Opinion
Civil Action No. 01-1774.
June 15, 2004
Richard R. Tarantine, Esq. Pittsburgh, PA, Counsel for Plaintiffs.
Dara B. Oliphant Trial Attorney, Tax Division U.S. Dept. Of Justice, Washington, DC, Counsel for Defendant.
Paul E. Skirtich Assistant U.S. Attorney United States Attorney's Office, Pittsburgh, PA, Counsel for Defendant.
MAGISTRATE JUDGE'S REPORT AND RECOMMENDATION
I. RECOMMENDATION
It is respectfully recommended that the Renewed Motion for Summary Judgment filed by Defendant be denied and the Renewed Motion for Summary Judgment filed by Plaintiffs be granted.
II. REPORT
This case involves a claim for the refund of certain federal income taxes paid by Plaintiffs. Plaintiffs' entitlement to refund for the overpayment of income tax is based on their assertion that payments made pursuant to a Court Order in criminal restitution of a fraudulent mortgage business scheme are a deductible "ordinary and necessary business expense" within the meaning of the applicable provisions of the Internal Revenue Code. This Court has jurisdiction pursuant to 28 U.S.C. § 1364(a)(1).
See Plaintiffs' Complaint at 1-2.
Defendant maintains that Plaintiffs are not entitled to deduct the restitution payments because (1) such payments do not qualify for deduction as an "ordinary and necessary business expense" within the meaning of 26 U.S.C. § 162(a), and (2) even if the payments otherwise qualified, they constitute a fine or similar penalty paid to a government and disqualified for income tax deduction under the provisions of 26 U.S.C. § 162(f).
Because it appears that there are no genuine issues of material fact and that Plaintiffs are entitled to judgment as a matter of law, their Renewed Motion for Summary Judgment should be granted.
A. Statement of Facts and Procedural History
This is a civil action for the recovery of federal income tax and interest for the 1989 and 1991 tax years paid by the Plaintiffs, John R. and Geraldine E. Woods ("Plaintiffs"), in June 1993 and August 1993, respectively. The amounts at issue are $454.00 and $1,167.00, refund claims which were filed by Plaintiffs on IRS Form 1040X. Plaintiffs allege an entitlement to these refunds on the basis of a reduction in tax owed after subtracting, as an "ordinary and necessary business expense" under Internal Revenue Code ("IRC") § 162, criminal restitution payments made in 1989 pursuant to Court Order following Plaintiff John Woods' 1985 conviction regarding fraudulent mortgage business activities.
See id. These payments were made by Plaintiffs in accordance with Notices of Deficiency issued by the Internal Revenue Service ("IRS") disallowing Plaintiffs' deductions, on their amended tax returns, of the criminal restitution payments. The IRS rejected Plaintiffs' assertion that Spitz v. United States, 432 F. Supp. 148 (E.D. Wis. 1977) entitled them to these deductions.
See 26 U.S.C. § 162.
In January 1995, Plaintiff John Woods ("Woods") pled guilty to, and was convicted on, charges related to a fraudulent investment scheme which generated losses to victims, investors in Safeguard Investment Company ("Safeguard"), approaching $2 Million. The sentencing judge suspended five of Woods' seven years of jail time in favor of probation conditioned on the payment by Woods of the $457,338.00 restitution. Said restitution was ordered by this Court following a lengthy Rule 11 colloquy and extensive inquiry by the Court into Woods' financial statements and the Probation Office's detailed determination of the amounts of original deposits made by Safeguard investors. This Court was quite express with regard to its intent that the misappropriated principal be returned to the victims, and the restitution ordered was carefully calculated to restore them, to the greatest extent possible, to the status quo ante.
The restitution order, which provided for payments to Woods' probation officer for disbursement to his victims, was twice unsuccessfully appealed to the Third Circuit and was ultimately complied with by Plaintiffs. See Memorandum of Points and Authorities in Support of the United States' Motion for Summary Judgment ("Memorandum of Points") at 1-2. See also United States v. Woods, 775 F.2d 82 (3d Cir. 1985) (hereafter "Woods I"); United States v. Woods, 986 F.2d 669 (3d Cir. 1995) (hereafter "Woods II").
Plaintiffs filed their joint income tax returns for the years in question on June 28, 1993. In September 1996, an audit deficiency assessment of $15,888 was made against Plaintiffs for tax year 1989. On January 14, 1999, Plaintiffs filed claims for refund for the years in question, asserting that the restitution payments constituted "ordinary and necessary business expense" under 26 U.S.C. § 162. Plaintiffs' refund claim was disallowed by the Commissioner by letter of September 23, 1999 and the Complaint was timely filed with this Court on September 21, 2001. The parties filed cross Motions for Summary Judgment, which were denied on the basis of the limited record before this Court on June 30, 2003. Defendant renewed its Motion for Summary Judgment on March 4, 2004; Plaintiffs renewed their Motion for Summary Judgment on March 5, 2004. B. Summary Judgment Standard
See Complaint Exhibits A C. The restitution payments were reflected on Schedule C forms for the sole proprietorship, G. Woods Mortgages ("G. Woods"). The reduction asserted as to Plaintiffs' 1989 return was attributable to a direct deduction of the restitution payments. The reduction asserted as to Plaintiffs' 1991 return was attributable to a net operating loss ("NOL") carryover generated by the deduction of the restitution payments in 1989.
See Woods v. United States, 2003 WL 21791242 (W.D. Pa. June 30, 2003) (hereafter "Woods III"). The Motions were denied because there was insufficient information before this Court "detailing the legal relationships between Plaintiffs, the Safeguard Investment Company and G. Woods Mortgages." Id. at *1.
Summary judgment is appropriate if, drawing all inferences in favor of the nonmoving party, "the pleadings, depositions, answers to interrogatories and admissions on file, together with the affidavits, if any, show that there is no genuine issue of material fact and the movant is entitled to judgment as a matter of law." Fed.R.Civ.P. 56 (c). Summary judgment may be granted against a party who fails to adduce facts sufficient to establish the existence of any element essential to that party's case, and for which that party will bear the burden of proof at trial.Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986).
More specifically, the moving party bears the initial burden of identifying evidence which demonstrates the absence of a genuine issue of material fact. Once that burden has been met, the nonmoving party must set forth "specific facts showing that there is a genuine issue for trial" or the factual record will be taken as presented by the moving party and judgment will be entered as a matter of law. Matsushita Elec. Indus. Corp. v. Zenith Radio Corp., 475 U.S. 574, 587 (1986) (quoting Fed.R.Civ.P. 56(e)) (emphasis added by Matsushita Court). An issue is genuine only "if the evidence is such that a reasonable jury could return a verdict for the non-moving party." Anderson v. Liberty-Lobby, Inc., 477 U.S. 242, 248 (1986).
C. Analysis
The taxpayer has the burden of establishing that the Internal Revenue Service was incorrect in disallowing a deduction.See, e.g., Estate of Landau v. Comm'r, 311 F.3d 458, 464 (3d Cir. 1955). See also, e.g., Capital Video Corp. v. Comm'r, 311 F.3d 458, 464 (1st Cir. 2002) (quoting Kornhauser v. United States, 276 U.S. 145, 153 (1928)).
