In July 2010, the Wall Street Journal reported that BP may be able to reduce its U.S. tax bill by $10 billion as a result of the money it set aside for oil spill claims. 1 This news has reopened the debate on the deductibility of restitution payments and the proper role of the denial of deductions that appear to violate public policy.
The Internal Revenue Code is designed to tax income. The fact that a taxpayer earned income in an illegal activity does not make the income exempt from taxation. 2 Likewise, taxpayers are entitled to deduct expenditures incurred to produce the illegal income. 3 To deny the deduction would revise the tax from one on net income to one on gross receipts. 4
What is less certain is the deductibility of expenditures that violate federal or state laws or national or state public policy. This uncertainty is the result of the basic policy conflict between not using the income tax to modify behavior and not allowing a deduction that would diminish the effect of government-imposed fines and penalties designed to deter or punish behavior. 5 In 1969, Congress enacted Sec. 162(f) to clarify and limit the types of nondeductible expenditures that are deemed to violate public policy. It chose to limit the nondeductibility to fines and penalties paid to a government. Nevertheless, disagreements and confusion have continued over the scope of Sec. 162(f) and its impact on other sections such as Sec. 165.
This article examines the issues and limitations of deductions under Secs. 162(f) and 165 and the violation of public policy doctrine raised in recent cases.
Public Policy Doctrine
Initially the Code was silent as to the deductibility of the payment of fines and penalties. Consequently, the courts decided to deny the deduction of these expenditures on the grounds that no deduction should be allowed for payments that violate public policy. 6
The scope of the public policy doctrine was well summarized by the Supreme Court in Tellier. 7 In that case, the Court allowed a deduction for legal fees paid to defend against criminal charges, stating that a deduction would be denied under the doctrine only if allowing the deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct.” 8 The national or state policies that are frustrated must be “evidenced by some governmental declaration of them.” 9 In addition, the “test on nondeductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction.” 10 Under this approach, the limitation based on violation of public policy doctrine is very narrow.
In the Tax Reform Act of 1969, Congress decided to codify the public policy doctrine by enacting Sec. 162(f) in the hope that it would eliminate the questions and conflicts raised in various cases. 11 This subsection provides that “[n]o deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.” The Code contains no further explanation of this rule. The Senate Finance Committee report states: “This provision is to apply in any case in which the taxpayer is required to pay a fine because he is convicted of a crime (felony or misdemeanor) in a full criminal proceeding.” 12 The committee report goes on to note that “[t]he provision for the denial of the deduction for payments in these situations which are deemed to violate public policy is intended to be all inclusive. Public policy, in other circumstances, generally is not sufficiently clearly defined to justify the disallowance of deductions.” 13
The regulations expand the scope of the denial. 14 Although the Senate report refers to fines for conviction of a crime, the regulations expand the scope of the section to include guilty and nolo contendere pleas. More important, the regulations apply Sec. 162(f) to civil penalties imposed under federal, state, and local law. This extension appears to conflict with the Code itself and the committee reports explaining the provision. Treasury justified the extension by its conclusion that the reference to criminal penalties in the committee reports was really only an example and not intended to be taken as a true limitation. 15
The validity of applying Sec. 162(f) to civil penalties has been questioned. The Tax Court in Tucker 16 pointed out that the legislative history can be read to exclude civil penalties from the scope of Sec. 162(f). Without actually resolving the conflict in the reading of the legislative history, the Tax Court appears to have accepted the extension by concluding that the purpose of Sec. 162(f) was to codify prior cases and that these cases did in fact deny deductions for civil penalties. In Middle Atlantic Distributors, 17 the Tax Court concluded that Sec. 162(f) definitely covers civil penalties, stating that “certainly, however, by 1972 it was clear that Sec. 162(f) was intended to include civil penalties which in general terms serve the same purpose as a fine exacted under a criminal statute.” The Court of Claims reached a similar conclusion about the scope of Sec. 162(f) in Meller. 18
Not all civil penalties are nondeductible. The Tax Court in Southern Pacific Transportation Co. 19 stated that the use of the phrase “similar penalties” was included to distinguish nondeductible punitive penalties from deductible remedial penalties rather than to distinguish civil from criminal sanctions. 20 (This distinction is discussed more fully below.) Finally, the regulations expand the scope to include settlements of actual or potential criminal or civil fines and penalties.
The IRS expanded the provision even further in Rev. Rul. 79-148. 21 In this ruling, the taxpayer pled no contest to violating a federal law restricting sales to a foreign country. The taxpayer offered to contribute the amount of the maximum fine that the court could impose to a charitable organization in exchange for a suspended sentence and probation. The court accepted the offer. The ruling concludes that the payment was nondeductible. It was not a charitable contribution because it was not gratuitous and the taxpayer expected a return benefit. 22 The regulations include in the definition of fines and penalties amounts paid in lieu of actual or potential fines or penalties. Since the taxpayer made the contribution to avoid the imposition of a fine, it came within the regulations’ definition of a penalty and was held nondeductible under Sec. 162(f).
Observation: The ruling does not discuss the fact that the money was given to a charity rather than a governmental agency as required by a literal reading of the statute. Thus, the ruling expands the scope of Sec. 162(f) to include nongovernmental payments without explanation.
