Technical Advice Memorandum 202434011 Released August 23, 2024 Advice

Punitive regulatory costs disallowed but corrective costs not barred

Apply this to your situation

This page covers one taxpayer's ruling from 2024, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

Not precedent. Under 26 U.S.C. § 6110(k)(3), this written determination may not be used or cited as precedent. It resolved one taxpayer's situation on its specific facts, and identifying details were redacted by the IRS before release. The official IRS release (linked on this page as a PDF) is the authoritative source.

About this page: The plain-English summary and ruling snapshot below were written by Ezel based on the official IRS release. The full text is the IRS's own document.

View official IRS release (PDF)

Plain-English summary

A subsidiary incurred several categories of costs after a state regulator found civil violations and imposed a package of fines, remedies, and corrective orders. The IRS advised that section 162(f) bars deductions for costs whose primary purpose was punitive, including amounts redirected to nongovernment recipients when they substituted for an otherwise warranted government penalty. It also concluded that the taxpayer could not capitalize punitive costs under sections 263(a) or 263A because the public policy doctrine and the Code prevent recovery of amounts analogous to nondeductible fines. A second redacted payment obligation was likewise nondeductible because it was imposed as punishment and deterrence. By contrast, reimbursement of the regulator's investigation-related costs fell within the regulation's exception for legal expenses and compensatory payments. Costs of specifically curing identified violations were also nonpunitive, so sections 162(f), 263(a), 263A, and the public policy doctrine did not themselves prevent deduction or capitalization under otherwise applicable rules.

Ruling snapshot

Question: Which costs imposed after state-law violations are punitive amounts barred from deduction or capitalization, and which are compensatory or corrective?
Outcome: Advice given, punitive costs are barred while investigation reimbursements and specific corrective costs are not barred by the cited penalty rules
Key authorities: IRC §§ 61, 162(a), 162(f), 263(a), 263A; Treas. Reg. §§ 1.162-21, 1.263A-1

Full text (IRS public release)

                       INTERNAL REVENUE SERVICE
             NATIONAL OFFICE TECHNICAL ADVICE MEMORANDUM

                                          May 1, 2024

                                              Third Party Communication: NONE
                                              Date of Communication: NONE

Number: 202434011
Release Date: 8/23/2024
Index (UIL) No.: 162.21-01
CASE-MIS No.: TAM-122851-21

Director, Field Operations (West), Western Compliance
LB&I
1301 Clay Street
Oakland, CA 94612
LB&I WCPA, DFO-W, T4, San Francisco Team 1232

     Taxpayer's Name:                          ---------------------------------------------
     Taxpayer's Address:                       ---------------------
                                               ----------------------

     Taxpayer's Identification No              ----------------
     Year(s) Involved:                         ---------------
     Date of Conference:                       ------------------

LEGEND:

Parent = -------------------------
Subsidiary = ----------------------------------------------
Month 1 = --------------
Month 2 = --------------
Month 3 = ------------------
Month 4 = ---------------------
Year 1 = -------
Year 2 = -------
Year 3 = -------
Year 4 = -------
Year 5 = -------
Date 1 = --------------------------
Date 2 = --------------------------
Date 3 = -----------------
TAM-122851-21 2

Date 4 = -------------------------
State = -------------
State Code = --------------------------------------
State Agency = -----------------------------------------------
Federal Agency = ------------------------------------------------------------
City = --------------
section a = ---------------
section b = -----------------
section c = -----------------
section d = ---------------
section e = ---------------
A = -------
B = -------------
C = -------

Parent is a publicly-traded corporation and files a consolidated U.S. federal income tax
return on behalf of an affiliated group (collectively, Taxpayer) that includes Subsidiary.
The Parent is a holding company whose primary operating subsidiary is Subsidiary, -----

-----------------------------.

In Month 1, Subsidiary was found to have violated various provisions of the State Code
in a civil proceeding conducted by State Agency. As a result of Subsidiary’s violations,
State Agency issued a decision imposing -------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

IRS Examination (Exam) is auditing the Taxpayer’s Year 1 and Year 2 tax returns. The
Taxpayer and Exam agree that section 162(f)1 of the Internal Revenue Code (Code)
prohibits the Taxpayer from deducting amounts incurred -----------------------------------------
--------. The Taxpayer and Exam request technical advice from the IRS Office of Chief
Counsel regarding the proper tax treatment of amounts -------------------------------------------

--------------------------------------------------------------------------------------------------.