Plaintiffs are entitled to deduct the criminal restitution payments at issue because such payments constituted an "ordinary and necessary business expense" within the meaning of 26 U.S.C. § 162(a), i.e., they were a non-capital expenditure of G. Woods Mortgages and were of benefit to that proprietorship. In addition, said payments are not rendered non-deductible for public policy reasons pursuant to the provisions of 26 U.S.C. § 162(f) because even if such payments were a fine or similar penalty, a matter this Court need not determine, they were not paid to a government. This Court and the Third Circuit have previously noted the compensatory nature of the restitution, Woods' underlying civil liability, and, most importantly for purposes of this decision, the government's role as a mere "conduit" for these payments to the victims. The circumstances of this case are inapposite to those cases cited by Defendant in which restitution was made in lieu of, or offset against, a fine or forfeiture that would otherwise have been paid or made to the government. Rather, they are largely analogous to the circumstances in Stephens v. Comm'r, in which the Second Circuit held that criminal restitution, ordered by a sentencing judge as compensation and required of a criminal defendant on whom a prison term was also imposed, is deductible for federal income tax purposes. 1. "Ordinary and Necessary Business Expense" Under § 162(a)
See Stephens v. Comm'r, 905 F.2d 667, 671 (2d Cir. 1990). This Court also concurs with the conclusion of the Second Circuit that there is no reason to disallow as frustrating public policy an off-setting federal income tax deduction for the repayment of misappropriated funds where the taxpayer previously reported those funds as income and paid the requisite federal tax.
Defendant appears to assert that Stephens provides no guidance to this Court's § 162(f) analysis because it permitted the deduction of restitution payments claimed under § 165, rather than § 162. See Memorandum of Points at 10 (asserting thatStephens is "unlike the instant case" in that "plaintiffs are not claiming the restitution as a loss deduction, but as a business expense"). Defendant is mistaken. Although the deduction was evaluated as a "loss in a transaction entered into for profit" under § 165 because Stephens was not engaged in a "trade or business" within the meaning of § 162(a), the Second Circuit expressly concluded that a payment that "would not pass muster under Section 162(f)" would not qualify for deduction under § 165. It therefore analyzed the factors of § 162(f) as "highly relevant" to its determination of deductibility. See Stephens, 905 F.2d at 672.
Indeed, Stephens is, to this Court's knowledge, the only federal court decision since Spitz to address by written opinion, and as a necessary part of its holding, the application of § 162(f) to restitution made to a private party as a condition of the suspension of a portion of the taxpayer's sentence of imprisonment. Cf. Waldman v. Comm'r, 88 T.C. 76, aff'd, 850 F.2d 611 (9th Cir. 1988) (affirming, per curium, Tax Court's holding that where entire sentence was suspended in favor of probation, restitution therefore served deterrent and rehabilitative purposes and was non-deductible); Kraft v. Comm'r, 991 F.2d 292 (6th Cir. 1993) (discussing applicability of § 162(f), in dicta, in case holding taxpayer unentitled to deduction of knowingly misappropriated funds under § 1341, which requires a reasonable subjective belief that taxpayer had a "claim of right" to said funds).
The determination of whether an expense is "ordinary and necessary is a question of fact." Capital Video Corp. v. Comm'r, 311 F.3d 458, 464 (3d Cir. 2002) (quoting Comm'r v. Heininger, 320 U.S. 467, 475 (1943)).
All ordinary and necessary expenses incurred by individuals or corporations in carrying on a trade or business are deductible under 26 U.S.C. § 162(a) provided the item claimed was paid or incurred during the taxable year. See Neomatology Assocs., P.A. v. C.I.R., 299 F.3d 221, 228 (3d Cir. 2002) (citing Comm'r v. Lincoln Sav. Loan Assoc., 403 U.S. 345, 352 (1971)). An expense is "ordinary" if it is not in the nature of a capital expenditure, and "necessary" if it is "appropriate and helpful for the development of the business." Comm'r v. Tellier, 383 U.S. 687, 689 (1966). In other words, it must be reasonable to expect business benefits to result from the expense. Kanelos v. Comm'r, T.C. Memo. 1943-429; see also Defendant's Memo in Opposition to Renewed Motion at 3 (citing Kanelos and concurring that the reasonable expectation of business benefits "goes to the very heart of" this case).
The term "ordinary" has also been understood to mean an expense that has occurred or could occur in connection with businesses similar to that claiming the deduction. The inquiry is whether the expense is a normal, reasonable or "ordinary" response to a particular circumstance. See Hill v. Comm'r, 181 F.2d 906 (4th Cir. 1950). However, the most common understanding of the term "ordinary" in this context has been simply the opposite of "capital." See Tellier, infra.
See also Defendant's April 5, 2004 Memorandum in Opposition to Plaintiffs' Renewed Motion for Summary Judgment ("Defendant's Memo in Opposition to Renewed Motion") at 3 (citing same definitions and quoting Tellier); Lilly v. Comm'r, 348 U.S. 90 (1952) (expenditure is necessary if it is appropriate and helps develop and maintain taxpayer's business).
Each of the cases cited by Defendant in support of its position that "[r]estitution payments, such as those at issue in this case, are not ordinary or necessary business expenses" is clearly distinguishable on this issue.
See Memorandum of Points at 4. See also Mitchell v. Comm'r, 73 F.3d 628, 633-34 (6th Cir. 1996) (disallowing deduction under 162(a) because taxpayer's restitution made to keep stocks obtained in violation of federal banking regulations constituted capital expenditure); Mannette v. Comm'r, 69 T.C. 990, 992-94 (1978) (disallowing deduction for repayment of monies embezzled from employer where taxpayer used monies for personal stock purchases; restitution expense was therefore unrelated to trade or business); Stephens v. Comm'r, 905 F.2d 667, 669-70 (2d Cir. 1990) (concurring in Tax Court's conclusion that restitution payments constituted a loss in a "transaction entered into for profit" under § 165(c)(2) rather than an "ordinary and necessary business expense" under § 162(a) where restitution was of funds embezzled from Raytheon and plaintiff was not engaged in a trade or business).
Plaintiffs argue, in essence, that the restitution is deductible under § 162(a) because Woods engaged in fraudulent acts in connection with Safeguard's mortgage brokerage business and was personally legally obligated to make restitution payments to the defrauded Safeguard investors. Plaintiffs assert that because such payments were made to make Safeguard investors whole, they were directly related to Safeguard's mortgage brokerage business. See Plaintiffs' October 2, 2002 Brief in Response to Government's Motion for Summary Judgment ("Plaintiffs' Brief in Response") at 6. See also Plaintiffs' Brief in Response at 10 (asserting that "inasmuch as [Plaintiff] was engaged in a trade or business, the restitution payments were made as a direct result of that trade or business" and were therefore deductible).
Cf. Comm'r v. Tellier, 383 U.S. 687, 689-90 (1966) (holding expense of defense of taxpayer's criminal charges deductible under § 162(a) where criminal charges found their source in taxpayer's business activities).
Defendant responds that Plaintiffs have failed to provide evidence establishing how the payment of Plaintiff's criminal restitution was related to "the development or maintenance of [his] mortgage business" or "how [it] could be considered normal, customary or appropriate for a mortgage company." Defendant's Objections to Magistrate Judge's Report and Recommendation Denying Motion for Summary Judgment ("Defendant's Objections") at 4.
