Violation of public policy and the denial of deductions.

• Author: Schnee, Edward J.

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.

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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 Sees. 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.

Sec. 162(f)

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 [162] (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)

Civil Penalties

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) stared 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. (14) 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 he 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.

Compensatory Damages

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...