1 Unless otherwise indicated, all statutory and regulatory references are to the Internal Revenue Code

and Income Tax Regulations in effect for the taxable years -----------.
TAM-122851-21 3

ISSUES:

(1) Whether ----------------------------------------------------------------------------------------------------
------------------------------------------------------------and, if so, whether section 162(f), 263(a),
or 263A, or the public policy doctrine, precludes the Taxpayer from deducting or
capitalizing amounts incurred -----------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------------;

(2) Whether ----------------------------------------------------------------------------------------------------
-------------- and, if so, whether section 162(f) precludes the Taxpayer from deducting, or
otherwise reducing gross receipts or taxable income, to account for amounts incurred ---
------------------------------------; and

(3) Whether sections 162(f), 263(a), or 263A, or the public policy doctrine, precludes the
Taxpayer from deducting or capitalizing amounts incurred ---------------------------------------
--------.

CONCLUSIONS:

(1) ----------------------------------------------------------------------------------------------------------------
---------------------------------------------------. Further, section 162(f) prohibits the Taxpayer
from deducting amounts incurred ------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------that
would otherwise be currently deductible under section 162(a) because they are imposed
as fines or similar penalties for the violation of laws, and are paid to the government
within the meaning of section 162(f). Additionally, the public policy doctrine, and
sections 263(a) and 263A, prohibit the Taxpayer from capitalizing amounts incurred -----
such capital expenditures are analogous to the types of fines or penalties that are
disallowed under section 162(f), and are not otherwise permitted to be taken into
account in determining taxable income;

(2) ------------------------------------------------------------------------------------------------------.
Section 162(f) prohibits the Taxpayer from deducting amounts incurred ----------------------
----------------- because ---------------------------------------------------------------------------------------
---------------that are imposed as fines or similar penalties for the violation of laws, and
are paid to the government within the meaning of section 162(f);

(3) Section 162(f), the public policy doctrine, and sections 263(a) and 263A do not
prohibit the Taxpayer from deducting or capitalizing amounts incurred ------------------------
------------------------------. Such amounts are nonpunitive compensatory payments or
amounts incurred to cure identified violations of law, and are therefore not subject to the
prohibition of section 162(f).
TAM-122851-21 4

FACTS:

A.       State’s Regulation of -------------------

State Agency is the state regulatory body that oversees and regulates -----------------------
-----------------------------------------------------------------------------------------. State Agency has
broad authority over -----------------------------------------------------------------------------------------
------------------------- enforcing state laws and regulations that provide safety
requirements --------------------------------------------------------------------------------------------------
----------------------.

---------------------------------------------------------------------------------------------------------------------

------------------------ --------------------------------------------------------------------------------------------

State Code section a provides that ----------------------------------------------------------------------

-----------------------------------------------. State Code section b provides ---------------------------

--------------------------------------------------------------------------------------------------------------, and
imposes a penalty of --------------------------------------------------------. State Code section c
provides, in relevant part, that every violation is a separate and distinct offense. Further,
State Agency has authority to order equitable remedies, in part pursuant to State Code
sections d and e. State Code section d confers broad authority on State Agency to -------

---------. State Code section e provides, ----------------------------------------------------------------

----------------------------------------------------------------------------.
TAM-122851-21 5

B.       ---------------------------------------------

On Date 1, -----------------------------------------------------------------------------------------------------

Subsidiary’s safety practices were the subject of federal and state investigations, and
civil and criminal proceedings.

     1. -----------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

     2. --------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 6

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

     3. ----------------------------------

------------------------------------------------------------------------------------- -------------------------------

---------------------------------------------------------------------------------------------------------------------

C.       State Agency Investigation & Initial Decisions (Year 3—Year 1)

In Year 3 and Year 4, State Agency opened A investigations related to ----------------------
--------------to determine whether Subsidiary’s --------------------------------- resulted in
violations of State Code section a, or any other applicable statute, law, general order or
State Agency decision ------------------------------. In opening each investigation, State
Agency indicated that, should these investigations result in a determination that
Subsidiary violated any legal safety requirements, State Agency would exercise its
authority to impose penalties and/or remedies as provided under State Code.