See also Defendant's Memo in Opposition to Renewed Motion at 3 (questioning how "payment of John Woods' criminal restitution for Safeguard [could] lead to any business benefits for G. Woods").
As noted in this Court's earlier denial of the parties' summary judgment motions, the deductibility of Plaintiffs' claimed expenses under § 162(a) turns on the relationship between Safeguard, Woods, and Plaintiffs' subsequently-established proprietorship, G. Woods. Woods and his criminal co-defendant, Anthony Pivirotto ("Pivirotto"), controlled Safeguard, which solicited money from investors for the avowed purpose of making mortgage loans on residential properties. Safeguard misrepresented to investors that their deposits were federally insured and that the company was a licensed banking institution. In 1973, Safeguard discontinued making secured loans to the general public and began to make unsecured loans in excess of $1 Million to Woods and Pivirotto and business entities controlled by them. After operating at a financial loss, Safeguard filed a petition for reorganization under Chapter 11 in May 1980. Woods was subject to criminal prosecution as a result of his fraudulent activities and was ordered to make restitution as a condition of his probation.
See Woods III.
See supra note 4. At the time of the Rule 11 colloquy, this Court was informed that money received from Safeguard by Woods and Pivirotto was used to purchase various real estate holdings in Maine, Texas and Pennsylvania and that the criminal defendants had turned over to the bankruptcy trustee some of the property purchased with proceeds from their scheme and had also relinquished about $300,000 in personal assets. See United States v. Woods, 775 F.2d 82, 84 (W.D. Pa. 1985). The restitution ordered at the time of Woods' criminal sentencing was coordinated with the bankruptcy trustee and intended to make Safeguard's investors whole as to principal. See infra note 18.
The restitution payments, made following Woods' release from prison, were made through G. Woods, a proprietorship formed by Plaintiffs in the early 1980's. G. Woods' principal business activity is the same mortgage brokering operation previously conducted by Woods through Safeguard. See Plaintiffs' Brief in Response at 3 (citing Deposition Testimony of John Woods ("Deposition") at 16:1-16:6 and Response to Interrogatories);see also Deposition at 32:10-32:22 (testifying that Woods' business activities have remained the same).
Although Defendant fairly criticizes the weakness of Plaintiffs' articulation of their entitlement to deductibility under § 162(a), the facts are nonetheless sufficient to establish qualification of the expense. Defendant argues that Plaintiffs have not established a direct or successorship relationship between Safeguard and G. Woods. See Defendant's April 13, 2004 Reply to Plaintiffs' Brief in Response to Government's Motion for Summary Judgment ("Defendant's April 13, 2004 Reply") at 3-4 (asserting that "plaintiffs provide no evidence linking the business entities"). However, this is not a case involving payment by one business entity of an obligation of another, in which case successorship status is generally required. Rather, this obligation was, as Defendant notes, personally incurred by Woods in the course of the line of business that Woods remains in, i.e., mortgage brokering. It may well be that, as Plaintiffs assert, a cost incurred by the taxpayer in the same line of business is per se an expense of that business. This Court need not, however, decide that here because the record also establishes a reasonable expectation that this non-capital expenditure would inure to the benefit of Plaintiffs' proprietorship, i.e., compliance with the restitution order kept its principal from violation of his probation and the consequent likelihood of imprisonment. Cf. Comm'r v. Heininger, 320 U.S. 467, 471 (1943) (expense of defending fraud charge was "appropriate and helpful" and thus within ambit of § 162(a) where continued existence of taxpayer's business would otherwise be threatened). 2. "Fine or Similar Penalty" Under § 162(f) 26 U.S.C. § 162(f) precludes the deduction of expenses otherwise deductible pursuant to § 162(a) when such expenses constitute a "fine or similar penalty paid to a government for the violation of any law." The related regulations define "fine or similar penalty" as "an amount — (i) paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding." See 26 C.F.R. § 1.162-21(b)(1)(i). In addition, the regulations define "paid to a government" as encompassing payments made to a "political subdivision of, or corporation or other entity serving as an agency or instrumentality of, any of the above." See 26 C.F.R. § 1.162-21(a)(3).
See Deposition Testimony of John Woods at 15:15-15:18 (testifying, in essence, that the connection between Safeguard and G. Woods was Woods himself); see also Defendant's April 13, 2004 Reply at 2 (summarizing the "crux" of Plaintiffs' argument as, in part, that "Woods was ordered to pay restitution as a result of mortgage business activities with Safeguard" and "Woods is now engaged in the mortgage business through . . . G. Woods").
See also Deposition at 34:15-35:9 (testifying that Woods was operating G. Woods and generating revenue after his release from prison and during his time in a halfway house).
The language of the statute clearly requires that a claimed deduction must meet both criteria to be disallowed, i.e., it must be both (a) a fine or similar penalty and (b) paid to a government. Cf. Stephens, 905 F.2d at 672-674 (noting that "[t]wo considerations drawn from Section 162(f) and the cases construing that provision" — i.e., (1) that the restitution payment was "primarily a remedial measure to compensate another party" and (2) that the payment was made to the victim and not to a government — "combine[d] to support [its] conclusion" and that "[w]hether either consideration alone would suffice [was] a matter [it] need not decide"). Because Stephens determined the permissibility of deduction under § 165, with reference to § 162(f) as its guide, it cannot fairly be read to suggest that disallowance under § 162(f) itself may turn on less than both of its two elements.
Plaintiff was sentenced to seven years of jail time. Five years of this sentence were suspended in favor of probation contingent on the payment of restitution ordered by this Court. The restitution payments were made to the probation office, which in turn controlled the subsequent distribution of the funds to the victims. Defendant therefore asserts that Plaintiffs' restitution payments are non-deductible under 162(f) as a penalty made to the probation office, an instrumentality of the federal government, pursuant to a plea in a criminal proceeding. a. Public Policy Exception Codified in § 162(a)
Woods pled guilty to two counts of a 35 count indictment. He was sentenced to two years on the first of these counts and five years on the second. The latter sentence was suspended in favor of probation subject to restitution. The restitution required of Woods represented his one-half of joint and several liability with co-defendant Pivirotto for $989,218, the amount of the balance of principal claimed by the investors.
The first of Woods' two prior appeals to the Third Circuit turned on his assertion that because the plea agreement letter did not mention restitution, this Court's imposition of restitution was a violation of his agreement with the government. The Third Circuit rejected this assertion, noting that the likelihood and extent of the restitution order were fully explained to Woods prior to acceptance of his plea and that Woods then prepared financial statements for his sentencing hearing.See Woods I.
See Memorandum of Points at 5.
The Courts have long applied a general public policy exception to income tax deductions in various circumstances. See Stephens, 905 F.2d at 671 n. 8 (compiling examples). And the exception has always turned on whether "the allowance of a deduction would `frustrate sharply defined national or state policies proscribing particular types of conduct'. . . ."Tellier, 383 U.S. at 694 (quoting Comm'r v. Heininger, 320 U.S. 467, 473 (1943)).
