Court-ordered payments to a regulator and related customer-debt forgiveness are nondeductible under § 162(f)

Plain-English summary

A taxpayer paid money to a government agency under a court order for violating that agency's laws, and the taxpayer's wholly owned S corporation forgave debt owed by the taxpayer's customers, also as the order required. The taxpayer deducted both the payments and the forgiven debt on a Form 1040. A field attorney asked Chief Counsel whether the deductions survive. The advice: no. Section 162(f)(1) bars any deduction for amounts paid to a government in relation to the violation of a law. The restitution exception in section 162(f)(2) does not apply for two independent reasons. First, the court order never identifies the payments or the debt forgiveness as "restitution" or as amounts "paid to come into compliance" with a law, which the statute requires. Second, the taxpayer did not establish that the money actually compensated victims: the agency had discretion over how to spend it (consumer redress was permitted, not required), and any leftover money went to the U.S. Treasury as disgorgement. Payments left to the government's discretion, and disgorgement into the general Treasury, are not restitution (citing Ziroli v. Commissioner). The 2021 final regulations under section 1.162-21 did not apply because the order predated them. The takeaway: to deduct a court-ordered payment to a regulator, the order itself must label the amount as restitution or compliance, and the taxpayer must be able to prove the money reached the harmed parties.

Ruling snapshot

• Question: Does § 162(f)(1) disallow deductions for court-ordered payments a taxpayer made to a government agency (and for debt the taxpayer's S corporation forgave to customers) when the agency may use the money for consumer redress but any remainder goes to the Treasury?
• Outcome: advice given (both deductions disallowed)
• Key authorities: IRC § 162(f)(1); § 162(f)(2)(A) exception (identification and establishment requirements); Treas. Reg. § 1.162-21; Ziroli v. Commissioner, T.C. Memo. 2022-75

Full text (IRS public release)

Office of Chief Counsel
Internal Revenue Service

memorandum

Number: 202439015
Release Date: 9/27/2024

CC:ITA:B01 EKirman
POSTS-124699-23

Third Party Communication: None
Date of Communication: Not Applicable

UILC: 162.21-01

date: June 13, 2024

to: Kevin Coy, Senior Counsel
(Small Business/Self-Employed)

from: Sharon Y. Horn, Senior Counsel
(Income Tax & Accounting)

subject: Application of § 162(f)[1]

This Chief Counsel Advice responds to your request for assistance. This advice may
not be used or cited as precedent.

LEGEND

Taxpayer = ------------------
Government Agency = ---------------------------------------------
Date = ---------------------------
Payments = -----------------------------------------------------------------------------

Tax Year = --------------------------

ISSUES

1. Whether § 162(f)(1) disallows Taxpayer's deduction for amounts (including
   amounts from the sale of Taxpayer's surrendered assets) Taxpayer paid to
   Government Agency, pursuant to a court order, for Taxpayer's violation of
   Government Agency laws if Government Agency may use the money for
   consumer redress and pays any remaining amount to the U.S. Treasury.

[1] § 162(f) as amended by the Tax Cuts and Jobs Act, Pub. L. No. 115–97, 131 Stat. 2126, § 13306(a) (2017).

2. Whether § 162(f) disallows Taxpayer's deduction for the forgiveness, by
   Taxpayer's wholly owned S corporation, of debt issued to Taxpayer's customers
   as required by the court order.

CONCLUSIONS

1. Section 162(f)(1) disallows Taxpayer's deductions for amounts paid to
   Government Agency, pursuant to the order, in relation to the violation of any law.

2. Section 162(f)(1) disallows Taxpayer's deduction for the forgiveness, by
   Taxpayer's wholly owned S corporation, of debt issued to Taxpayer's customers.

The exception, under § 162(f)(2), to the general disallowance rule does not apply
because the order does not identify Payments as restitution or an amount paid to come
into compliance with the law and Taxpayer failed to establish that either the amount
paid or the debt forgiven constitutes restitution.

FACTS

Pursuant to a Date court order, (1) Taxpayer made Payments to Government Agency
and (2) Taxpayer's wholly owned S corporation forgave debt issued to Taxpayer's
customers. On Taxpayer's Form 1040 for Tax Year, Taxpayer claimed a deduction for
Payments and the debt forgiveness.

The court order states:

  All money paid to the Government Agency pursuant to this Order may be
  deposited into a fund administered by the Government Agency or its
  designee to be used for equitable relief, including consumer redress and
  any attendant expenses for the administration of any redress fund. If a
  representative of the Government Agency decides that direct redress to
  consumers is wholly or partially impracticable or money remains after
  redress is completed, the Government Agency may apply any remaining
  money for such other equitable relief (including consumer information
  remedies) as it determines to be reasonably related to Defendants'
  practices alleged in the Complaint. Any money not used for such equitable
  relief is to be deposited to the U.S. Treasury as disgorgement.