     1. Proposed ---------and Penalty Decisions (Year 5)

On Date 2, State Agency issued proposed decisions ----------------------------------------------
------------------, finding that Subsidiary violated State Code and other authorities -----------
TAM-122851-21 7

------------------------------------------------. State Agency issued a separate proposed
decision recommending that “the penalty imposed” for Subsidiary’s violations --------------
--------------------------------------------------------------------totaling approximately $B (Proposed
Penalty Decision). This Proposed Penalty Decision contained C orders directing
Subsidiary to:

     (1) -------------------------------------------------------------------------------------------------------
     -----------------

     (2) -------------------------------------------------------------------------------------------------------
     --------------------------------

     (3) -------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------------
     ----------------------.

     2. Appeal/Request for Review of Proposed Penalty Decision (Year 5)

Subsidiary and ------------------------------intervenors appealed and requested review of the
Proposed Penalty Decision. -------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

-------------------------------------------.

---------------------------------------------------------------------------------------------------------------------

     ------------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------------
     ---------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 8

---------------------------------------------------------------------------------------------------------------------

     3. Final ---------and Penalty Decisions (Year 1)

On Date 3, State Agency largely adopted the findings and determinations of the
proposed decisions in the ----------------------------, finding that Subsidiary engaged in
numerous violations of the State Code, applicable State Agency orders, and the laws,
regulations, and standards incorporated thereby ----------------------------------------------------

------------------------------------------------------(Final Penalty Decision).

In the Final Penalty Decision, State Agency observed that ---------------------------------------

---------------------------------------------------------------------------------------------------------------------

------------------------------------------------------------------------------------- -------------------------------

---------------------------------------------------------------------------------------------------------------------

Accordingly, in the Final Penalty Decision State Agency imposed on Subsidiary -a fine
and other ------------------------------------------------------------------------- -----------------------------
------------------------------ consisting of:

     (1) -------------------------------------------------------------------------------;

     (2) -------------------------------------------------------------------------------------------------------
     --------------------------------------------------------------;

     (3) -------------------------------------------------------------------------------------------------------
     ------------------------------------------------------------------------------------------------------;
     and

TAM-122851-21 9

     (4) -------------------------------------------------------------------------------------------------------
     ---------------------------------.

State Agency imposed the -------------------pursuant to State Code sections b and c. With
regard to the ---------------------------------------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------,
State Agency noted that these were equitable remedies imposed pursuant to its
authority under the State Constitution and State Code sections d and e.

---------------------------------------------------------------------------------------------------------------------

         a. --------------------------

---------------------------------------------------------------------------------------------------------------------

         b. ------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 10

---------------------------------------------------------------------------------------------------------------------

         c.   ---------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 11

         d. ------------------------------

---------------------------------------------------------------------------------------------------------------------

----------------------.

         e. --------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

D.        ------------------------------------------------------------------------------------------------------
         -------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 12

---------------------------------------------------------------------------------------------------------------------

E.       Parties’ Positions

     1. Taxpayer’s Position

The Taxpayer argues that neither section 162(f) nor the public policy doctrine applies to
prohibit the deduction or capitalization of any of the amounts at issue.

While the Taxpayer does not dispute that the State Agency acted with punitive intent in -

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------, and therefore does not
implicate section 162(f) nor the public policy doctrine, which apply to expenses.

In the alternative, the Taxpayer argues that -----------------------------------------------------------

------------ the costs -------------------------------------------------------may still be distinguished
TAM-122851-21 13

from a fine or penalty subject to section 162(f). The Taxpayer argues that those costs
originated from non-punitive -------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

-------------------------------------------------------------------------------------------------- -----------------

---------------------------------------------------------------------------------------------------------------------

Finally, Taxpayer argues that none of these amounts were paid to a government, nor
were they “in lieu of” a fine or similar penalty.