The particular genesis of the public policy exception to deductibility for governmental fines and penalties may be found in Tank Trunk Rental, Inc. v. Comm'r, 356 U.S. 30 (1958), in which the Supreme Court unanimously concluded that allowing a tax deduction for the payment of a monetary penalty imposed by the government (in that case, the state) would reduce its "sting" and therefore thwart the government's underlying policy. See id. at 35-36. It is important to note that the Courts viewed the disallowance as appropriate in these cases because a tax deduction would effectively permit the criminal defendant to shift payment of a portion of his fine to the government.
Cf. Holt v. Comm'r, 69 T.C. 75, 80, aff'd, 611 F.2d 1160 (5th Cir. 1980) (noting that loss deduction for forfeiture would be contrary to public policy because "the government would in effect be carrying a portion of the loss inflicted" on the petitioner because of his illegal activity).Compare Stephens, 905 F.2d at 671 (explaining that where tax plaintiff has previously paid income tax on misappropriated funds, allowance of off-setting deduction at time of restitution does not effect any lessening or shifting of that financial burden; to contrary, disallowance of corrective deduction would create a "double sting"). See also infra at 24-25.
Once the public policy doctrine was developed by the Courts, Congress chose to codify it by amending § 162 to preclude certain deductions emanating from illegal activities. It indicated its intent that those "provision[s] for the denial of the deduction for payments in [the specified] situations . . . be all inclusive." See S. Rep. No. 552, 91st Cong., 1st Sess., reprinted in 1969 U.S. Code Cong. Admin. News 2027, 2311. See also Stephens, 905 F.2d at 674 (noting that in codifying public policy exception to deductibility of expenses under § 162, Congress specifically limited the exception to "bribes, kickbacks and other illegal payments; a portion of treble damage payments; and fines and similar penalties paid to a government"). The legislative intent and its underlying common law history must, of course, guide this Court's construction of the statutory language.
Cf. Robert T. Manicke, A Tax Deduction for Restitutionary Payments? Solving the Dilemma of the Thwarted Embezzler, 1992 U. Ill. L.Rev. 593, 600 (1992) (hereafter "Tax Deduction") (observing that "Congress' only obvious intention in enacting section 162(f) was to stem judicial expansion of the public policy doctrine").
b. Regulatory Definition
Defendant asserts that this Court should apply the language of the regulation, and understand it to mean that any amount paid as a result of a criminal plea or conviction is ipso facto within the ambit of § 162(f), as has the Tax Court. See Waldman v. Comm'r, 88 T.C. 1364, 1387, aff'd, 850 F.2d 611 (9th Cir. 1988) (concluding that because the criminal court would have lacked authority to order payment of restitution absent defendant's plea agreement, "[p]etitioner's restitution was thus paid pursuant to his plea of guilty and was thus a `fine or similar penalty' as defined by Section 1.162-21(b)(1)(i)" of the Regulations"). However, the regulation's substitution of the term "any amount" for the statutory language "fine or similar penalty" must be carefully assessed, as it may work an unwarranted expansion of the statute.
See also Kraft v. United States, 991 F.2d 292, 298 (6th Cir. 1993) (implying, in dicta, that Sixth Circuit precedent establishes that a restitution payment arising out of criminal proceedings constitutes a non-deductible penalty). The sole case to which the Kraft Court cites as establishing the Circuit precedent is Bailey v. Comm'r, 756 F.2d 44, 47 (6th Cir. 1985), which is inapposite to this Court's analysis in that it involved a government fine subsequently applied to civil restitution. See infra at 15, 27-28. Indeed, the Kraft Court cites the earlier decision as holding that "Bailey . . . forfeited the [dollar amount] as punishment for his violations of the Federal Trade Commission Act, and the payment was thus a fine imposed for purposes of enforcing the law and as punishment for a violation thereof." Id. at 298-99. Cf. F. Philip Manns, Jr.,Internal Revenue Code Section 162(f): When Does the Payment of Damages to a Government Punish the Payor?, 13 Va. Tax Rev. 271, 273 n. 4 (1993) (hereafter "Payment of Damages") (noting that the split panel in Kraft "did not reach the § 162(f) issue" because the decision was based upon § 1314).
More specifically, to define "a fine or similar penalty . . . for the violation of any law" as any amount paid pursuant to a criminal plea or conviction appears to ignore limitations inherent in the statutory language, for the only remaining qualifying condition in § 1.162-21(b)(1)(i) — that the payment be made pursuant to plea or conviction — was subsumed in the statute's requirement that the payment be related to a "violation of [the] law" and the statute's additional condition — that the payment be a "fine or similar penalty" has been discarded. Accordingly, courts have not relied solely on rote application of the regulation, but have looked to additional criteria in assessing the "fine or similar penalty" status of criminal restitution.
See Chevron U.S.A. Inc. v. Natural Resource Defense Council, Inc., 467 U.S. 837 (1984) (instructing that interpretations of law by implementing agency, if reasonable, are entitled to respect); General Dynamics Land Systems, Inc. v. Cline, ___ U.S. ___, 124 S. Ct. 1236, 1238-39 (2004) (holding that where regular interpretive method of judicial construction yields clear sense of congressional intent, deference is not owed to agency's contrary reading) (citing Chevron).
One commentator has suggested that barring deductibility of any restitution made pursuant to criminal court order is justified by the non-voluntary nature of the payment. That is, where the claimant must be made to make financial amends under a Court's authority, disallowance of a deduction under 162(f) is appropriate. See John J. Pease, III, Stephens v. Commissioner and the Continuing Confusion Surrounding the Public Policy Doctrine of the Internal Revenue Code (hereafter "Continuing Confusion"), 11 J.L. Com. 105 (1991). See also id. at 110 (criticizing Second Circuit's decision in Stephens for "not find[ing] significant the fact that, as in Waldman, had Stephens been acquitted, the court would not have been able to order restitution"). There may well be moral appeal to the argument that no tax deduction should be allowed for restitution made "only because [claimant] was ordered to do so by the court."See id. The two most significant difficulties with this position are, however, that (1) it is, of course, flatly at odds with the undisputed tax deductibility of restitution made only after civil proceedings, in accordance with a Court-imposed civil judgment, and (2) it ignores the Supreme Court's repeated instruction that the Tax Code is not intended to serve penal or moral purposes. See supra note 45.
A review of the applicable case law and commentary indicates that the payment's compensatory or punitive nature has generally determined its characterization as a fine or penalty.See, e.g., Bailey v. Comm'r, 756 F.2d 44, 46-7 (6th Cir. 1985) (holding that "civil penalties imposed for purposes of enforcing the law and as punishment for the violation thereof are non-deductible payments under § 162(f), while civil payments imposed . . . as a remedial measure to compensate another party for expenses incurred as a result of the violation fall outside the scope of the deduction prohibition in § 162(f)"); Huff v. Comm'r, 80 T.C. 804, 821-22 (1983) (same) (citing Southern Pac. Transp. Co. v. Comm'r, 75 T.C. 497, 652 (1980)). See also Stephens, 950 F.2d at 673 (noting that "[c]ompensatory payments generally return the parties to the status quo ante" and that "[u]nder 162(f), civil payments, although labeled `penalties', remain deductible if imposed . . . as a remedial measure to compensate another party"). c. Origin of the Liability as Compensatory or Punitive
Cf. Middle Atlantic Distrib., Inc. v. Comm'r, 72 T.C. 1136, 1143 (1979) ("[I]t is clear that, if the deduction of a civil fine (or similar penalty) is to fall within the proscription of section 162(f), the fine must be one which punishes and/or deters.").
