Publications: Denial of tax deductions on public policy grounds

Recent newspaper accounts indicate that British Petroleum will receive a $10 billion income tax refund for the money that it set aside to cover claims relating to the Deepwater Horizon disaster. Reports of this tax "windfall," and reports of similar "windfalls" associated with the settlements negotiated by some of the more notorious participants in the recent financial crisis, have renewed questions about whether and when payments associated with illegal or questionable conduct should be deductible for tax purposes. The history surrounding this issue is, to put it mildly, tortured; and the governing legal principals are, in many respects, still unclear. One important lesson to be drawn from all of this is that great care needs to be exercised in documenting settlement payments in this area in order to avoid the loss of a potential tax benefit for clients and avoid protracted litigation with the IRS over the tax treatment of a settlement payment.

Prior to 1969, there was no provision in the Internal Revenue Code dealing specifically with these issues. In Commissioner v. Sullivan ,the Supreme Court held that expenses paid by a bookmaker were deductible even though the underlying activity was itself illegal. Later, in Commissioner v. Tellier , the Supreme Court permitted a deduction for legal fees paid in the unsuccessful defense of criminal charges arising from the sale of securities. In Tellier , the court stated that a tax deduction would be denied under the public policy doctrine only where allowing the deduction would "… frustrate sharply defined national or state policies proscribing particular types of conduct. …" Closer to home, in Kane the tax court held that commercial kickbacks, prohibited under Illinois law, were deductible since they were found to be both "ordinary" and "necessary" in the taxpayer's industry and there was no "sharply defined" public policy in Illinois against this practice. The absence of any prosecutions under the Illinois commercial bribery stature was cited as evidence of the lack of any public policy prohibiting such payments in Illinois.

In the Tax Reform Act of 1969, Congress attempted to codify and bring some measure of clarity to the public policy doctrine through the enactment of Code §162(f). This provision provides that " … no deduction … [for a trade or business expenses] … shall be allowed … for any fine or similar penalty paid to a government for a violation of any law … " Regulations issued shortly after the enactment of this provision "clarified" the statutory language and held that the statute applied not only to fines paid as a result of a criminal conviction after a full trial on the merits, but also to fines resulting from a guilty plea or a plea of nolo contender. Additionally, the regulations provided that the statute was not limited to criminal proceedings, but also applied to civil penalties paid to federal, state and local authorities. Further, the regulations swept up payments made in connection with settlements of potential criminal or civil fines and penalties.

The initial issue that arose under the regulations involved the question of whether all civil penalties paid to governmental organizations were nondeductible. Although there was scant legal authority for the extension of Code §162(f) to purely civil matters by regulatory fiat, by 1972 the courts were fairly uniform in concluding that a civil assessment paid to the government that was designed to enforce a statute (i.e. , a punitive assessment) was nondeductible. However, civil assessments paid to the government which were compensatory in nature and computed based upon the harm done to the governmental unit or members of the public (i.e., a remedial assessment) are treated by most, but not all, courts as deductible expenses.

Obviously, the distinction between punitive and remedial sanctions and the issue of whether a remedial payment is being made in lieu of a punitive sanction, can become blurred. For example, in Allied Signal Inc. v. Commissioner of Internal Revenue, the taxpayer entered a nolo contendere plea in a criminal case involving water pollution caused by its manufacturing activities. The fine that was being considered by the court was in excess of $13 million. However, based on further discussions involving the court, prosecutors and the company, the fine was reduced based upon Allied Signal agreement to contribute $8 million to a trust established to cover the cost of remediation. In later litigation over the tax consequences of this payment, it was ultimately held that the $8 million payment was nondeductible since it was not a voluntary payment designed to compensate those harmed but rather was a quid pro quoexchange in consideration for a reduction of the criminal fine.

The IRS has also unsuccessfully attempted to extend Code §162(f) to civil penalties imposed by self-regulating organizations (such as the Chicago commodities exchanges) claiming that they were exercised government powers through statutory delegations of regulatory authority. However, since "SROs" are not government agencies, this argument has been abandoned. On the same theory, punitive damages awarded in litigation between private parties are generally treated as currently deductible since the amount in question is not paid, directly or indirectly, to the government, and the payment is not associated with any criminal prosecution.

The issue of deductibility often arises in connection with restitution payments. There, a preliminary issue is whether the restitution payment is being made in order to mitigate potential criminal sanctions or to reimburse the injured party. The analysis in these cases is further complicated by the fact that restitution payments are generally not treated as ordinary and necessary business expenses under Code §162 but rather are deemed to arise from transactions that are entered for profit and, therefore, are governed by Code §165. In this context, the courts generally concluded that Code §162(f) is not directly applicable, but rather, the public policy principles in existence before the enactment of Code §162(f) provide the legal basis for denial of any deduction.

Forfeiture provisions also give rise to a question of whether a tax loss can be claimed. As a general rule, based upon the Supreme Court decision in United States v. Bajakajian (a nontax case), courts generally conclude that forfeitures to the government are fines since they generally are intended to serve as punishment and, therefore, no tax loss can be claimed from such activity. Similarly, victims of theft can be denied a deduction if they are co-conspirators in actual or perceived criminal activity. For example, Richey v. Commissioner of Internal Revenue and Mazzei v. Commissioner of the Internal Revenue , individuals who were induced to participate in a fictitious counterfeiting scheme, and lost their own money in the process, were denied a theft loss on public policy grounds.

In addition to Code §162(f) (and Code §165), it should be noted that there are several other provisions that have been added over the years that are potentially relevant to this analysis. For example, Code §162(c) denies any deduction for illegal payments to governmental officials or employees, other illegal payments under any federal or a generally enforced state criminal law, and Medicare or Medicaid kickbacks, rebates and the like. Code §162(g) denies the deduction for two-thirds (i.e., the punitive portion) of the triple damages imposed in connection with a conviction for an anti-trust violation. Code §165(d) limits gambling losses to the gambling income reported in a given year. Code §280E denies the deduction for expenses incurred in drug activity.

Reprinted with Permission from Chicago Daily Law Bulletin.