Payments to Nongovernmental Entities
The extension of Sec. 162(f) to payments made to persons or entities other than governmental units appears to be accepted by the courts, but with limitations. In Bailey, 23 the taxpayer was ordered to pay a $1,036,000 civil penalty for violating the Federal Trade Commission Act. The district court allowed the taxpayer to apply the penalty toward settlement of his potential class action liability. The Sixth Circuit confirmed the nondeductibility of the payment. It concluded that although the cash was directed to the class action liability, that did not change the fact that it was still a civil penalty. Specifically, the origin of the liability was a fine payable to the government; therefore, it remained a fine even though the funds were paid to a nongovernmental entity.
The Tax Court relied on the appellate decision in Bailey to conclude that a restitution payment was a nondeductible fine paid to a government in Waldman. 24 The court reasoned that even though a fine payable to a government is allowed to be paid directly to a third party, that does not change the fact that it was a fine payable to a government. The actual recipient of the money is not determinative.
In Allied-Signal Inc., 25 the Third Circuit approved and clarified the extension. In the court’s opinion, a fine or penalty is deemed paid to a government if, instead of having the taxpayer make the payment directly to the government, a court directs the payment to be made to a third party. The court quoted the decision in Waldman: “We do not believe that a government must actually ‘pocket’ the fine or penalty to satisfy the ‘paid to a government’ requirement.” The court continued: “We find no practical difference between a situation where a fine is paid to the Treasury and the government then expends that money for a public purpose, and a situation where the fine is paid directly into a fund to benefit the public at the direction of the government.” This clarification is consistent with the earlier cases, since the funds would have been paid to the government if the courts had not allowed the alternate payment. In conclusion, if the origin of the liability is a fine payable to a government, it remains a nondeductible fine regardless of the actual recipient of the cash.
Observation: There was an interesting dissent from the decision in Allied-Signal arguing that the Code’s requirement of a payment to a government should not be expanded to payments to third parties. In the dissent’s opinion, if Congress intended to include these payments, they should have written the Code as such and not used the plain language “paid to a government.” If the courts continue to limit the extension to payments to third parties at the government’s or court’s direction or acceptance, the extension is reasonable.
As previously stated, the regulations appear to expand the list of nondeductible payments. They also create an exclusion. Regs. Sec. 1.162-21(b)(2) states that “[c]ompensatory damages . . . paid to a government do not constitute a fine or penalty.” Therefore, certain payments to governments, even if they are the result of a criminal or civil suit, will be deductible.
The scope of this exclusion is discussed in Letter Ruling 8704003, 26 which ruled on the deduction of a settlement payment that arose from an anti-dumping suit. It cites Middle Atlantic Distributors 27 for the proposition that penal or punitive assessments are nondeductible, whereas remedial assessments are deductible. Punitive assessments are designed to enforce the law, whereas remedial assessments are compensatory and are computed based on the harm done to the governmental unit assessing the penalty or to a third party the government is trying to protect. The fact that the assessment is used to mitigate harm or injury does not prevent the assessment from being punitive and therefore nondeductible.
Punitive vs. Remedial Payments
Distinguishing between deductible and nondeductible payments based on whether they were intended to be punitive or remedial has resulted in some interesting court cases. For example, in Waldman, 28 the Tax Court had to decide whether a restitution payment was remedial or punitive. The taxpayer pled guilty to one count of conspiracy to commit grand theft. He was sentenced to 1–10 years in prison, but the sentence was stayed based on a restitution payment to the victims. The court had to examine the state law and the initial judge’s decision in detail to decide which was the primary purpose for the restitution payment in this case. The court decided that the primary purpose was punitive, and therefore it was a nondeductible fine.
Another frequently cited and important case involving remedial versus punitive payments is Allied-Signal. 29 In this case, the taxpayer pled nolo contendere to a 1,940-count indictment for waste and water pollution resulting from its manufacturing of Kepone. The trial judge imposed a fine of $13,240,000 but indicated he wanted the money used to help those persons harmed by the pollution. The taxpayer met with the judge to discuss the creation of a fund to remove the pollution and help those harmed. The judge indicated that he would be willing to reduce the fine if the trust containing the money was actually created. Allied-Signal funded the trust with $8 million, and the judge reduced the fine by $8 million. The taxpayer deducted the $8 million, arguing that the amount was deductible since it was a voluntary payment designed to compensate those harmed.
The Third Circuit rejected the taxpayer’s argument. It first considered whether the fact that a payment is voluntary would affect its classification. The court stated that assuming that the voluntariness of the payment was relevant, the facts indicated that the contribution was a quid pro quo for a reduction in the criminal fine and thus was not voluntary.
The court also rejected the argument that the payment was compensatory and therefore deductible. It found that the fact that the funds were used to benefit those harmed does not make it compensatory. A compensatory payment is one that is awarded to a specific victim based on injuries suffered. According to the court, Allied-Signal’s contribution to the fund served a general public purpose. Since all payments to governments are ultimately used for general public purposes, accepting Allied-Signal’s argument that this general trust fund designed to mediate the harm done was a compensatory payment would, in the court’s words, nullify Sec. 162(f). Thus, the contribution to the fund was a nondeductible fine.