On the one hand, the Courts have consistently disallowed a deduction for a clearly penal payment, one that we would ordinarily think of as a fine or similar penalty. The available case law reflects quite clearly that a traditionally-understood "fine or similar penalty", including criminal forfeiture, is not deductible for federal income tax purposes; nor are monies paid in lieu of payment otherwise owing to the government as a result of the taxpayer's criminal activity. See, e.g., Allied Signal, Inc. v. Comm'r, 1992 WL 67399 (deduction disallowed where court reduced its criminal fine, imposed for company's environmental violations, by amount of payment made by Allied to endowment fund to clean up its toxic pollution), aff'd, 54 F.3d 767 (3d Cir. 1995); Ginsburg v. Comm'r, 1994 WL 259249 (U.S. Tax Ct. June 14, 1994) (deduction disallowed where restitution made in connection with monetary bribes to county officials was applied against monies otherwise payable to federal government pursuant to RICO forfeiture provisions). See also Bailey v. Comm'r, 756 F.2d 44, 47 (6th Cir. 1985) (disallowing deduction where restitution was originally imposed as fine and therefore retained its characteristic as a penalty despite subsequent diversion to class members); Murillo v. Comm'r, 166 F.3d 1201 (2d Cir. 1998) (holding that forfeiture of accounts constituted "fine or similar penalty" under 162(f)).
See, e.g., Cold Industries, Inc. v. United States, 11 Cl.Ct. 146, 149 (1986) (penalties for violations of Clean Water Act and Clean Air Act were not deductible), aff'd, 880 F.2d 1311 (Fed. Cir. 1989).
Defendant's reliance on these cases as authority for its assertion that the restitution payments at issue constitute a fine or penalty under § 162(f) is therefore misplaced.
On the other hand, the Courts have consistently allowed a deduction for a clearly compensatory payment; the case law holds with comparable clarity that a restitutionary settlement or judgment as to a civil liability or obligation is deductible.See, e.g., Grossman Sons, Inc. v. Comm'r, 48 T.C. 15, 28-29 (1967) (permitting deduction for amounts paid to government in settlement of civil claims under FCA where settlement agreement specified payment as damages for breach of contract);Ditmars v. Comm'r, 302 F.2d 481 (2d Cir. 1962) (permitting stockbroker's deduction of civil judgment following suit for "churning" account); Helvering v. Hampton, 79 F.2d 358 (9th Cir. 1935) (permitting deduction of civil judgment paid to tenant in satisfaction of fraudulent lease claim).
Similarly, income derived from illegal sources, such as embezzlement, has been held to be gross income but taxable income is then correspondingly reduced "if, when, and to the extent" that restitution is subsequently made. See James v. United States, 366 U.S. 213 (1961); Fed. Tax Coordinator 2d ¶ J-1603.See also Norman v. Comm'r, 407 F.2d 1337 (3d Cir. 1969) (holding that taxpayers who repay embezzled funds are ordinarily entitled to a deduction in the year of repayment).
Criminal restitution obligations, however, fall within a grey area between punitive criminal fines and penalties, which are not deductible for income tax purposes, and compensatory civil restitution obligations, which are. In response, the Courts have concluded that the non-deductibility of a criminal restitution payment as a "fine or similar penalty", for purposes of § 162(f), depends on the origin of the liability giving rise to it. See, e.g., Waldman, 88 T.C. 1384, 1390, aff'd, 850 F.2d 611 (9th Cir. 1988). Thus, "[w]here a payment ultimately serves each of these purposes, i.e., law enforcement (nondeductible) and compensation (deductible) our task is to determine which purpose the payment was designed to serve."Waldman, 88 T.C. at 1387. See also Defendant's Memo in Opposition to Renewed Motion at 4 ("Because restitution payments are not clearly designated as a fine or penalty, Courts examine whether the restitution is intended to be compensatory or punitive."). The Courts have taken differing approaches to their determination of the punitive or compensatory nature of the restitution's origin of liability, as exemplified by Waldman, 88 T.C. at 1387 (holding payment made pursuant to a criminal plea or conviction to be presumed penal) and Stephens, 905 F.2d at 673 (examining sentencing record to determine purpose of restitution).
Cf. Manicke, Tax Deduction, 1992 U. Ill. L.Rev. at 612 ("In the case of court-ordered restitution in the criminal context, the state assumes a role traditionally limited to the individual in the civil legal system. . . . [T]his de facto intertwining of victim compensation and institutionalized punishment creates confusion in practice.").
Cf. United States v. Halper, 490 U.S. 435, 447 (1989) ("It is commonly understood that civil proceedings may advance punitive as well as remedial goals, and, conversely, that both punitive and remedial goals may be served by criminal penalties.").
The commentators have recognized the inter-Circuit conflict between these cases. See, e.g., Manns, Payment of Damages, 13 Va. Tax Rev. at 273 (stating that Second and Ninth Circuits disagree on whether criminal restitution is deductible in light of § 162(f)); Manicke, Tax Deduction, 1992 U. Ill. L. Rev. at 614 (stating that "recent cases reflect a split in judicial opinion over whether to consider the repaid amounts compensation to the victim or a judicially imposed penalty") (citing Stephens and Waldman). See also Stephens, 905 F.2d at 674 (stating that "[t]o the extent that Waldman may be interpreted as suggesting that a restitution payment, ordered in addition to punishment and paid directly to a victim, would not be a deductible loss, [the Second Circuit] respectfully disagree[s]").
In Stephens, the Second Circuit held that criminal restitution made to a private corporation as a condition of probation, and in addition to other punishment, was compensatory in nature and therefore deductible for income tax purposes. The Second Circuit reviewed "the proceedings at Stephens' sentencing" and concluded that the restitution payment was "primarily a remedial measure to compensate another party, not a `fine or similar penalty,' even though Stephens repaid the embezzled funds as a condition of his probation." 905 F.2d at 672-73. This Court finds the circumstances of Stephens markedly analogous.
Compare Waldman (concluding that restitution in lieu of prison was ipso facto punitive). Stephens has been criticized as rewarding intransigent behavior by a wrongdoer:
The lesson of Stephens is that an embezzler may steal, pay tax on the proceeds of his crime with the funds stolen, and then wait until he is detected, indicted, tried, convicted and ordered to pay restitution by a court of law. When ordered to do so, the convicted embezzler earns a windfall in the form of a loss deduction . . . and in effect is able to purchase a reduction in his prison sentence by repaying money which never belonged to him in the first place.
Pease, Continuing Confusion, 11 J.L. Com. at 110. But again, this commentator's analysis misses the mark. For of course, having used part of the misappropriated funds to pay tax, the wrongdoer must use other funds to make restitution; he cannot both "pay tax . . . with the funds stolen" and fulfill his restitution obligation with "money which never belonged to him in the first place". Where full restitution is ordered and taxes have been paid, the wrongdoer is "out of pocket" in one place or another. Thus, because it is counterbalanced by a prior tax payment, a loss deduction for the restitution payment does not constitute a "windfall". On the contrary, as the Stephens Court observed, denying a deduction in these circumstances would amount to a "double sting".
