The Unclean Hands Doctrine and How it Applies to Tax

The Definition of Unclean Hands Doctrine in Tax Law

The Unclean Hands Doctrine in Tax Law

The unclean hands doctrine is a very important concept that applies in all areas of law, including tax law. From a general legal perspective, the doctrine of unclean hands means that a person is making allegations against someone or an agency but they themselves have acted fraudulently or with deceit. In some scenarios, this can result in the court rejecting the claims by the taxpayer with unclean hands.  In the Supreme Court case of Precision Instrument Mfg., the court broke down the concept of unclean hands and how it can apply. This concept was then applied in the recent 2023 crypto tax law case of Kim v CIR.

Definition of Unclean Hands

As provided by Thomas Reuters about the definition of unclean hands:

• • • An equitable defense that bars relief to a party who has engaged in inequitable behavior (including fraud, deceit, unconscionability, or bad faith) related to the subject matter of that party’s claim. The unclean hands doctrine is also known as the “clean hands doctrine” and the “dirty hands doctrine.”

    • The unclean hands doctrine typically applies only to equitable claims such as requests for injunctive reliefor specific performance, but some jurisdictions permit it as a defense to legal claims as well.

    • Although the unclean hands doctrine is typically an affirmative defense asserted by a defendant, it may also be asserted by a plaintiff in opposition to an equitable defense such as estoppel.

    • General immoral or corrupt conduct is not enough to warrant application of the unclean hands doctrine. To prevail, a party must demonstrate that its opponent engaged in inequitable behavior that is related to the subject matter of the litigation.

Important Cases about the Unclean Hands Doctrine

Here are two cases regarding the Unclean Hands Doctrine to understand when it may (or may not) apply.

Precision Instrument Mfg. Co. v. Automotive Co. (Supreme Court)

• • • “The guiding doctrine in this case is the equitable maxim that “he who comes into equity must come with clean hands.” This maxim is far more than a mere banality. It is a self-imposed ordinance that closes the doors of a court of equity to one tainted with inequitableness or bad faith relative to the matter in which he seeks relief, however improper may have been the behavior of the defendant. That doctrine is rooted in the historical concept of court of equity as a vehicle for affirmatively enforcing the requirements of conscience and good faith. This presupposes a refusal on its part to be “the abetter of iniquity.” Bein v. Heath, 6 How. 228, 47 U. S. 247. Thus, while “equity does not demand that its suitors shall have led blameless lives,” Loughran v. Loughran, 292 U. S. 216, 292 U. S. 229, as to other matters, it does require that they shall have acted fairly and Page 324 U. S. 815 without fraud or deceit as to the controversy in issue. Keystone Driller Co. v. General Excavator Co., 290 U. S. 240, 290 U. S. 245; Johnson v. Yellow Cab Transit Co., 321 U. S. 383, 321 U. S. 387; 2 Pomeroy, Equity Jurisprudence (5th Ed.) §§ 397-399.

    • This maxim necessarily gives wide range to the equity court’s use of discretion in refusing to aid the unclean litigant. It is “not bound by formula or restrained by any limitation that tends to trammel the free and just exercise of discretion.” Keystone Driller Co. v. General Excavator Co., supra, 290 U. S. 245-246. Accordingly, one’s misconduct need not necessarily have been of such a nature as to be punishable as a crime or as to justify legal proceedings of any character. Any willful act concerning the cause of action which rightfully can be said to transgress equitable standards of conduct is sufficient cause for the invocation of the maxim by the chancellor.

Kim vs Commissioner of Internal Revenue (Tax Court)

In the recent case of Kim vs. Commission of Internal Revenue, the taxpayer made the argument that the IRS should not have the ability to tax certain transactions due to unclean hands. While it is a very creative argument, unfortunately, the U.S. Tax Court did not agree and rejected the taxpayer’s claims.

As provided by the U.S. Tax Court:

• • • Petitioner does not dispute the amounts of gain determined by respondent. But he contends that the IRS is estopped from collecting tax on these gains. Representing that he suffered large losses on cryptocurrency transactions in 2020, he contends that these losses were caused or exacerbated by the Government’s actions (or inaction) in response to the COVID epidemic. Unable to carry his 2020 losses back to 2017 — individual taxpayers are permitted to carry capital losses forward, but [*2] not back — he contends that the “unclean hands” doctrine prevents the IRS from taxing his 2013 and 2017 gains. Although we have sympathy for petitioner’s predicament, we are unable to accept his argument.

    • [*5] Petitioner’s argument has no legal basis. The doctrine of estoppel can be invoked against the United States only in the rarest of circumstances. See Schuster v. Commissioner, 312 F.2d 311, 317 (9th Cir. 1962), aff’g in part, rev’g in part 32 T.C. 998 (1959) and First W. Bank & Tr. Co. v. Commissioner, 32 T.C. 1017 (1959); Estate of Stein v. Commissioner, 37 T.C. 945, 952 (1962); Howe v. Commissioner, T.C. Memo. 2020-78, 119 T.C.M. (CCH) 1530, 1534 (citing Schuster v. Commissioner, 312 F.2d at 317).

    • In any event, the “unclean hands” principle is designed to withhold equitable relief from one who has acted improperly. See Stafford v. Rite Aid Corp., 998 F.3d 862, 865 (9th Cir. 2021). Respondent is not seeking equitable relief but is endeavoring to recover taxes determined to be due from petitioner under the Internal Revenue Code. And while petitioner may disagree with the Government’s policy response to the COVID epidemic, he has not shown that any agency of the Government (much less the IRS) acted improperly.

    • When relevant, the “unclean hands” defense applies only to con-duct immediately related to the cause in controversy. See Seller Agency Council, Inc. v. Kennedy Ctr. for Real Estate Educ., Inc., 621 F.3d 981, 986-87 (9th Cir. 2010). The Government’s actions in response to the COVID epidemic have no relationship whatever to the determination of petitioner’s 2013 and 2017 tax liabilities. Those governmental actions occurred in 2020, three years after petitioner had realized the most recent gains in question.

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