Not all courts accept the remedial versus punitive approach to deciding the deductibility of fines. In Colt Industries, Inc., 30 the taxpayer paid and deducted $1.6 million it paid to the Pennsylvania Clean Air and Clean Water funds as part of a consent decree. The decree labeled the payment a civil penalty. The taxpayer argued that the penalty was not punitive and was therefore deductible.
The Federal Circuit rejected the taxpayer’s argument and held the payment nondeductible. According to the court, the regulations under Sec. 162(f) do not make a distinction between punitive and remedial penalties. Since Treasury is authorized to issue these regulations, they should be followed. Therefore, all civil fines and penalties are nondeductible. Whether the purpose of the fine is punitive or remedial is not relevant.
The court of appeals also addressed the limitation on nondeductibility contained in Regs. Sec. 1.162-21(b)(2). This exception removes compensatory damages from the list of nondeductible expenditures. Because the law under which the penalty was levied did not authorize the government to seek compensatory damages, the civil penalty paid by Colt Industries was not compensatory and therefore was not within the scope of the exceptions, according to the court. As an example of an item within the exception, the court referred to 15 U.S.C. Section 15(a), which allows the government to recover actual damages sustained and court costs. The appellate court’s approach to the regulation would greatly expand the list of nondeductible expenditures by severely limiting the payments that qualify as compensatory damages. 31
Origin of the Liability
Assuming the courts continue to distinguish between nondeductible punitive penalties and deductible remedial penalties, the question becomes how to make the distinction. In Bailey, 32 the Sixth Circuit cited Middle Atlantic Distributors for the proposition that the origin of the liability should determine its objective. It also cited the Tax Court’s decision in Southern Pacific Transportation Co. 33 for the conclusion that nondeductible penalties are those designed to enforce the law or as punishment, whereas deductible penalties are those imposed to encourage prompt compliance with a requirement of the law or to compensate a party for expenses incurred because of a violation of the law. Since Bailey’s penalty was the result of his failure to obey an FTC consent order, the payment was designed to enforce a law and was a nondeductible penalty. The inclusion of the distinction between enforcement of a law and prompt compliance is likely to result in more nondeductible penalties, since prompt compliance penalties will be limited to those resulting from a failure to act within a set deadline, whereas enforcement will encompass most other penalties.
Treasury was more specific as to the proper analysis of a penalty in a Chief Counsel Field Service Advice memorandum. 34 According to the memorandum, it is first necessary to determine all the facts and circumstances leading up to the litigation as well as the true substance and nature of the claim. If no lawsuit is instituted, attention must be paid to the documents, letters, and testimony surrounding the claims. Based on this information, the proper classification of the payment can then be made.
As previously mentioned, the regulations expand the scope of Sec. 162(f) to include settlements of actual or potential liabilities for fines or penalties. In analyzing the deductibility of the settlement payment, the courts have looked to the origin of the underlying liability. 35 The IRS Office of Chief Counsel used a two-step approach to classifying settlements. 36 The first step is to analyze the underlying statute. If it is punitive, it is a penalty. If it is remedial, the settlement does not come under Sec. 162(f). If the statute has aspects of both, the settlement agreement must be examined to determine which aspect of the law is the origin of the settlement.
In these situations, the wording in the settlement agreement will be carefully considered. For example, in Letter Ruling 7736040, 37 the attorneys carefully drafted the settlement agreement to state that the payment was compensatory and not a fine or penalty. This was important in the conclusion that the payment was deductible and implies that an agreement stating that the penalty is compensatory and not punitive will be determinative.
However, it is important that too much reliance not be placed on the wording of a settlement. Recently a district court was asked to rule on a taxpayer’s motion for summary judgment that a payment to settle a Medicare fraud claim was deductible because the agreement stated the payments were nonpunitive. 38 The court held that summary judgment was inappropriate. The judge explained: “Because of the conflicting language in the agreements, the placement of the nothing-punitive language, and its wording, I conclude that the contract is ambiguous” and not suitable for summary judgment. In other words, just because the agreement states it is nonpunitive does not mean it is deductible. The existence of any ambiguity may lead a court to review the payment under the two-step process described above rather than accept the agreement as determinative.
The Cavaretta case 39 examines several aspects of the rules concerning the deductibility of fines and penalties. Peter Cavaretta opened his dental practice in 1970. In 1995, Karen Cavaretta, who worked in her husband’s dental practice, started billing one of the insurance companies for procedures that Peter had not performed. The fraud was discovered, and Karen pled guilty to one count of health care fraud. She stated that Peter did not know of the fraud and that the money was reported as revenue on the dental practice’s tax return. Karen was sentenced to 18 months in prison and 2 years of supervised release. The judge did not order either a fine or restitution but did attach a letter to the sentencing judgment stating that Karen would pay the insurance company $600,000 in full settlement of all civil claims. Peter actually made the payments and deducted them on his Schedule C. These payments created a net operating loss, which Peter carried back. The government denied the carryback refund claims.