Taxpayer did not provide any documents to the Service with respect to how
Government Agency used the amounts Taxpayer paid pursuant to the court order.

LAW

Section 162(f)(1) provides:

  [N]o deduction otherwise allowable shall be allowed [under chapter 1] for
  any amount paid or incurred (whether by suit, agreement, or otherwise) 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.

Section 162(f)(2)(A) provides an exception from the general disallowance rule for an
amount that (in relevant part):

  (i) the taxpayer establishes—

        (I) constitutes restitution (including remediation of property) for
        damage or harm which was or may be caused by the violation of
        any law or the potential violation of any law, or

        (II) is paid to come into compliance with any law which was violated
        or otherwise involved in the investigation or inquiry described in
        paragraph (1), [and]

  (ii) is identified as restitution or as an amount paid to come into
  compliance with such law, as the case may be, in the court order or
  settlement agreement.

On January 19, 2021, the Treasury and the IRS issued final regulations under § 1.162-
21, implementing § 162(f). The final regulations apply to taxable 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 § 1.162-21(e)(4)(A)(4)(B) of the regulations contains rules for
treating disgorgement as restitution, the final regulations do not apply to Taxpayer's
deduction because Taxpayer's Payments and the debt forgiveness were pursuant to the
Date court order.

In Ziroli v. Commissioner, T.C. Memo. 2022-75, the Tax Court considered whether pre-
TCJA § 162(f)[2] and the related regulations[3] disallowed petitioner's § 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. Petitioner argued
that the disgorgement was intended to be compensatory and therefore deductible. Ziroli,
slip op. at 7. The court disallowed the deduction because petitioner did not prove that
the intent of disgorgement was compensatory, not a "fine or similar penalty." Id., slip op.
at 12.

ANALYSIS

The court order required Taxpayer to make Payments to Government Agency and
required Taxpayer's S Corporation to forgive consumer debt with respect to Taxpayer's
violation of Government Agency laws. Therefore, unless an exception under § 162(f)(2)
applies, both Payments and the debt forgiveness, which otherwise may have given rise
to allowable deductions under chapter 1 of the Internal Revenue Code and the
Regulations thereunder, fall squarely within the general disallowance rule of
§ 162(f)(1).

[2] Pre-TCJA § 162(f) provides that "[n]o deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law."
[3] § 1.162-21(b), T.D. 7345, 40 FR 7437 (1975); 40 FR 8948 (1975), as amended by T.D. 7366, 40 FR 29290 (1975).

Taxpayer argues that the restitution exception under § 162(f)(2) applies to allow
Taxpayer's deduction for 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."

Taxpayer is mistaken. The court order does not meet the identification requirement
under § 162(f)(2)(A)(ii) because it does not specifically state that Payments or the debt
forgiveness constitute "restitution" or an amount "paid to come into compliance with any
law." Moreover, assuming, but not conceding, that the order's use of the word "redress"
could meet the identification requirement, the court order still fails to meet the
requirement because the court order provides that Government Agency may, but does
not have to, use Payments to provide consumer redress. Amounts paid to the
government for its discretionary use do not constitute restitution. See Ziroli, T.C. Memo.
2022-75, slip op. at 7 (the court stated that, even if the SEC 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, Taxpayer failed to meet the establishment requirement under
§ 162(f)(2)(A)(i) because Taxpayer did not provide documentation to support Taxpayer's
claim that Government Agency's use of the Payment, or the debt forgiveness, provided
restitution to the victims harmed by Taxpayer's actions. Further, 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." Disgorged amounts deposited to the general account of the
government do not constitute restitution. See id., slip op. at 10-11 (the court in Ziroli
found no support for petitioners' 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 does not meet the identification requirement and Taxpayer has
not met the establishment requirement, the exception under § 162(f)(2) does not apply
to allow the deduction. Therefore, § 162(f)(1) disallows Taxpayer's deductions for
Payments and the debt forgiveness, as required by the court order, for Taxpayer's
violation of Government Agency law.

CASE DEVELOPMENT AND POTENTIAL HAZARDS

Case Development
Based on the documents we reviewed, we suggest the Service confirm the following: (1)
the amount of Taxpayer's deduction, (2) the amount the liquidator received from the
sale of the surrendered assets and the amount it turned over to Government Agency;
and (3) the amount of debt forgiven.

Potential Hazards
Although § 162(f) applies to the tax year at issue, the related regulations under
§ 1.162-21, providing rules for treating disgorgement as restitution, do not. [remainder of this paragraph redacted]

[4] [redacted]