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Thereafter, he operated the scheme through his wholly owned S
corporation, the O'Bryon Co. As part of the scheme, Phillip sold
nonexistent certificates of deposit (CD's) to various
individuals. Phillip used the funds he received in the scheme to
pay individuals who thought they owned CD's that had matured, to
finance his other businesses, and to pay for his personal
expenses.
On March 30, 1995, Phillip was charged with grand theft
under Ohio law. The prosecution alleged that Phillip had
operated a fraudulent Ponzi scheme involving fictitious CD's.
Phillip pleaded guilty to the charges. On April 28, 1995, the
State court judge sentenced Phillip to 2 years in prison and
ordered him to pay $468,834 in restitution to the individuals he
had defrauded.
In the notice of deficiency, respondent determined that
petitioners failed to report embezzlement income of $423,850 for
1992, $289,578 for 1993, and $46,700 for 1994.
In the petition, petitioners asserted that respondent erred
in determining that Phillip received funds by illegal means in
the amounts set forth in the notice of deficiency. Petitioners
asserted that the money Phillip received in the Ponzi scheme was
not includable in his gross income. Petitioners asserted in the
alternative that, if the money did constitute gross income, then
petitioners should be allowed a deduction under section 162 in
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