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Payments for restitution may be deductible if not in lieu of a fine.

Sec. 162(a) allows a deduction for ordinary and necessary expenses paid or incurred ... in carrying on any trade or business." In the case of litigation, ordinary and necessary expenses include legal fees, court costs and amounts paid in settlement of litigation, as long as the costs are in connection with the taxpayer's business. However, Sec. 162(f) specifically denies a deduction for "any fine or similar penalty paid to a government for the violation of any law."

But what if, in lieu of paying a fine or penalty, a taxpayer makes a charitable contribution? Rev. Rul. 79-148 held that an amount paid to a charitable organization in satisfaction of a condition of probation was not deductible under either Sec. 162 or 170. In the ruling, the amount of the contribution was equal to the maximum fine that could have been imposed. Because the payment was made solely to avoid the fine, the IRS held that the payment was not deductible as either an ordinary business expense, or a charitable contribution.

The treatment of restitution made in lieu of paying a fine is not as clear. The Ninth Circuit, in Waldman, 850 F2d 611 (1988), concluded that the payment of restitution to a victim was a fine or penalty paid to the government for a violation of law; it was thus not deductible under Sec. 162(f). The facts in Waldman indicated that the taxpayer was placed on probation and ordered to make restitution to his victims. The terms of his probation specified that if restitution were not made, the taxpayer would receive a prison term. Due to these facts, the court held that restitution was not compensatory in nature but was in fact a "fine or similar penalty."

The Second Circuit, in Stephens, 905 F2d 667 (1990), held that the repayment of embezzled funds was compensatory, not punitive, and thus was deductible. In this case, the taxpayer had recognized income from the embezzlement in a prior year. In addition, the taxpayer received a prison term for his crime, and was ordered to make restitution in lieu of an additional prison term. The court found that under these circumstances the payment of restitution was neither a fine nor similar penalty and thus could be deducted.

From Joseph Gleason, CPA, Iskowitz & Koo, Los Angeles, Cal.
COPYRIGHT 1995 American Institute of CPA's
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Author:Gleason, Joseph
Publication:The Tax Adviser
Article Type:Brief Article
Date:Oct 1, 1995
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