No Deduction Allowed for S Corp's Payments to Government Agency

(Parker Tax Publishing September 2024)

The Office of Chief Counsel advised that Code Sec. 162(f) disallowed a taxpayer's deduction for amounts the taxpayer paid to a government agency pursuant to a court order for the taxpayer's violation of law and for debt issued to the taxpayer's customers that the taxpayer forgave as required by the court order. The Chief Counsel's Office found that the court order did not qualify for the exception in Code Sec. 162(f)(2)(A) because it did not specifically state that the payments or the debt forgiveness constituted restitution or amounts paid to come into compliance with any law. CCA 202439016.

Background

The Office of Chief Counsel was asked whether a taxpayer was permitted to deduct (1) amounts it paid to a government agency under a court order for the taxpayer's violation of law and (2) amounts representing debt issued to the taxpayer's customers that was forgiven by the taxpayer's wholly owned S corporation as required by the court order.

The court order stated that all money paid to the government agency pursuant to the order was to be deposited into a fund administered by the government agency to be used for "equitable relief, including consumer redress and any attendant expenses for the administration of any redress fund." The order further stated that if any money remained after redress was completed, the government agency could apply any remaining money for such other equitable relief as it determined to be reasonably related to the taxpayer's practices, and any money not used for such equitable relief was to be deposited to the U.S. Treasury as "disgorgement."

Under Code Sec. 162(f)(1), no deduction is allowed for any amount paid or incurred "to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law." An exception is provided in Code Sec. 162(f)(2)(A) for an amount that constitutes restitution for damage or harm caused by the violation of law or is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry and that is identified as restitution or as an amount paid to come into compliance with the law in the court order or settlement agreement.

On January 19, 2021, the IRS issued final regulations under Reg. Sec. 1.162-21 implementing Code Sec. 162(f). The final regulations apply to tax years beginning on or after that date but do not apply to amounts paid under any order or agreement, pursuant to a suit, agreement, or otherwise, that became binding under applicable law before such date. Although Reg. Sec. 1.162-21(e)(4)(A)(4)(B) of the regulations contains rules for treating disgorgement as restitution, the final regulations did not apply to the taxpayer's deduction because the taxpayer's payments and the debt forgiveness were pursuant to court order entered before the regulations went into effect.

In Ziroli v. Comm'r, T.C. Memo. 2022-75, the Tax Court considered whether Code Sec. 162(f), as in effect before the enactment of the Tax Cuts and Jobs Act of 2017, disallowed a taxpayer's Code Sec. 162(a) ordinary and necessary business expense deduction for disgorgement paid to the United States Treasury to settle civil liabilities for violations of federal securities law. The taxpayer in that case argued that the disgorgement was intended to be compensatory and therefore deductible. The court disallowed the deduction because the taxpayer did not prove that the intent of disgorgement was compensatory, not a "fine or similar penalty."

In this case, the taxpayer argued that the restitution exception under Code 162(f)(2) applied to allow the taxpayer's deduction for the payments because the court order "made reference to equitable monetary relief and consumer redress, and no reference to either a fine or penalty, and further that the amount of the settlement itself was reduced as a result of consumer debt relief."

Analysis

The Office of Chief Counsel concluded that (1) Code Sec. 162(f)(1) disallowed the taxpayer's deductions for amounts paid to the government agency, pursuant to the order, in relation to the violation of any law; and (2) Code Sec. 162(f)(1) also disallowed the deduction for the forgiveness, by the taxpayer's wholly owned S corporation, of debt issued to the taxpayer's customers.

According to the Chief Counsel's Office, the court order did not meet the identification requirement under Code Sec. 162(f)(2)(A)(ii) because it did not specifically state that the payments or the debt forgiveness constituted "restitution" or an amount "paid to come into compliance with any law." Moreover, the Chief Counsel's Office found that even if the order's use of the word "redress" could meet the identification requirement, the order still failed to meet the requirement because the order provided that the government agency may, but does not have to, use the payments to provide consumer redress. The Chief Counsel's Office explained that under Ziroli, amounts paid to the government for its discretionary use do not constitute restitution. In Ziroli, the Tax Court stated that, even if the Securities and Exchange Commission distributed the disgorged amounts to harmed investors, "courts have held that any post hoc exercise of discretion by the government to use the disgorged funds to compensate victims does not transform the payment from a penalty into compensatory damages."

In addition, the Office of Chief Counsel advised that the taxpayer failed to meet the establishment requirement under Code Sec. 162(f)(2)(A)(i) because the taxpayer did not provide documentation to support the taxpayer's claim that the government agency's use of the payment, or the debt forgiveness, provided restitution to the victims harmed by the taxpayer's actions. Further, the Chief Counsel's Office noted that pursuant to the court order "[a]ny money not used for such equitable relief is to be deposited to the U.S. Treasury as disgorgement." Under Ziroli, disgorged amounts deposited to the general account of the government do not constitute restitution. The Chief Counsel's Office noted that the court in Ziroli found no support for the taxpayer's argument that disgorgement to the United States Treasury compensated the government and, thus, "presume[d] that the disgorgement was imposed by the government to protect the general welfare, not to compensate itself for any losses."

Because the court order did not meet the identification requirement and the taxpayer failed to meet the establishment requirement, the exception under Code Sec. 162(f)(2) did not apply to allow the deduction. Therefore, the Chief Counsel/'s Office found that Code Sec. 162(f)(1) disallowed the taxpayer's deductions for the payments and the debt forgiveness, as required by the court order, for the taxpayer's violation of law.

For a discussion of the disallowance of a deduction for fines and penalties under Code Sec. 162(f), see Parker Tax ¶96,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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