---------------------------------------------------------------------------------------------------------------------

-------------------------------------------Therefore, the Taxpayer contends that the costs of
complying with the order are not deductible expenses that may be disallowed by section
162(f) or the public policy doctrine.

In the alternative, the Taxpayer argues ----------------------------------------------------------------
----------------------------------------------- the costs were not a fine or similar penalty for which
a deduction is disallowed under section 162(f). Instead, the Taxpayer argues that these
costs represented compensatory damages, ----------------------------------------------------------

TAM-122851-21 14

Finally, --------------------------------------------------------, the Taxpayer argues that the ---------
------------------------------------are analogous to compensatory damages and court costs
and are therefore excluded from the scope of section 162(f) by Treas. Reg. section
1.162-21(b)(2). With respect to the -------------------------, the Taxpayer indicates that
many of those costs were necessary to cure Subsidiary’s violations of law and ------------
-------------------------------------------------------------------------------------------------------As such,
the Taxpayer argues the --------------------------are costs of complying with applicable
requirements, and are excluded from the scope of section 162(f) as illustrated by Treas.
Reg. section 1.162-21(c), Example 3.

Additionally, the Taxpayer argues that, except for -----------------------------------------, none
of these amounts were paid to a government, nor were they “in lieu of” a fine or similar
penalty under section 162(f).

     2. Exam’s Position

Exam disagrees with the Taxpayer’s position that ---------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------------------------------------. Additionally, Exam argues that section 162(f)
and the public policy doctrine preclude deduction or capitalization of all the amounts
incurred by the Taxpayer -----------------------------------------------------------------------------------
----------------------------------In support of this position, Exam relies on the holdings of the -
---------Decisions, and the rationale offered by State Agency in the Proposed and Final
Penalty Decisions, -------------------------------------------------------------------------------------------
---------------------. Those decisions ------------------primarily focused on Subsidiary’s
violations of the State Code and expressed State Agency’s overarching intent to impose
a penalty proportionate to the scope and severity of Subsidiary’s violations of law.
Viewing the totality of the record, then, Exam argues that the amounts at issue are a
comprehensive penalty meant to punish Subsidiary for its violations of safety
requirements, and to deter ----------------from ever engaging in similar conduct in the
future.

Specifically, -------------------------------------------------------------------------, Exam argues that
the Taxpayer’s liability arises “in lieu of” its liability for a portion of an otherwise
warranted cash penalty. ------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 15

--------------------Exam thus takes the position that Taxpayer’s liability --------------------------
---------------------------------------arises “in lieu of” its liability for a cash penalty that may
have otherwise been imposed and paid to the government for Subsidiary’s violations of
the State Code. -----------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Exam also argues that section 162(f) and the public policy doctrine disallow any tax
benefit for all costs associated with --------------------------------------------------------. In
particular, Exam argues that State Agency imposed -------------------as a means of
punishing Subsidiary’s malfeasance. Accordingly, Exam takes the position that -----------
---------is an amount for which a deduction would otherwise be subject to disallowance
under section 162(f). ----------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Further, Exam argues that State Agency’s -------------------------------exists as a
component piece of an overarching penalty meant to punish the Taxpayer in a manner
proportionate to the scope and severity of its safety violations. In support of that
position, Exam relies on the entirety of the record ---------------------------------------------------
----------------------------------------------------.

LAW:

Section 162(a) of the Code generally provides taxpayers with a deduction for all the
ordinary and necessary expenses paid or incurred during the taxable year in carrying on
any trade or business.

Section 162(f), as applicable to the years at issue, provides that no deduction shall be
allowed under subsection (a) for any fine or similar penalty paid to a government for the
violation of any law.2

2 The reference to subsection (a), which allows a deduction for ordinary and necessary expenses paid or
incurred, indicates that section 162(f) applies to amounts paid or incurred for fines or similar penalties.
For accrual-method taxpayers, a liability is incurred, and generally taken into account for Federal income
tax purposes, in the taxable year in which the events have occurred that establish the fact of liability, the
amount of the liability can be determined with reasonable accuracy, and economic performance has
occurred with respect to the liability. See section 461(h) and section 1.461-1(a)(2)(i). Additionally, an
amount that a taxpayer expends or will expend for capital improvements to property must be incurred
before the taxpayer may take the amount into account in computing its basis in the property. Section
1.446-1(c)(ii)(B). We do not express any opinion on whether any of the amounts at issue were properly
TAM-122851-21 16