As the judge in the case noted, the case is interesting because the government did not argue that the payments were nondeductible. Instead it said that the payments were deductible as losses in a transaction entered into for profit under Sec. 165(c)(2) and not as business expenses under Sec. 162. The implication of the government’s argument is that although they were deductible in the year paid, the amounts could not be included in the calculation of the net operating loss carryback.
Although the government did not argue against deductibility, the court first analyzed whether the restitution payments were deductible or nondeductible. All the paperwork indicated that the payments were restitutions and not fines or penalties. In addition, Karen was sentenced to time in jail. Therefore, the payments were not designed to be punitive but to reimburse the insurance company for its excess payments. As such, they were not fines or penalties but deductible restitution payments.
The main question considered by the court was whether the restitution payments was deductible under Secs. 162 or 165. The government argued that the Second Circuit decision in Stephens 40 concluded that restitution payments, if deductible, are only deductible under Sec. 165. As support it quoted from the decision:
[A] restitution payment, such as is involved herein, is not an “ordinary and necessary” expense as required by section 162(a) but rather gives rise to a loss in a “transaction entered into for profit” under section 165(c)(2).
As the Tax Court pointed out, the government’s argument ignored the critical phrase “such as is involved herein.” The restitution in Stephens resulted from a conviction for criminally defrauding an employer. It was not associated with a business and so could not meet the requirements of Sec. 162. Therefore, the deduction, if permitted, would have to be under Sec. 165(c)(2). The case did not involve an expenditure that arose in a business, and therefore the decision in Stephens does not preclude a deduction for restitution payments under Sec. 162.
It is interesting that the decision in Cavaretta does not refer to Ostrom 41 and the cases and rulings cited therein. In Ostrom, the taxpayer made fraudulent misrepresentations concerning his company’s financial statements to encourage an investor to purchase stock. The investor sued Ostrom and obtained a judgment against him. The Tax Court permitted Ostrom to deduct the payment of the judgment as a business expense under Sec. 162. The court supported its decision by citing Helvering v. Hampton, 42 in which the Ninth Circuit permitted a business deduction for a judgment based on fraudulent activities related to the business, and Caldwell & Co., 43 in which the Sixth Circuit allowed a business deduction for payment of a judgment for fraud. Finally, the court in Ostrom pointed out that the IRS had adopted the conclusions reached in these cases in Rev. Rul. 80-211, 44 which allowed a business deduction for punitive damages for fraudulent acts and contractual violations. Going forward, there should be no question that taxpayers can take deductions under Sec. 162 as well as Sec. 165 for deductible payments for civil fines and penalties.
The court in Cavaretta then analyzed whether the restitution payment was an ordinary and necessary expense of Peter’s dentistry practice. They noted that it arose from a contract between Peter and the insurer, that Peter credibly testified that he would have lost his business if he did not make the payment, and that the actual payment was less than what would have resulted from litigation. The court concluded that the payment was in fact an ordinary and necessary expenditure of Peter’s business.
The final potential stumbling block for the deduction was the fact that Peter made the payment, but the wrongdoing was Karen’s. Under Lohrke, 45 third-party payments can be deductible in certain circumstances. However, in this case the court felt that the Musgrave 46 decision was more applicable than Lohrke. In Musgrave an employer was permitted to deduct payments made to a client from whom an employee embezzled money. The court permitted the deduction because it was designed in part to avoid a lawsuit and in part to protect the employer’s reputation. The Cavaretta facts are similar to those in Musgrave; therefore, according to the Tax Court, Peter could deduct the payment as an ordinary and necessary business expense under Sec. 162.
The conclusion from Cavaretta is that civil restitution payments made by a business can be deductible and that they can fall under Sec. 162, but, to the extent such payments arise from personal and not business actions, a deduction, if allowed, will be restricted to Sec. 165. However, restitution paid in lieu of a fine, as in Allied-Signal, is nondeductible since it will be considered a fine and not a restitution payment.
Treasury’s Additional Extensions
Congress modified the Code to deny a business an ordinary and necessary deduction for fines and penalties in Sec. 162(f). Through regulations and other guidance, Treasury has extended this denial to deductions permitted under other Code sections.
Sec. 212 permits a deduction for expenditures incurred to produce income. Regs. Sec. 1.212-1(p) states that no deduction is allowed under Sec. 212 for the payment of a fine or penalty that would not be deductible under Sec. 162(f). Therefore, the regulations extend the denial of a deduction for fines and penalties from primary businesses to secondary businesses and other income-producing activities. This consistent approach (primary and secondary business) adopted by Treasury results in treating taxpayers engaged in all income-producing activities equally.
Treasury also extended the rule to an indirect deduction. The flush language under Regs. Sec. 1.471-3, Inventories at Cost, states: “Notwithstanding the other rules of this section, cost shall not include an amount which is of a type for which a deduction would be disallowed under section 162(c), (f), or (g).” In other words, the cost of inventory will not include fines or penalties paid. It is highly unlikely that any court would accept the argument that a fine or penalty was a necessary cost to obtain inventory. Therefore, by denying this inclusion, the regulation prevents these expenditures from becoming indirectly deductible by increasing the cost of goods sold.
