The Deductibility of Fines, Penalties, and Restitution Related to Illegal Activities

Abstract

Determining the deductibility of fines, penalties, settlements, and other forms of restitution paid by taxpayers as a result of violations of criminal and civil law fall under a number of sometimes conflicting code sections, IRS pronouncements, and case law. In this article, we discuss the deductibility of fines, penalties, and other forms of restitution under the provisions of IRC Section 162(f) and the violation of public policy doctrine. Since some taxpayers attempt to capitalize the expenditures rather than deduct them, we also discuss the application of Sections 263 and 263A to these payments. If a taxpayer incurs expenditures in a transaction not part of a trade or business, then the deduction of the expenditure is controlled by Section 165. The application of the violation of public policy doctrine and Section 162(f) to Section 165 are also evaluated. Following the discussion of the current cases and rulings, we recommend several changes in tax law that will clarify and simplify when expenditures related to illegal activities are deductible.