Section 1.162-21(b)(1)(ii) and (iii) of the Regulations provides that for purposes of
section 162(f), a fine or similar penalty includes an amount paid as a civil penalty
imposed by Federal, state, or local law or in settlement of a taxpayer’s actual or
potential liability for a fine or penalty. The amount of a fine or penalty does not include
legal fees and related expenses paid or incurred in the defense of or prosecution or civil
action arising from a violation of the law imposing the fine or civil penalty. Id. At (b)(2).
Additionally, compensatory damages paid to a government do not constitute a fine or
penalty. Id.

Section 1.162-21(a) provides that “a government” includes the government of the United
States, a state, or any political subdivision, corporation, or other entity serving as an
agency or instrumentality thereof.

Section 263(a) provides that no deduction shall be allowed for permanent improvements
or betterments to increase the value of any property or estate or for amounts expended
in restoring property or in making good the exhaustion thereof for which an allowance
has been made. See Treas. Reg. section 1.263(a)-1(a).

Section 1.263(a)-1(d) provides that capital expenditures include, for example, amounts
paid to acquire, produce, or improve a unit of real or personal tangible property. See
section 1.263(a)-2(d); section 1.263(a)-3(d).

Section 1.263(a)-1(b) provides that “nothing in this section changes the treatment of any
amount that is specifically provided for under any provision of the Internal Revenue
Code . . . other than section 162(a) or section 212” and the regulations associated with
those sections.

Section 263A prohibits current deductions for certain direct and indirect costs of
producing property.

Section 263A(a) and (b) provide, in part, that a taxpayer must capitalize all the direct
and allocable indirect costs of any real or tangible personal property produced by the
taxpayer. Section 263A(g)(1) provides that the term “produce” includes construct, build,
install, manufacture, develop, or improve.

Section 263A(a)(2) provides that any cost which (but for section 263A and the
regulations thereunder) could not be taken into account in computing taxable income for
any taxable year shall not be treated as a cost described in that paragraph. See Treas.
Reg. section 1.263A-1(c)(2).

reported on Taxpayers’ Year 1 and Year 2 returns, including whether the amounts were incurred in those
taxable years.
TAM-122851-21 17

Sections 1.263A-1(c)(3), 1.263(a)-2(g) and 1.263(a)-3(o) provide that amounts
capitalized are included in inventory costs or charged to a capital account or basis.
Section 1012 provides that the basis of a taxpayer’s property shall be the cost of such
property. Section 1016 provides that a taxpayer’s basis in property must be adjusted by
the amount of any expenditures properly chargeable to a capital account, including the
cost of improvements or betterments made to the property. See Treas. Reg. section
1.1016-2(a).

Sections 1.263A-1(c)(4), 1.263(a)-2(h) and 1.263(a)-3(p) provide that taxpayers may
recover capitalized amounts, generally, through depreciation, amortization, cost of
goods sold, or by an adjustment to basis at the time property is used, sold, placed into
service, or otherwise disposed of by the taxpayer.

Section 61 of the Code generally provides that gross income means all income from
whatever source derived. The term “income” is broadly defined as “instances of
undeniable accessions to wealth, clearly realized, and over which the taxpayers have
complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S. 426, 431 (1955).

ANALYSIS:

A. ------------------------------------------------

    1. Costs Otherwise Currently Deductible under Section 162

We conclude that ---------------------------------------------------------------------------------------------
----------------------------------------------------------------------. Further, we hold that costs
incurred to satisfy the order that are otherwise currently deductible under section 162
are disallowed pursuant to section 162(f) because they are imposed as fines or similar
penalties for the violation of laws, and are paid to the government within the meaning of
section 162(f).

