IRS disallows deductions for fines, penalties

The IRS recently released Chief Counsel Advice (CCA202439015), concluding that a taxpayer’s deductions for payments made to a government agency and for certain customer debt forgiveness pursuant to a court order were disallowed fines or penalties under Section 162(f). The determination hinged on whether the payments could qualify for the exception under Section 162(f)(2)(A) for restitution payments or payments to come into compliance with the law.

Section 162(f)(1) generally provides that no deduction shall be 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. An exception to the general disallowance rule is provided in Section 162(f)(2)(A) for amounts constituting restitution or paid to come into compliance with the law.

Under this exception, the general disallowance rule does not apply to amounts that meet both the following requirements:

• The taxpayer establishes the amounts were paid or incurred as restitution or to come into compliance with a law (establishment requirement)
• The amounts are identified in a court order or settlement agreement as restitution, remediation, or amounts paid to come into compliance a law (identification requirement).

The IRS issued final regulations under Treas. Reg. Sec. 1.162-21 in January 2021, implementing Section 162(f) and providing additional guidance regarding the identification and establishment requirements. However, the IRS stated that the final regulations do not apply to taxpayer’s payments and debt forgiveness because the court order became binding prior to the effective date of the final regulations.

The memorandum is very light on facts, but states that pursuant to a court order, the taxpayer in the CCA made payments to a government agency and the taxpayer’s wholly owned S Corporation forgave debt issued to customers presumably with respect to the taxpayer’s violation of governmental agency laws. In accordance with the terms of the court order, all amounts paid to the government agency were to be deposited into a fund administered by the government agency for equitable relief including consumer redress. Any amounts that were not used for equitable relief were to be deposited with U.S. Treasury as disgorgement. The facts do not provide any details regarding the debt forgiveness to customers.

The IRS concluded that the taxpayer’s payments and debt forgiveness did not meet the identification requirement because the court order did not specifically state that such payments and debt forgiveness constituted restitution, or an amount paid to come into compliance with any law. Further, the IRS asserted that the taxpayer failed to meet the establishment requirement because the taxpayer did not provide any documentation with respect to how the government agency used the amounts, nor with respect to how the debt forgiveness provided restitution to the victims harmed. Citing the Tax Court decision in Ziroli v. Commissioner (T.C. Memo. 2022-75) the IRS reasoned that amounts paid to the government for its discretionary use do not constitute restitution and disgorged amounts deposited to a general account of the government do not constitute restitution. 

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