It appears that this commentator's real objection is to the notion that a wrongdoer may "purchase a reduction in his prison sentence by repaying money which never belonged to him in the first place." While this objection may have a visceral appeal, any contention that the resulting sentence was too lenient, or that a suspension of prison time related to victim restitution is in general improper, should be addressed to the sentencing Court; the issue before the Court in Stephens was not the propriety of the sentence, but the interpretation and application of the Tax Code.
i. Woods' Restitution was Compensatory
In determining the penal or compensatory nature of restitution, Courts have frequently considered the expressed intent of the sentencing Court. See Manns, Payment of Damages, 13 Va. Tax Rev. at 289 (surveying related cases and explaining that, in determining deductibility under § 162(f), courts seek to discern intent, or absence of intent, to punish based on "examination of facts and circumstances specific to the case" as reflected in, e.g., a transcript of the sentencing proceedings). This Court recognizes that in some cases such an approach may be fraught with difficulty. Compare Pease, Continuing Confusion, 11 J.L. Com. at 110 (criticizing Court's consideration of sentencing judge's intent as opening seemingly limitless "possibilities for ambiguity with its resulting arbitrariness"); id. at 112 (questioning "how or why [a sentencing judge's] subjective motivations should be dispositive in determining whether a sanction is compensatory or punitive in nature") with Manns,Payment of Damages, 13 Va. Tax Rev. at 318-19 (concluding that where "a direct declaration that restitution is (or is not) intended to punish is found . . . in the specific facts of the case" it should govern).
In this case, a review of the reasoning of the sentencing judge strongly suggests, as in Stephens, that the restitution payment was principally compensatory. See Sentencing Hearing Before the Hon. Donald E. Zeigler, April 12, 1985, at 8 ("Now, my purpose today is to impose a sentence which is fair and just and do what I can to recover for the depositors funds, not only today, but perhaps some time in the future."); see id. at 8-9 (explaining that the recommendation had been made to this "Court that, as part of the sentence, [it] consider an order of restitution" and that it had arrived at a formula for calculating what might be recovered, and further explaining that the Court would "attempt to assist the victims in recovering" the "balance remaining on principal"); id. at 60 (explaining court's power to award restitution "on behalf of the investors for the amounts that [they] have not recovered" and "to attempt to help these people to recover, at least, on principal"); id. at 84 (discussing need to determine what defendants were capable of paying and what could legitimately be claimed, which "ha[d] to be done out of fairness to the government, the investors, and the defendants"); id. at 85 (noting that any future payments made to the victims by the bankruptcy trustee would reduce the amount of criminal restitution owed by the defendants). Compare Allied-Signal, 1992 WL 67399 (concluding, after examining the record of the sentencing proceedings, that "if there were a compensatory or remedial purpose for the payment, it was minimal").
Cf. Waldman v. Comm'r, 88 T.C. 1384, 1388 (raising, as concern against court determination that criminal restitution was compensatory, "how the [criminal court] could determine the taxpayer's liability to his victim"); Manns, Payment of Damages, 13 Va. Tax Rev. at 289 (explaining that measurement of restitution by reference to victims' loss indicates its compensatory nature).
The final citation, regarding set-off for payments made by the bankruptcy trustee, suggests to this Court with particular clarity that the purpose of the restitution order was to compensate the victims, rather than to "sting" the offender. See also Woods III, 986 F.2d at 672 (noting that restitution calculated by sentencing court included allowance for "money already disbursed to the investors by Safeguard's trustee in bankruptcy").
In addition, although Defendant correctly quotes the judge's concluding remarks at Woods' sentencing as requiring incarceration "to satisfy the concept of deterents [sic]", Defendant's quotation is selective and fails to acknowledge the Court's hope, expressed in the following sentence, that the limited term of confinement imposed would permit Woods to "pay the victims in full." Compare Defendant's April 13, 2004 Reply at 6 with Sentencing Report at 95. More importantly, this Court's selectively-cited reference was specifically to the deterrent purposes of Woods' imprisonment and does not illuminate the sentencing judge's objectives in ordering restitution. See Stephens, 905 F.2d at 668, 673 (noting that sentencing judge "believe[d] a period of imprisonment [was] absolutely necessary" and that, after specifying the term of imprisonment, the judge "reiterated her concern that [the victim] must get its money back").
Moreover, in response to Plaintiff's second challenge to the restitution order, the Third Circuit has emphasized at length this restitution's compensatory nature, and its derivation from Woods' underlying civil liability to the defrauded investors. See, e.g., id. at 679 (noting that the sentencing Court went to great lengths to review the financial statements and determine restitution to the victims in the amount of principal "that [Woods] owed to them as a result of the fraudulent scheme"); id. (noting that Woods "was liable to the Safeguard investors for restitution that could have been enforced through a civil proceeding").
See Woods II, 986 F.2d 669 (holding that subsequent decision of United States Supreme Court that restitution is authorized only for losses stemming from offenses for which accused was convicted, and not dismissed charges, would not be retroactively applied to invalidate restitution order).
The Third Circuit expressly recognized its holding in Pollak that "criminal restitution `is imposed as part of sentencing and remains inherently a criminal penalty.'" Id. at 680 (quotingUnited States v. Pollak, 844 F.2d 145 (3d Cir. 1988)). It went on, however, to observe that Pollak was not determinative of the issue at hand, and to discuss the restitution's "acknowledged . . . marked similarity to a civil judgment," ultimately concluding that non-retroactivity was appropriate. Id. at 680-81. In so holding, it repeatedly noted that it did not regard the restitution ordered of Woods as a fine. See, e.g., 986 F.2d at 680 (observing that "Woods was required to pay restitution rather than a fine" and that "the restitution order represents money that Woods owed . . . as a result of a civil liability").
See also United States v. Sleight, 808 F.2d 1012, 1020 (3d Cir. 1987); United States v. Brown, 744 F.2d 905, 909-10 (2d Cir. 1984) (discussing differences between criminally- and civilly-imposed restitution); Defendant's Memo of Points at 5.
See id. at 681:
As we stated in United States v. Kress, 944 F.2d 155 (3d Cir. 1991), `when reduced to a judgment, restitution does not differ in essence from a judgment arising out of civil proceedings. In other words, we view a judgment of restitution as a debt to a victim.' Id. at 160 (citing Slieght, 808 F.2d at 1020). Although there are obvious procedural differences between the creation and enforcement of civil and criminal restitutionary liabilities, a restitutionary obligation, whether civil or criminal, represents essentially the same outcome: a financial debt owed by the defendant.
Although Defendant emphasizes Pollack and Sleight, these cases do not seek to characterize restitution for purposes of assessing whether the related diminution of an intended criminal sentence works a frustration of public policy. The Third Circuit's observation that the cases were inapposite to a determination of retroactivity because they did not address those underlying policy considerations is therefore equally apt with regard to our § 162(f) analysis.
See also Spitz v. United States, 432 F. Supp. 148, 149-50 (E.D. Wis. 1977):
The payment does not satisfy the criteria set forth in § 162(f). It is not a fine.
