It is a crime to knowingly overstate one’s deductions. I.R.C. Section 7201. The question posed here is whether one’s overstatement of his deductions somehow may be “justified” by his later, fortuitous, losses which are carried back to prior years.
The answer to the question is “No.” If you previously knowingly overstated your deductions, that criminal action cannot be “wiped out” by your legitimate losses, however convenient they might happen to be. This matter was address in the Fifth Circuit in the 1960s. In Willingham v. U.S., 289 F.2d 283 (5th Cir. 1961), the taxpayer made some false deductions in 1953 in attempt to evade the tax liability. Two years later, in 1955, he sustained legitimate losses. Thus, the taxpayer desired to carry back those loses as a defense against the government.
How would this create a defense? It is a clever argument. To prove tax evasion, the government must show, among other things, that there was a tax due and owing. By carrying back net operating losses to prior years (i.e. the years when one falsely claimed a deduction), he attempted to “wipe out” his tax liability for those years (i.e. so there would be no tax “due and owing”). In this way, the taxpayer sought to “justify” his original overstatement of deductions.
Unfortunately for taxpayers, the court ruled that this argument is too clever. The courts to date now frame the matter in terms of when the taxpayer’s intent to commit tax evasion is complete. The Fifth Circuit maintains that the intent is complete in the year the false deduction is claimed. Thus, later “adjustment[s] that may be permissible resulting from subsequent losses does not prevent [a prior] fraud committed . . . from being [tax evasion].” Willingham v. U.S., 289 F.2d 283, 288 (5th Cir. 1961), cert. denied, 368 U.S. 826 (1961).