Payments for law violation are not deductible restitution

Editor: Greg A. Fairbanks, J.D., LL.M.

In Chief Counsel Advice memorandum (CCA) 202439015, the IRS Chief Counsel’s Office determined that deductions claimed by a taxpayer for payments made to a government agency and for certain customer debt forgiveness under a court order are disallowed as fines or penalties under Sec. 162(f). The Chief Counsel’s Office examined the exception under Sec. 162(f)(2) for amounts that qualify as restitution or are paid to comply with the law, concluding that the necessary establishment and identification requirements were not satisfied.

Sec. 162(f)(1) stipulates that deductions are generally disallowed for any payments made to, or at the direction of, a government or governmental entity in connection with the violation of any law. However, Sec. 162(f)(2)(A) provides an exception to this rule for amounts that are either restitution or payments made to comply with the law.

To qualify for this exception: (1) The taxpayer must demonstrate that the amounts were paid or incurred as restitution or to come into compliance with a law (establishment requirement), and (2) the amounts must be identified in a court order or settlement agreement as restitution, remediation, or payments made to come into compliance with a law (identification requirement).

In January 2021, Treasury and the IRS issued final regulations under Regs. Sec. 1.162-21, implementing Sec. 162(f) and offering further guidance on the identification and establishment requirements. However, these final regulations did not apply to the taxpayer’s payments and debt forgiveness, as the court order became binding before the regulations’ effective date.

Facts of the CCA

In accordance with a court order, (1) a taxpayer made payments to a government agency, and (2) the taxpayer’s wholly owned S corporation forgave debt owed by the taxpayer’s customers. According to the court order, any funds paid to the government agency could be deposited into a fund managed by the agency or its designee. The order earmarked these funds for equitable relief, including consumer redress and related administrative expenses. Any funds remaining after the redress efforts could be allocated to other equitable relief measures, such as consumer information remedies. Any funds not used for equitable relief would be transferred to the U.S. Treasury as disgorgement.

The memorandum did not provide specific details regarding the debt forgiveness to customers. It is presumed that the debt forgiveness was related to the taxpayer’s violation of governmental agency laws.

Analysis

The Chief Counsel’s Office concluded that the taxpayer’s payments and debt forgiveness did not satisfy the identification requirement, as the court order did not “specifically state that Payments or the debt forgiveness constitute ‘restitution’ or an amount ‘paid to come into compliance with any law.'” Furthermore, even if the term “redress” as used in the court order could meet the identification requirement, the government agency had discretion over the use of those funds. Citing the Tax Court decision in Ziroli, T.C. Memo. 2022-75, the Chief Counsel’s Office reasoned that amounts paid to the government for its discretionary use do not constitute restitution.

The Chief Counsel’s Office also asserted that the taxpayer in the CCA failed to meet the establishment requirement because the taxpayer did not provide any documentation regarding how the government agency used the amounts or how the debt forgiveness provided restitution to the harmed victims. Additionally, the Chief Counsel’s Office noted that under the court order, any money not used for equitable relief was required to be deposited to the U.S. Treasury as disgorgement and that under Ziroli, disgorged amounts deposited to the general account of the government do not constitute restitution.

Takeaways

While the final regulations do not apply to the taxpayer in the memorandum, the preamble to the final regulations in Regs. Sec. 1.162-21 clarifies that an order or agreement can satisfy the identification requirement even if it does not explicitly use terms such as “restitution,” “remediation,” “remediate,” “come into compliance,” or “comply.” The key is that “the nature and purpose of the payment, as described in the order or agreement, are clearly and unambiguously to restore the injured party.”

The CCA lacks an analysis explaining why the debt forgiveness to customers is not considered restitution thereby failing to meet the identification requirement. Furthermore, it is crucial to highlight that the taxpayer seemingly did not meet the establishment requirement not because the payments were not used for restitution, but because the taxpayer did not provide sufficient documentation to substantiate that they were.

Taxpayers should take note of this development and understand the importance of explicitly identifying payments as restitution, remediation, or compliance-related in any order or agreement to meet the identification requirement. Additionally, they must ensure proper documentation is provided to establish that the payments (or debt forgiveness) are indeed for restitution purposes.

Editor Notes

Greg A. Fairbanks, J.D., LL.M., is a tax managing director with Grant Thornton LLP in Washington, D.C.

For additional information about these items, contact Fairbanks at greg.fairbanks@us.gt.com.

Contributors are members of or associated with Grant Thornton LLP.