Taxpayers who make payments in conjunction with a forfeiture action should attempt to understand the characterization of a payment to see if the specific payment can avoid being treated as a fine or penalty.
A taxpayer is generally not allowed to take a deduction for fines or similar penalties paid to a government for the violation of any law. For this purpose, a "government" includes the following: (1) the government of the United States, a state, a territory or possession of the United States, the District of Columbia, or the Commonwealth of Puerto Rico; (2) the government of a foreign country; or (3) a political subdivision of, or corporation or other entity serving as an agency or instrumentality of, any of the above.1 What is considered a fine or penalty paid to the government is very clear in many cases. There are instances, however, where the characterization of a payment as a fine or penalty is murky. It may also be unclear as to whether the payment of a fine or penalty is being paid to an instrumentality or agency of the government based on the nature of the organization. Recently, in two separate instances, the Internal Revenue Service (IRS) and the U.S. Court of Appeals for the Federal Circuit weighed in on the side of the government over whether specified amounts that were paid were deductible under section 162(f).
On May 2, 2016, the IRS Chief Counsel’s office released ILM 201623006 (ILM), which addressed whether an amount paid to the Financial Industry Regulatory Authority (FINRA) was deductible under section 162(f). FINRA is a nonprofit corporation that was formed in July 2007 when the National Association of Securities Dealers, Inc. consolidated with the New York Stock Exchange. It is considered a self-regulatory organization (SRO) under the Securities Exchange Act of 1934 (Act) and has the authority to create and enforce rules for its members in order to provide "regulatory oversight of all securities firms that do business with the public." As part of its regulatory authority, FINRA can assess and collect fines for violations of the rules it enforces.
The IRS noted in the ILM that the terms "agency" and "instrumentality" are not defined in the statute or the Treasury Regulations. The ILM cited Guardian Industries Corp. v. Commissioner as to how to determine whether a corporation is acting as an agency or instrumentality of the U.S. government.2 In that case, the tax court developed a functional test whereby if an entity has the authority to impose and collect fines with the imprimatur of the government behind it, then it is considered an agency or instrumentality of the government for purposes of applying section 162(f). The IRS concluded that FINRA is an agency or instrumentality of the government under this test because it is exercising powers granted to it under the Act. The ILM further noted that, if a fine is imposed on a taxpayer for violating the securities laws, its deductibility should not be dependent on whether the same type of conduct could be punished by the Securities and Exchange Commission (SEC). The ILM concluded that FINRA is a corporation serving as an agency or instrumentality of the U.S. government and thus meets the test under Treasury Regulations section 1.162-21(a). Therefore, the fine was not deductible.
Nacchio v. United States
On June 10, 2016, the U.S. Court of Appeals for the Federal Circuit overturned a Court of Federal Claims decision concerning Joseph Nacchio, the former CEO of Qwest Communications, who had sought to claim a deduction for taxes paid on profits that he had to disgorge. Nacchio had trading profits of $44,632,464 and was ordered to forfeit these profits to the SEC following his conviction for insider trading with respect to those profits.3 Nacchio’s forfeiture was entered into as part of a settlement of a concurrent action against him by the SEC, pursuant to which he also paid a $19 million penalty to the SEC for which he did not seek a deduction. The settlement required that Nacchio disgorge the sum of $44,632,464, less any amounts forfeited and paid to the United States by Nacchio in connection with his criminal case. Nacchio’s criminal forfeiture thus satisfied his disgorgement obligation in the SEC civil action.
Nacchio sought tax relief for the disgorgement because he had previously included the profits from those trades on his 2001 federal income tax return. He had sought relief under section 1341 on his tax return for $17,999,030, which was the tax that he paid on his profits. Section 1341 provides special relief to a taxpayer who is required to restore funds to a third party where the taxpayer included the funds in his income in a prior taxable year when it then "appeared that the taxpayer had an unrestricted right" to the funds.
The Federal Claims court decision, which was overturned by the Federal Circuit, held that (1) Nacchio could deduct his criminal forfeiture payment as a loss under section 165, but not as a trade or business expense under section 162, and (2) Nacchio was not collaterally estopped from pursuing special tax relief under section 1341. The Federal Claims court expressly rejected the government’s argument that a deduction of the forfeiture was barred by section 162(f). The Federal Claims court’s rationale was that the disgorgement of the illicit net gain from insider trading was used for a compensatory purpose, even if not characterized as restitution, since the amounts paid ultimately were returned to victims of Nacchio’s crimes. Moreover, disallowing a tax deduction was seen as a double sting because Nacchio had properly included the net gain in his 2001 federal tax return, and disallowing a future return of those taxes was essentially a double punishment under the Federal Claims court’s reasoning.
The Federal Circuit disagreed. It held that, even if the forfeiture was a loss under section 165(c)(2), the forfeiture is not deductible because allowing the deduction would contravene public policy, as codified in section 162(f). It framed the question as whether the criminal forfeiture was a "fine or similar penalty," and thus not deductible under section 162(f). The Federal Circuit noted that the U.S. Court of Appeals for the Tenth Circuit had held that Nacchio’s forfeiture would be calculated in accordance with a statutory provision that suggests that his forfeiture should be paid with after-tax dollars. The Federal Circuit court further connected the disgorgement of the gains in the civil action to criminal statutes that require forfeiture in connection with a felony conviction on ill-gotten gains because the disgorgement is meant to be punitive.
Nacchio argued that the forfeiture was in the nature of restitution. The court rejected that contention, noting that, in Nacchio’s case, forfeiture, and not restitution, was at issue. The court noted that the lower court’s amended judgment had specifically provided that the amount of restitution owed was $0 and that restitution was not applicable to Nacchio. In addition, at Nacchio’s resentencing hearing, the judge stated that his sentence of imprisonment, fine and disgorgement were "three forms of penalty." The Federal Claims court also dismissed characterizing the forfeiture as restitution made to the victims since the penalty was not equal to the amount of their losses and because there was no provision in the applicable law for restitution. The court stated, "We think Congress could not have intended to create a scheme in which the applicability of § 162(f) would depend upon how the government, in its discretion, later decided to use the funds generated by a fine or similar penalty."
As a result of this recent guidance, taxpayers who are considering the proper tax treatment of the payment of a fine to any agency or SRO of the government need to carefully consider whether that entity would be considered an agency or instrumentality of the government because these entities raise the possibility of the payment being treated as a penalty. Some taxpayers have taken the position that SROs cannot be considered instrumentalities since those organizations are self-regulating and thus not considered an extension of the government. However, the ILM rejects this provision with respect to FINRA. Other organizations get their authority by means of the contractual obligations of their members and not through any regulatory authority (e.g., the Chicago Mercantile Exchange governs its members and may impose fines for violations), and thus such payments made to those organizations may not be barred from deduction under section 162(f).
Taxpayers who make payments in conjunction with a forfeiture action should attempt to understand the characterization of a payment to see if the specific payment can avoid being treated as a fine or penalty. We understand that the federal government will not permit any characterization of the payment in the settlement or payment documents at least in False Claims Act cases, and therefore other types of documents in the record may have probative value regarding the tax characterization of the payment. If the payment is characterized as compensatory and not penal, it should be evaluated for deductibility because, under Regulations section 1.162-21(b), amounts that are compensatory in nature and paid to a government do not constitute a fine or penalty and are therefore deductible.4