Neither is it a penalty since it was payment of an amount due and owing.
Manns, Payment of Damages, 13 Va. Tax Rev. at 320 (noting that "[r]estitution normally does not serve the same purpose as a fine exacted under a criminal statute . . . [r]ather, it serves the same purpose as damages exacted under a tort claim").
This Court accordingly concludes that here, as in Stephens, the sentencing judge's purpose in ordering restitution was unquestionably to address the rights of the crime victims to compensation, to restore — to the greatest extent possible — their misappropriated property, and to prevent the unjust enrichment of the criminal defendant.
Cf. Manicke, Tax Deduction, 1992 U. Ill. L.Rev. at 610-11 (contrasting "split in opinion over restitution" by comparing "property" and "deterrence" approaches and noting that property courts focus on traditional theories of restitution and disgorgement) (citing Daniel Friedmann, Restitution of Benefits Obtained Through the Appropriate of Property or the Commission of a Wrong, 80 Colum. L.Rev. 504, 510 (1980)).
ii. Other factors
As discussed above, this Court finds the decision of the Second Circuit in Stephens to be largely analogous. Defendant argues, however, that Stephens is distinguishable because it involved restitution ordered in addition to the originally-intended sentence, rather than restitution more clearly "in lieu of" a suspended portion of the intended sentence. Indeed, it has been noted that, in reaching its decision in Stephens, the Second Circuit observed that the sentencing judge apparently followed the prosecution's recommendation that "in addition to whatever custodial and fine requirements the court decided to impose, it sentence Stephens to an additional consecutive period of incarceration and suspend that additional incarceration on condition of restitution." Stephens, 905 F. 2d at 668.However, Stephens distinguishes itself fromWaldman, the decision with which the commentators have noted its disagreement, by emphasizing that in Waldman the entire sentence was suspended, so that the ordered restitution was the only criminal punishment imposed on the criminal defendant. The case at hand, therefore, remains more like Stephens than Waldman — other, punitive, punishment was imposed. Woods, like Stephens, was sentenced to a term of imprisonment, which this Court noted was intended to deter and rehabilitate him, as well as to restitution, which this Court noted was intended to compensate Woods' victims.
See Waldman v. Comm'r, 88 TC 1384, aff'd, 850 F.2d 611 (9th Cir. 1987). In Waldman, the Tax Court concluded that restitution payments made to crime victims in lieu of imprisonment are the equivalent of fines or penalties paid to a government and consequently nondeductible. The Tax Court reasoned that the taxpayer's restitution was in satisfaction of his criminal liability to the state and that the obligation to pay restitution was imposed for purposes of enforcing the law and not as a substitute for a civil action to recover damages. It therefore concluded that the restitution payments constituted a fine or similar penalty under § 162(f) even though the government did not actually "pocket" those monies. The Tax Court's holding was affirmed, per curiam, by the Ninth Circuit.
The Second Circuit thus concluded that the purpose of Waldman's restitution was "equally compensatory and punitive in nature." 905 F.2d at 673. It went on to note that whether or not it would allow disqualification of the tax deduction under the same circumstances need not be decided, as Waldman was clearly distinguishable. Id.
See supra note 34. Cf. Martha M. Cleary, Annotation,Deductibility as a Nonbusiness Loss Under 26 U.S.C.A. § 165(c) of Restitution Payments Made Pursuant to Sentencing Order, 112 A.L.R. Fed. 289 (2004) (noting that the Stephens Court "reasoned that to the extent that a petitioner's sentence consisted of a prison term, fines, and an order to make restitution, such a sentence supported the inference that the restitution payment was compensatory in nature, and not in the nature of a fine or penalty"). See also Stephens, 905 F.2d at 670-71 (rejecting Tax Court's conclusion that because "payment was ordered in lieu of an additional prison term and as a condition of probation" it was nondeductible).
It is important to note that the instant case also remains analogous to Stephens and distinguishable from Waldman with regard to the tax aspects and consequences of the deduction at issue. Woods, like Stephens, reported the misappropriated income when received and paid taxes on it at that time. Allowing a subsequent off-setting income tax deduction for the subsequent repayment of those monies does not, therefore, in any way "lessen the sting" of the Court order imposed, i.e., that restitution be made. To the contrary, disallowing a deduction for the repayment of monies previously taxed would create an additional punishment, and would serve no public purpose. See Stephens, 905 F.2d at 671 (explaining that because Stephens had already paid taxes on the misappropriated funds, "disallowing the deduction for repaying the funds would in effect result in a `double sting'. . . . . Stephens would pay . . . taxes on income he did not retain" and noting that "[t]he sentencing judge made no reference to these tax consequences at the sentencing hearing"). In contrast, in Waldman, the Tax Court noted that, because the fraud scheme involved the misappropriation of real estate by the taxpayer's corporation, from which Waldman received a salary, Waldman "did not receive the amounts converted by [the corporation] and did not report such amounts as income." 88 T.C. at 1386.
See Brief in Support of Plaintiffs' Motion for Summary Judgment ("Plaintiffs' Brief in Support") at 16.
Cf. United States v. Constantine, 296 U.S. 287 (1935) (concluding that higher tax on illegal income amounts to penalty imposed on wrongdoer and federal income tax law was not intended to be penal); Tellier, 383 U.S. at 691 (noting that "the federal income tax is a tax on net income, not a sanction against wrongdoing"); Manicke, Tax Deduction, 1992 U. Ill. L.Rev. at 593-94 (concluding that § 162(f) should not be read to disallow deduction for criminal restitution of monies previously taxed as income to defendant on basis of (1) taxation equity of off-setting deduction for repayment and (2) traditional separation of the tax system from punitive functions of government). But see Pease, 11 J.L. Com. at 112 (asserting that "purposes of the statutes" would be "severely frustrated if Stephens' sanction were softened through allowance of a loss deduction").
Balanced against the foregoing factors of other punishment and prior payment of tax is the undeniable fact that the restitution was paid in lieu of incarceration. Indeed, with respect to the restitution order at issue herein, the Third Circuit has expressed "little doubt that had the district court believed it was unable to impose a larger restitutionary condition on its sentence, it would have fixed a longer jail term." 986 F.2d at 681 n. 25. The position of the Waldman Court that a payment in lieu of punishment is ipso facto penal has a certain logical appeal.
This statement was avowedly dicta, as it was expressly stated to be "not a basis for our decision". 986 F.2d at 681 n. 25.
Nonetheless, on balance, because a review of the sentencing hearing in this case strongly suggests, as in Stephens, that the primary purpose of the ordered restitution was compensatory; because the deterrent and rehabilitative purposes of the criminal defendant's sentencing remained served, as in Stephens, by the term of imprisonment imposed; because here, as again inStephens, the disallowance of a corresponding tax deduction for the repayment of income on which the taxpayer had previously paid taxes would work an inappropriate "double sting" ( i.e. Woods would pay additional monies in taxes on income he did not retain, tax consequences which the sentencing judge made no reference to intending); and, significantly, because the Third Circuit has rejected the characterization of this restitution as a "fine" and has reiterated its compensatory nature — for all these reasons, this Court is inclined to concur with the Second Circuit's holding that in such circumstances the taxpayer's restitution payments do not constitute a "fine or similar penalty" under an appropriately narrow application of § 162(f), one that respects the codification's legislative intent and underlying common law history. The Court recognizes, however, that the breadth of the regulatory definition, the presence of a clearly penal sanction suspended in lieu of the restitution, and the Third Circuit's description of criminal restitution in Pollak as "inherently a criminal penalty" may leave resolution of this issue open to doubt. The Court concludes that the issue need not be decided because, as discussed below, the payment at issue clearly does not meet the second requisite element of being "paid to a government". See supra note 17.
