or in connection with Morgan’s employment as sheriff. Because employee business expenses are miscellaneous itemized deductions, which were not deductible in 2018, the court held that Franklin could not deduct them. Therefore, the court did not need to analyze whether the legal expenses were connected with her employment as sheriff or nondeductible personal expenses.
Regarding the accounting fees, the court found that they were not deductible as trade or business expenses because they were for the preparation of original and amended individual tax returns for Franklin. While fees for preparing tax returns are miscellaneous itemized deductions for individuals, the court held that, like the legal fees, Franklin could not deduct them because miscellaneous itemized deductions were not deductible in 2018.
Reflections
Franklin filed her 2015 return in response to receiving notice that she was under criminal investigation by the Department of Justice for failing to file her return for that year. One year after she filed her 2015 return, on Dec. 18, 2018, she was charged with willful failure to file a tax return for the 2015 tax year in violation of Sec. 7203. She pleaded guilty to the charge and was sentenced to probation for 24 months.
Franklin, T.C. Memo. 2025–8
Contributor
James A. Beavers, CPA, CGMA, J.D., LL.M., is The Tax Adviser‘s tax technical content manager. For more information about this column, contact [email protected].
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