The IRS applied the rule even more expansively in Technical Advice Memorandum 200629030. 47 In this ruling, the taxpayer was facing a possible fine for violating federal environmental law. The taxpayer agreed to a settlement of all claims with the government. The settlement required the taxpayer to build a beneficial environmental project (BEP). The taxpayer capitalized and depreciated the cost of the project, but the IRS denied part of the depreciation. The question raised by the letter ruling is whether the total costs of the BEP were capitalizable under Secs. 263A or 1012.
The initial inquiry was whether the expenditures would be nondeductible under Sec. 162(f) if they were not capitalizable. The taxpayer argued that since no fine or penalty was ever levied and formal proceedings were not opened, Sec. 162(f) did not apply. The government, based on the origin of the claim doctrine, looked beyond the fact that no fine had been levied to conclude that the expenditures had their origin in an environmental law violation and were incurred to prevent the imposition of a fine. Since they were in lieu of a fine that was designed to be punitive, the expenditures met the definition of a fine or penalty under Sec. 162(f). This is consistent with the regulations under Sec. 162(f) that deny a deduction for settlements of actual or potential criminal or civil fines and penalties.
Having ruled that the expenditures were the equivalent of a fine, the government examined the rules of Sec. 263A. Under Sec. 263A(a)(2), only expenses that would be deductible absent Secs. 263(a) and 263A are capitalizable. Since these expenditures would not be deductible because of Sec. 162(f), they are not included in the depreciable basis of an asset under Sec. 263A.
Finally, the government turned to Sec. 1012. Nothing in this section or its regulations makes any reference to fines, penalties, or Sec. 162(f). However, according to the government, the violation of public policy doctrine applies to Sec. 1012, and therefore the taxpayer may not include these amounts in basis. The government acknowledged that the doctrine was codified and limited in Sec. 162(f). However, in the absence of Code or regulation, the IRS argues that as a common law rule of federal income tax law, the doctrine continues to apply. The implication is that the IRS can apply the broad judicial doctrine in any case where Congress or Treasury have not specifically limited it to fines or penalties.
Observation: A better argument would be that allowing the expenditure to be capitalized would have resulted in an indirect deduction, which would conflict with Treasury’s policy as stated in Regs. Sec. 1.471-3(d) and Sec. 263A discussed above.
Although the ruling’s broad conclusions are subject to questions, disallowing an indirect deduction through depreciation in this case, for an amount that would be nondeductible under Sec. 162(f), is a reasonable application of the intent of Congress.
Sec. 165 permits taxpayers to deduct losses not compensated by insurance. Losses deductible by individuals are limited by Sec. 165(c) to losses incurred in a business, a transaction entered into for profit, and casualty and theft losses. Neither the Code nor the regulations has been changed to address the violation of public policy doctrine as it applies to losses under Sec. 165 following the passage of Sec. 162(f).
In Richey, 48 a case that predates the enactment of Sec. 162(f), the taxpayer deducted $15,000 under Sec. 165. The loss arose as part of a plan to counterfeit U.S. currency, which was in fact a plan to defraud the taxpayer of money. The Tax Court denied the deduction on the grounds that it would violate the clearly defined policy against counterfeiting money. Therefore, the rules for nondeductibility of expenditures that violate public policy were consistent under Secs. 162 and 165 prior to 1969.
The IRS believes, despite the enactment of Sec. 162(f), that it can still deny deductions under Sec. 165 based on a violation of public policy. In Rev. Rul. 77-126, 49 the IRS stated that the public policy doctrine still applies to Sec. 165 since Congress did not change this section when it enacted Sec. 162(f). The IRS repeated this conclusion in Rev. Ruls. 81-24 and 82-74. 50
The Tax Court and other courts have also held that the public policy doctrine still applies. The Tax Court used the violation of public policy to deny a deduction in Mazzei, 51 another counterfeiting scheme, under Sec. 165 following enactment of Sec. 162(f). The majority felt that the case was ruled by Richey and did not discuss what, if any, impact Sec. 162(f)’s enactment had on the viability of the doctrine or the precedential value of cases decided before its enactment.
Similarly, in Wood, 52 a case involving a forfeiture related to illegal drug smuggling, the Fifth Circuit disallowed a loss under Sec. 165 because it would violate public policy. As authority the court cited Holt, 53 another drug forfeiture case, which also disallowed a loss using the public policy doctrine. Holt, in turn, cited pre-1969 cases without discussing the impact of the enactment of Sec. 162(f). Reviewing the post-1969 cases that have applied the public policy doctrine, each relied on a pre-1969 precedent.