        a. Fines or Similar Penalties for Violation of Law

Courts have long held that section 162(f) prohibits a deduction for liabilities “imposed for
purposes of enforcing the law and as punishment for the violation thereof,” or otherwise
imposed for the purpose of deterring future proscribed conduct. Waldman v.
Commissioner, 88 T.C. 1384, 1387 (1987), aff’d, 850 F.2d 611 (9th Cir. 1988). Amounts
imposed as a nonpunitive measure, such as to compensate another party, fall outside
the prohibitions of section 162(f). Id. Courts—and the Service—have recognized that
the origin of an ostensible penalty may bear a dual nature, in that its effect may be both
punitive and nonpunitive. When confronted with this duality in applying section 162(f),
courts assess the primary purpose of and for the imposition of that ostensible penalty.
Waldman, 88 T.C. at 1387; see also Stephens v. Commissioner, 905 F.2d 667, 673 (2d
Cir. 1990).
TAM-122851-21 18

Whether an amount is imposed as a fine or similar penalty, for the violation of any law,
requires a determination of the origin and character of the liability. Bailey v.
Commissioner, 756 F.2d 44, 47 (6th Cir. 1985); Ostrom v. Commissioner, 77 T.C. 608
(1981); see also Nacchio v. United States, 824 F.3d 1370, 1380-81 (Fed. Cir. 2016);
see also United States v. Gilmore, 372 U.S. 37, 48-49 (1963). Subsidiary’s violations of
law as determined ------------------------------, and the imposition of -------------------------------
---------------------------- as a consequence for those violations, serve as the origin of the
Taxpayer’s liability for amounts incurred --------------------------.

We conclude that the State Agency’s primary purpose for the -----------------------------------
----------------------------was punitive. The -------------------------------------------------was
imposed pursuant to State Agency’s authority under State Code sections d and e, which
provide State Agency with the equitable authority to -----------------------------------------------

---------------------------------------------------------------------------------------------------. The order
reflects State Agency’s intent to punish Subsidiary for its violations of law as determined
in the ------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------. ------------

---------------------------------------------------------------------------------------------------------------------

----------------we find the primary purpose was punitive; specifically, ----------------------------
-------------------------------------------------------------------------------- as a substitute for a ---------

cash penalty that was otherwise warranted under the law.

The State Agency’s decision to ---------------------------------------------------------------------------
------------------- also demonstrates State Agency’s punitive intent. In the Final Penalty
Decision, -------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 19

---------------------------------------------------------------------------------------------------------------------

As discussed above, the punitive aspects of the -----------------------------------------------------
are express, and outweigh any ostensibly competing nonpunitive purpose for the ---------
------------------------------------------------. Accordingly, the primary purpose of -------------------
---------------------------------------is to enforce the law by punishing the Taxpayer for
Subsidiary’s violations of law, and to deter future offenses.

We disagree with the Taxpayer’s characterization of the ------------------------------------------

---------------------------------------------------------------------------------------------------------------------

---------------------- ---------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 20

For similar reasons, we do not agree with the Taxpayer that the costs cannot be viewed
as punitive because the origin of this liability is laws that applied to all ------------------------
-----------regardless of wrongdoing. As noted above, we find the origin of the Taxpayer’s
liability for these costs is the -----------------------and the subsequent ----------------------------
----------------------------, for which the State Agency’s primary purpose was to punish
Subsidiary. Therefore, we do not agree the -----------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

Finally, the Taxpayer argues that the costs of satisfying the -------------------------------------
--------------------------- cannot be punitive because they ---------------------------------------------

-----------------------------------------. The Taxpayer fails to explain why this is relevant to the
determination of the origin and character of the Taxpayer’s liability. In order to evaluate
the deductibility of an amount imposed as a potential fine or similar penalty, the courts
and the Service look to the origin and character of the liability giving rise to the claim,
not the effect of the payment on the taxpayer.

         b. Paid to the Government Within the Meaning of Section 162(f)

Although section 162(f) prohibits deductions for penalty amounts paid to the
government, courts have held that “paid to a government” does not mean that the
“government must actually ‘pocket’ the fine or penalty.” Waldman, 88 T.C. at 1389.
Rather, courts have held that fines for a violation of law otherwise payable to the
government, and that are redirected by the government to a non-government payee,
may remain nondeductible fines or similar penalties within the meaning of section
162(f). Id. (criminal restitution payments made directly to victims was a nondeductible
penalty); Bailey, 756 F.2d at 47 (civil penalty imposed for violating a Federal Trade
Commission consent order was not deductible even though taxpayer was permitted to
apply the settlement of his liabilities in a class-action lawsuit toward the penalty); Allied-
Signal, Inc. v. Commissioner, T.C. Memo. 1992-204, aff’d in unpublished opinion, 54
F.3d 767 (3d Cir. 1995) (trial court reduced criminal penalty by amount of taxpayer’s
payment to environmental endowment fund; payment to fund held to be nondeductible
penalty).