See Stephens, 905 F.2d at 671-72.
Cf. Jacob L. Todres, Internal Revenue Code Section 162(f): An Analysis and Its Application to Restitution Payments and Environmental Fines, 99 Dick. L.Rev. 645, 716 (1995). This commentator observes, in discussing why criminal restitution payments should be deductible, that
[I]n a related area addressed in tandem with the enactment of section 162(f), Congress recognized that restitution payments arising from criminal conduct should be deductible while any additional punitive sanctions should not. Thus, Code section 162(g) disallows a deduction for only the punitive two-thirds of any anti-trust treble damages paid after a criminal conviction or plea of guilty or nolo contendre. The one-third restitution remains deductible.
Cf. Charles A. Borek, The Public Policy Doctrine and Tax Logic: The Need for Consistency in Denying Deductions Arising from Illegal Activities, 22 U. Balt. L.Rev. 45, 55 (1992) (hereafter "Public Policy") (noting that "the judicial formulation of the public policy doctrine which culminated inTellier contained discernable parameters" and that "it was acknowledged that all ordinary and necessary business expenses were presumed deductible . . . [and it was] only in specific, narrowly drawn circumstances that the allowance of a deduction [would] be considered to so sharply frustrate public policy that an exception [would] be read into the Code").
b. Paid to a Government
Defendant correctly observes that the Third Circuit has held that § 162(f)'s requirement that the fine or penalty at issue have been "paid to a government" may be satisfied by payments that are made at the direction of a court. See Allied-Signal, 1992 WL 67399, aff'd, 54 F.3d 767 (3d Cir. 1995). It must be noted, however, that in Allied, the $15 Million criminal fine otherwise owed to the government was reduced by the amount of the corporate defendant's $8 Million payment to a fund established to clean up its toxic pollution. Thus, disallowance of a deduction for these monies paid as against the criminal fine was consistent with the legislative intent of § 162(f) and the public policy exception which it codified. See supra at 16. See also Bailey, 756 F.2d at 47 (disallowing deduction where Court imposed fine in excess of $1 Million for violation of consent decree, but subsequently permitted monies owed to government to be applied as restitution in settlement of a pending class action).
The same reasoning does not, however, extend to monies never imposed as a fine and never owed to, or to be paid to, the government. Compare Woods III, 986 F.2d at 680 (noting that "because the court ordered restitution, and not a fine, the government did not retain the money paid, but acted only as a conduit to pass the money along to the Safeguard investors").See also Spitz v. United States, 432 F. Supp. 148, 149-50 (E.D. Wis. 1977) (noting that "although the payment was funneled through the State Department of Public Welfare, it was paid to [the victim], not `to a government' within the meaning of § 162(f)"); Manns, Payment of Damages, 13 Va. Tax Rev. at 319 ("The use of a court or probation office as a financial intermediary or escrow agent cannot affect" the conclusion that restitution disbursed to the victim is not "paid to a government.").
Although the Tax Court, as affirmed by the Ninth Circuit, has held that restitution made in lieu of any other punishment is "paid to a government" within the meaning of the statute, each factor of the Court's underlying analysis is unpersuasive. The Tax Court reaches its conclusion on two bases: (1) that petitioner's restitution was "in satisfaction of his criminal liability to the state" and imposed to enforce the law — but concluding that monies were "paid to a government" because the purpose was punitive ( i.e., because the restitution was a "fine or other penalty") merely collapses the statutory elements and does not further the analysis; and (2) that a government need not "actually `pocket' the fine or penalty to satisfy the `paid to a government' requirement" and, relatedly, that this conclusion was consistent with the Sixth Circuit's holding in Bailey — but, while Bailey certainly stands for the proposition that the government need not pocket, but retains the right to re-direct, payment of monies owed to it, that decision is fundamentally distinguishable for the reasons already discussed, reasons which escaped the Tax Court's consideration.
See supra note 41.
See Manns, Payment of Damages, 13 Va. Tax Rev. at 316 (noting that "after incorrectly deciding that Waldman's restitution was both a `fine' and `a similar penalty'" the Tax Court "premised its assertion [that it was `paid to a government'] on a tautology").
It might well be said that the hallmark of payee status is the right to spend or assign, i.e., direct the use of, the funds. Thus, cases in which the government retained its payee status despite redirecting monies otherwise owed to it are uninstructive as to the case at hand. This important distinction was emphasized in the concluding remarks of the Stephens Court.See 905 F.2d at 674. Cf. Manns, Payment of Damages, 13 Va. Tax Rev. at 316 (noting that the Waldman Tax Court "bolstered its conclusion with an inapposite citation to Bailey").
Thus, this Court concludes, as did the Second Circuit, that where the payment of restitution is ordered as a condition of probation, and is not made in lieu of, or as an off-set against, a fine, forfeiture or similar penalty otherwise payable to the government, and said restitution is made to the victim, it does not constitute money "paid to a government" within the meaning of § 162(f). Determination of this element is guided, as was determination under the preceding section, by the common law history codified in § 162(f) and contemporaneous statements of legislative intent. III. CONCLUSION
Criminal restitution defendants may make unsympathetic tax plaintiffs. Indeed, the original public policy exceptions arose because the courts found the idea that tax deductions might properly accrue to those who operated illegal enterprises unpalatable. See Charles A. Borek, Public Policy, 22 U. Balt. L.Rev. at 46.
Nonetheless, there is no indication in the history of the Tax Code that it was intended to impose a higher burden of taxation on individuals obtaining income through illegal means; rather, "the tax legislation was meant to be blind to the character of both the taxpayer and their means of obtaining income." Id. at 47-49. See also United States v. Constantine, 296 U.S. 287, 295-96 (1935) (concluding that federal income tax law is not intended as a penal statute, but as a revenue-producing measure);Lilly v. Comm'r, 343 U.S. 90, 97 (1952) (explaining that the judiciary need "voice no approval of the business ethics" involved in determining the deductibility of payments within the tax statute).
Because Plaintiffs' restitution constitutes an "ordinary and necessary business expense" within the meaning of § 162(a), and meets neither of the requisite two elements for disallowance under § 162(f), it is recommended that the Renewed Motion for Summary Judgment filed by Defendant be denied and the Renewed Motion for Summary Judgment filed by Plaintiffs be granted.
In accordance with the Magistrates Act, 28 U.S.C. § 636(b)(1)(B) and (C), and Rule 72.1.4(B) of the Local Rules for Magistrates, the parties are allowed ten (10) days from the date of service to file objections to this report and recommendation. Any party opposing the objections shall have seven (7) days from the date of service of objections to respond thereto. Failure to file timely objections may constitute a waiver of any appellate rights.