Not all courts and judges have ignored the enactment of Sec. 162(f) while analyzing deductions under Sec. 165. For example, the dissent in Mazzei points out that Congress, when it enacted Sec. 162(f), stated that public policy beyond fines and penalties was not defined clearly enough to deny a deduction. The dissent would therefore not apply the doctrine under Sec. 165 to deny deductions. The Second Circuit raised the question in Stephens, finding that “the public policy considerations embodied in Section 162(f) are highly relevant in determining whether the payment . . . was deductible under Section 165.” 54 The Tax Court majority raised but did not address the question of the effect of the enactment of Sec. 162(f) on the public policy doctrine in Medeiros. 55
The authors believe that the enactment of Sec. 162(f) does affect the application of the public policy doctrine under Sec. 165 and endorse the approach taken by the Tax Court and the Second Circuit in Murillo. 56 In this case, the courts limited the denial of a deduction to an expenditure that was the equivalent of a fine by applying the rules of Sec. 162(f) rather than a general public policy doctrine to Sec. 165. By limiting the denial of deductions to fines and penalties, the courts would apply Sec. 165 consistently with Congress’s and Treasury’s approach to Secs. 162, 212, 471, and 263A. This approach is consistent with the congressional belief as stated in the committee reports on Sec. 162(f) that public policy in other cases is too uncertain to be applied consistently and reasonably. It also eliminates the perceived conflict in prior court decisions regarding when public policy is sufficiently clear and the resultant frustration sufficiently severe to justify denying a loss deduction. It is hoped that future court decisions will limit the denials under Sec. 165 to items nondeductible under Sec. 162(f).
It has been argued that Congress did not intend to limit the public policy doctrine to fines and penalties. One commentator 57 points out that the complete statement in the Senate report states that
[t]he provision for the denial of the deduction for payments in these situations which are deemed to violate public policy is intended to be all inclusive. Public policy, in other circumstances, generally is not sufficiently clearly defined to justify the disallowance of deductions. 58
The commentator argues that the use of the word “generally” indicates that there are cases beyond fines and penalties where Congress intended that the violation of public policy doctrine should apply.
Congress enacted Secs. 162(c) and (g) at the same time as Sec. 162(f). Sec. 162(c) denies a deduction for illegal bribes, kickbacks, and other payments, while Sec. 162(g) denies a deduction for treble damage payments under antitrust law. The authors believe that the Senate report uses the word “generally” to acknowledge that the deduction denied in Secs. 162(c) and (g), similar to the fines and penalties under Sec. 162(f), is denied under the violation of public policy doctrine, rather than to imply that additional expenditures should be denied under the doctrine.
The authors propose that the use of the violation of public policy doctrine under Sec. 165 be limited to expenditures that would be nondeductible under Sec. 162(f). To analyze this proposal, we review three troublesome issues: forfeitures, casualties, and thefts.
Holt is a typical forfeiture case. 59 The taxpayer was engaged in transporting and selling marijuana. He was arrested and his truck, which he was using to transport the drugs, was seized and forfeited. The Tax Court held Sec. 165, not Sec. 162, governed the losses sustained from the forfeiture. It held that the deduction should be disallowed because allowing it would violate public policy.
Wood is another forfeiture case. 60 The taxpayer received commissions on sales of marijuana and invested those commissions in real estate. He pled guilty to importing marijuana and forfeited the real estate since it was purchased with money he earned from his marijuana activities. The Fifth Circuit held that the difference between a forfeiture of property used in a drug business and property acquired with profits from the illegal business was immaterial. It then cited Holt to conclude that the loss was nondeductible under Sec. 165 because it violated public policy.
The court considered and rejected Wood’s argument that his case was distinguishable from prior cases because his forfeiture was a civil action and not a criminal action. In the court’s opinion, all forfeitures related to drug trafficking are economic penalties that augment the criminal fines and penalties, so deducting them would violate the public policy doctrine.
In Murillo, the Second Circuit took a better approach to the problem that incorporated Sec. 162(f). 61 The taxpayer pled guilty to structuring bank accounts to avoid federal financial reporting requirements. He forfeited some unrelated individual retirement accounts as part of the plea agreement. Since he had previously reported the accounts as income, he claimed a loss on the forfeiture. Although the court referred to the public policy doctrine, it concluded that the forfeiture was nondeductible because it was a fine or penalty as defined in Sec. 162(f). It cited the Supreme Court’s decision in Bajakajian, 62 a nontax case, for the conclusion that all forfeitures are fines if they constitute punishment even in part. Therefore, based on Murillo and Bajakajian, all forfeitures that have punitive aspects are fines and would be nondeductible using the recommended approach without having to rely on the old violation of public policy doctrine.
The second issue to consider is the deduction of casualty losses under Sec. 165. In Blackman, 63 the taxpayer’s employer transferred him from Baltimore to South Carolina. His wife did not like South Carolina and so moved back to Baltimore. On a visit to Baltimore, the taxpayer found another man living with his wife. The taxpayer and his wife quarreled, and several days later he went to their house and took some of her clothes, put them on the stove, and set them on fire. The fire spread throughout the house and destroyed it. The taxpayer claimed a loss under Sec. 165.
The IRS conceded that the taxpayer suffered a loss due to the fire but argued that the loss was nondeductible since it was set intentionally and allowing the deduction would violate public policy. The Tax Court stated that the taxpayer was entitled to a casualty loss deduction unless he was grossly negligent. It found that he was grossly negligent and that the public policy doctrine barred the deduction. The conclusion is correct; however, the court could have simplified the analysis. For the fire loss to be deductible, it must qualify as a casualty. A fire that a taxpayer sets himself is not a casualty because it is a knowing and willful act by the taxpayer. 64 Therefore, the Tax Court could have ruled it nondeductible without having to resort to the violation of public policy doctrine. True casualties are deductible under Sec. 165(c); deliberate actions that violate public policy are not casualties. Therefore, the suggested approach to Sec. 165 will yield the correct outcome.