In Waldman, the Tax Court held that restitution paid to victims in lieu of incarceration
was a nondeductible penalty under section 162(f). In that case, the taxpayer pleaded
guilty to a count of conspiracy to commit grand theft. The trial court sentenced the
taxpayer to one to 10 years in prison, but stayed execution of that sentence on condition
that taxpayer pay restitution to his victims. The Tax Court determined that, while
restitution is generally a compensatory remedy, the trial court’s primary purpose for
imposing a restitution obligation in lieu of incarceration remained a punishment for
taxpayer’s crime, i.e., a punitive measure to deter future criminality and enforce the law.
TAM-122851-21 21

In Allied–Signal, the Tax Court held that an $8 million contribution to an environmental
endowment constituted a fine or similar penalty for purposes of section 162(f). In that
case, the taxpayer was criminally indicted for, and pleaded no contest to, violations of
environmental laws. As a result, the trial court sentenced the taxpayer to the maximum
criminal fine. In doing so, however, the court noted that although it wished to allocate
the criminal fine to the parties and individuals harmed by the taxpayer’s violations, it
determined that it lacked the authority to do so. Consequently, the trial court signaled its
receptiveness to a motion to reduce that fine in consideration of any uncompelled efforts
undertaken by the taxpayer to directly alleviate the public harms caused by the
taxpayer’s criminal violations. After engaging in discussions with the trial court, the
taxpayer established an environmental endowment to research and remedy the effects
of the taxpayer’s environmental crimes, and provided that endowment with a
contribution of $8 million. The next day, the taxpayer filed a motion to reduce its criminal
penalty. This effort was successful, and on reconsideration the court reduced the
taxpayer’s fine by an amount roughly equal to the contribution. In determining whether
section 162(f) disallowed the taxpayer’s deduction for the $8 million contribution to the
endowment, the Tax Court evaluated the substance of the arrangement giving rise to
the contribution. Relying on Waldman, the court determined that the primary purpose of
the contribution—and that of the statute giving rise to the initial otherwise warranted
penalty—was to enforce the law and exact a punishment, and that on balance this
purpose outweighed any remedial purpose or other effect served by the endowment
arrangement. The structure of the arrangement had no bearing on this determination;
the form did not control, and the substance of the taxpayer’s contribution remained a
nondeductible payment imposed as a punishment for, and deterrent to future,
environmental crimes.

Here, State Agency found itself presented with competing interests, similar to the courts
in Allied-Signal and Waldman. The State Agency determined that Subsidiary’s violations
warranted a significant penalty that would enforce the law by appropriately punishing
Subsidiary, and deter future violations. -----------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

The Taxpayer argues that unless there is a “quid pro quo” involving a government
reducing or eliminating a fine or sanction in exchange for some other payment, the “in
lieu of” argument—as exhibited in Allied-Signal and Waldman—fails. We do not agree
that the relevant case law requires such an arrangement in order for the “in lieu of”
TAM-122851-21 22

analysis to apply. We note that the trial court in Allied-Signal lacked authority to order
the tailored outcome it desired, thus necessitating a voluntary arrangement between the
court and the defendant. In contrast, in the present case, State Agency had authority to
order the outcome desired, and thus did not need to obtain the Taxpayer’s agreement. -

---------------------------------------------------------------------------------------------------------------------

Thus, because the Taxpayer’s liability for these amounts originates from a punitive
sanction for Subsidiary’s violation of law imposed in lieu of a ----------------------------
otherwise warranted, cash penalty to be paid to the State, we conclude that such
amounts are paid to the government within the meaning of section 162(f). Such a
determination is consistent with case law including Allied-Signal, Waldman and Bailey.

