Restitution Payments are Tax Deductible

Restitution payments are now tax deductible

Restitution Payments are Tax Deductible

Restitution Payments are Tax Deductible

Restitution payments are now tax deductible

Author: James F. McDonough|September 25, 2015

The IRS recently issued a final private letter ruling which held that a principal of a business could deduct the amount of money paid as restitution in a business crime plea deal. This ruling was significant because while Sec. 162(f) states that no fines or penalties paid for violation of a law are tax deductible, Sec. 162(b)(2) provides that compensatory damages paid to any entity do not constitute a fine or penalty. Treas. Reg. Sec. 1.162-21(b)(2) provides that a fine or penalty includes an amount paid in settlement of a taxpayer’s actual or potential liability in a civil or criminal matter. The same regulation provides that compensatory damages paid to the government do not constitute a fine or penalty.

The Case

In this case, the taxpayer was the principal of his company and was compensated for his work on a particular sale. The U.S. prosecuted the company for the sale of its products and services and the taxpayer pleaded guilty to two criminal counts and was sentenced to incarceration, probation and a fine as a result. However, the taxpayer then entered into a cooperation agreement with the U.S., for which he agreed to pay restitution to the government.

The court then found that the taxpayer owed four times the amount in question in restitution, and the government incurred three times that amount in real losses. Further, the restitution judgment was imposed separately from punitive sentence, which meant that the restitution judgment was intended to pay the government, and not part of the punitive damages. Therefore, the taxpayer did not receive indemnification for the restitution payments.

The Ruling

The court concluded that the taxpayer's restitution payments were tax deductible because the payment was not part of the punitive fine, and thus a business expense. In its decision, the court determined that the facts indicated that the restitution was intended to compensate the government for its actual losses. Then, for the taxpayer's conduct, he was sentenced to imprisonment with a fine. So the court determined that since the restitution ruling and the sentence were made independent of one another at different times, the payments were not part of the fine under Sec. 162(f). The independence of these events is significant to obtaining the deduction.

A second issue of contention for the court was the distinction between business expenses and personal expenditures as determined in United States v. Gilmore. In Gilmore, the Supreme Court ruled that since the payments were the result of criminal activities related to the taxpayer's business, the ruling did not impact the personal wealth of the taxpayer. Therefore, it was clear that the illegal activities were within the normal course of business functions, regardless if they violated a law.  It is worth noting that the taxpayer was no longer employed by the company, which denied wrongdoing, and was no longer engaged in the trade or business at the time the restitution payment was made.

We do not know if the separation of the criminal proceeding from the restitution proceeding was intentional on the part of taxpayer’s counsel, but the tax result was positive.

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About Author James F. McDonough

James F. McDonough

James F. McDonough, Jr. concentrates on wealth preservation and estate planning for high net worth individuals, closely held business matters and ownership succession, estate administration and income tax planning.

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