The final issue to be considered is the deduction of theft losses. Individuals normally can deduct theft losses under Sec. 165(c). However, if a co-conspirator in a related criminal venture perpetrates the theft, should the taxpayer be allowed a deduction?
In Edwards v. Bromberg, 65 the Fifth Circuit allowed the taxpayer to claim a deduction. The taxpayer gave money to an individual who told the taxpayer that he had fixed a horse race and the taxpayer’s money would be bet on the prearranged winner. In reality, the recipient kept the taxpayer’s money. The court allowed the deduction without any reference to the violation of public policy doctrine.
On the other hand, the Tax Court denied a deduction in Richey. 66 As previously mentioned, this was a putative counterfeiting scheme. The court denied the deduction on the grounds that allowing it would violate public policy. The court did not cite or refer to Edwards v. Bromberg.
The Tax Court reconsidered the deductibility of theft losses in Mazzei, 67 another putative counterfeiting scheme that resulted in the taxpayer’s being swindled out of funds he transferred. The court again used violation of public policy to deny the deduction. The court distinguished Edwards v. Bromberg on the grounds that the taxpayer in that case did not intend to participate in “fixing” the race. This distinction is questionable since the taxpayers in both Richey and Mazzei were not going to do the counterfeiting but were simply providing the cash to be used. This appears to be the same type of action as a taxpayer who supplies cash to be used to bet on a “fixed” horse race. One judge dissented on the grounds that Edwards v. Bromberg controlled the result, and another dissented on the grounds that it is possible to read the Senate report on Sec. 162(f) as restricting public policy to fines and penalties. Even if it is not so restricted, it does require limited use of the doctrine; this limited use is not justified under these facts, according to the second dissent.
The results of these three cases leave doubt as to which theft losses will be nondeductible under the public policy doctrine. The proposed approach of limiting the public policy exception to deductibility would permit the deduction, consistent with Edwards v. Bromberg. The authors believe that if Congress wants to deny these theft loss deductions, it must amend the Code. Currently, gambling losses are limited to the amount of gambling winnings reported in the same year. 68 If Congress adopted a similar approach for theft losses associated with criminal activities (i.e., limiting theft losses and other deductible expenditures in criminal activities to the income reported in the activities), it would settle the issue of violating public policy in a rational fashion and would also prevent criminal losses from offsetting legal income.
Over time the courts have developed a doctrine that denies a deduction for any expenditure that violates a narrowly defined public policy. In 1969, Congress codified this doctrine and limited it by enacting Sec. 162(f), which denies deductions for fines and penalties. Since 1969, the IRS and some courts have continued to apply the violation of public policy doctrine to deny deductions under Sec. 165 for losses other than those attributable to fines and penalties.
A better approach would be to deny losses under Sec. 165 for expenditures that would not be deductible under Secs. 162(c), (f), or (g). This would create a consistent rule for business expenditures and expenditures incurred to produce income. If Congress wants to deny expenditures that violate other specific public policies, such as criminal activities, it should amend the Code. Since the tax law originally was not designed to modify behavior, the amendment should limit the deduction to the amount of income reported from these “unacceptable” activities and behaviors.
1 King, “BP Seeks Tax Cut on Cleanup Costs,” Wall Street Journal A8 (July 28, 2010). See also Congressional Research Service, “Tax Deductible Expenses: The BP Case” (August 11, 2010).
2 James, 366 U.S. 213 (1961).
3 Sullivan, 274 U.S. 259 (1927).
4 The major exception is expenses related to the sale of illegal drugs, which are nondeductible under Sec. 280E.
5 For a more complete discussion of the policy issues, see Taggart, “Fines, Penalties, Bribes and Damage Payments and Recoveries,” 25 Tax L. Rev. 611 (1969–1970).
6 For a detailed discussion of the pre-1969 cases, see Manns, “Internal Revenue Code Section 162(f): When Does the Payment of Damages to a Government Punish the Payor?” 13 Va. Tax Rev. 271 (1993–1994).
7 Tellier, 383 U.S. 687 (1966).
8 Id. at 694, quoting Heininger, 320 U.S. 467, 473 (1943).
9 Id., quoting Lilly, 343 U.S. 90, 97 (1952).
10 Id., quoting Tank Truck Rentals, 356 U.S. 30, 35 (1958).
11 See, e.g., McDonald, 323 U.S. 57 (1944); Carey, 56 T.C. 477 (1971). The act also contained Sec. 162(c), denying deductions for bribes and illegal kickbacks, and Sec. 162(g), denying deduction for treble damages.
12 S. Rep’t No. 552, 91st Cong., 1st Sess., p. 274 (1969), 1969-3 C.B. 423, 597.
14 Regs. Sec. 1.162-21(a).
15 See Manns, “Internal Revenue Code Section 162(f),” note 6 above.
16 Tucker, 69 T.C. 675 (1978).
17 Middle Atlantic Distributors, Inc., 72 T.C. 1136 (1979). The issue of remedial versus punitive assessments is discussed in detail later in the article.
18 Adolf Meller Co., 600 F.2d 1360 (1979).
19 Southern Pacific Transp. Co., 75 T.C. 497 (1980).
20 See Smith, “Should Environmental Monetary Sanctions Be Tax Deductible?” 76 B.C. Envtl. Aff. L. Rev. 435 (Winter 1999).
21 Rev. Rul. 79-148, 1979-1 C.B. 93.
22 See Rev. Rul. 76-257, 1976-2 C.B. 52.
23 Bailey, 756 F.2d 44 (6th Cir. 1985).
24 Waldman, 88 T.C. 1384 (1987).
25 Allied-Signal Inc., 54 F.3d 767 (3d Cir. 1995).
26 IRS Letter Ruling 8704003 (10/3/86).
27 Middle Atlantic Distributors, Inc., 72 T.C. 1136 (1979).
28 Waldman, 88 T.C. 1384 (1987).
29 Allied-Signal, Inc., 54 F.3d 767 (3d Cir. 1995).
30 Colt Indus. Inc., 880 F.2d 1311 (Fed. Cir. 1989).
31 In Talley Indus., Inc., 116 F.3d 382 (9th Cir. 1997), the Ninth Circuit reversed the Tax Court’s decision to permit a deduction because a finding that a payment is compensatory for double jeopardy purposes did not automatically make it compensatory for purposes of Sec. 162(f). This case raises additional questions about the compensatory payment exception.
32 Bailey, 756 F.2d 44 (6th Cir. 1985).
33 Southern Pacific Transp. Co., 75 T.C. 497 (1980).
34 Field Service Advice 200146008 (11/16/01).
35 Middle Atlantic Distributors, Inc., 72 T.C. 1136 (1979); Bailey, 756 F.2d 44 (6th Cir. 1985).
36 General Counsel Memorandum 39596 (2/4/87). See also Smith, “Should Environmental Monetary Sanctions Be Tax Deductible?” note 20 above.
37 IRS Letter Ruling 7736040 (5/31/77).
38 Fresenius Med. Care Holdings, Inc., No. 08-CV-12118-PBS (D. Mass. 6/25/10). It should be noted that the government based its argument on the Justice Department’s tracking document, the value of which has been questioned. See Elliott, “Tracking Document Is of Least Significance in Government Settlement Taxation, IRS Official Says,” 2010 TNT 186-7 (September 27, 2010).
39 Cavaretta, T.C. Memo. 2010-4.
40 Stephens, 905 F.2d 667 (2d Cir. 1990), rev’g 93 T.C. 108 (1989).
41 Ostrom, 77 T.C. 608 (1981).
42 Helvering v. Hampton, 79 F.2d 358 (9th Cir. 1935).
43 James E. Caldwell & Co., 234 F.2d 660 (6th Cir. 1956).
44 Rev. Rul. 80-211, 1980-2 C.B. 57.
45 Lohrke, 48 T.C. 679 (1967).
46 Musgrave, T.C. Memo. 1997-19.
47 IRS Technical Advice Memorandum 200629030 (7/21/06).
48 Richey, 33 T.C. 272 (1959).
49 Rev. Rul. 77-126, 1977-1 C.B. 47.
50 Rev. Ruls. 81-24, 1981-1 C.B. 79; and 82-74, 1982-1 C.B. 110.
51 Mazzei, 61 T.C. 497 (1974).
52 Wood, 863 F.2d 417 (5th Cir. 1989).
53 Holt, 69 T.C. 75 (1977).
54 Stephens, 905 F.2d 667 (2d Cir. 1990), rev’g 93 T.C. 108 (1989).
55 Medeiros, 77 T.C. 1255 (1981).
56 Murillo, 166 F.3d 1201 (2d Cir. 1998), aff’g T.C. Memo. 1998-13.
57 Pace, “The Tax Deductibility of Punitive Damage Payments: Who Should Ultimately Bear the Burden for Corporate Misconduct?” 47 Ala. L. Rev. 825 (1996).
58 S. Rep’t No. 552, 91st Cong., 1st Sess., p. 274 (1969).
59 Holt, 69 T.C. 75 (1977).
60 Wood, 863 F.2d 417 (5th Cir. 1989).
61 Murillo, 166 F.3d 1201 (2d Cir. 1998), aff’g T.C. Memo. 1998-13.
62 Bajakajian, 524 U.S. 321 (1998).
63 Blackman, 88 T.C. 677 (1987).
64 See White, 48 T.C. 430 (1967); Rev. Rul. 81-24, 1981-1 C.B. 79.
65 Edwards v. Bromberg, 232 F.2d 107 (5th Cir. 1956).
66 Richey, 33 T.C. 272 (1959).
67 Mazzei, 61 T.C. 497 (1974).
68 Sec. 165(d).
Edward Schnee is the Hugh Culverhouse Professor of Accounting and director of the MTA Program at the University of Alabama in Tuscaloosa, AL. Eugene Seago is the R. B. Pamplin Professor of Accounting at Virginia Polytechnic Institute and State University in Blacksburg, VA. For more information about this article, contact Prof. Schnee at email@example.com.