     2. Costs that are Otherwise Capital Expenditures

We conclude that the costs --------------------------------------------------------------------------------

------------------------------------------------------------------------------------------------may not be
capitalized pursuant to the public policy doctrine and sections 263(a) and 263A,
because such capital expenditures are analogous to fines or penalties that are
disallowed under section 162(f), and these costs are not otherwise permitted to be
taken into account in determining taxable income.

         a. Public Policy Doctrine

The public policy doctrine is a common law rule that disallows deductions when
allowance of such deductions “would frustrate sharply defined national or state policies
proscribing particular types of conduct, evidenced by some governmental declaration
thereof.” Tank Truck Rentals, 356 U.S. at 34. The Supreme Court has noted that
“[d]eduction of fines and penalties uniformly has been held to frustrate state policy in
severe and direct fashion by reducing the ‘sting’ of the penalty prescribed by the state
legislature.” Id. Congress enacted section 162(f), inter alia, to effectively codify the
public policy doctrine. While the doctrine has been in part codified (and its scope
limited) by the text of section 162 and associated regulations, courts continue to apply
the judicial public policy doctrine to limit tax benefits when warranted. See e.g., Smith v.
Commissioner, 34 T.C. 1100 (1960), aff’d per curiam 294 F.2d 957 (5th Cir. 1961)
(disallowing section 165 loss or section 166 bad debt deduction for a penalty imposed
for failure to pay F.I.C.A. and F.U.T.A taxes, in part, because the deterrent impact of the
tax penalty would be reduced, and violations of statutory duty would be encouraged);
Nacchio v. United States, 824 F.3d 1370 (Fed. Cir. 2016) (public policy precludes
TAM-122851-21 23

deduction under section 165 for mandatory punitive forfeitures); Coit v. Green, 404 U.S.
997 (1971) (private schools maintaining racially discriminatory admissions policies that
clearly violate Federal policy denied qualification under section 501(c)(3)).

Allowing the Taxpayer to capitalize and recover basis for amounts imposed as a penalty
would permit the Taxpayer to derive a tax benefit that would “soften the sting” of that
intended penalty. As described previously, State Agency determined that Subsidiary’s
conduct violated applicable statutory and regulatory safety requirements, -------------------
-------------------------------------------------------------------------------------, and that Subsidiary
should be subjected to penalties. Accordingly, the --------------------------------------------------

was a punitive sanction for Subsidiary’s violation of a sharply defined public policy
objective: -------------------------------------------------------------------------------------------------------

------------------------------------------------------------------Therefore, the public policy doctrine
applies to these amounts to prevent capitalization and recovery of basis, because
allowing these amounts would severely and immediately frustrate the statutory scheme
regarding -----------------------------------------------------, and would undermine State’s ability
to enforce that policy as intended by blunting the punitive and deterrent effect of State’s
penalty provisions. See e.g., Rev. Rul. 82-74, 1982-1 C.B. 110 (public policy doctrine
precludes arsonist from basis adjustments under section 165); see also Rev. Rul. 77-
126, 1977-1 C.B. 47 (public policy precludes deduction under section 165 for forfeiture
losses of illegal gambling devices).

         b. Capitalization under Sections 263(a) and 263A

In addition to the public policy doctrine, the Taxpayer is precluded from capitalizing its
costs of complying with ------------------------------------------------------under sections 263(a)
and 263A because, as discussed below, to capitalize an amount under sections 263A
and 263(a), the Code must otherwise permit that amount to be taken into account in
determining taxable income. Because Subsidiary’s capital expenditures result from a
fine or similar penalty under section 162(f), these costs are not otherwise permitted to
be taken into account in determining taxable income. Accordingly, the Taxpayer may
not capitalize these expenditures under sections 263(a) or 263A.

Section 263A provides that capital expenditures include the direct and allocable indirect
costs of any real or tangible personal property produced by the taxpayer. Congress
intended section 263A to be a single, comprehensive set of capitalization rules for
property produced by a taxpayer or acquired for resale; therefore, section 263A is often
referred to as the “uniform capitalization rules”. Prior to the enactment of section 263A,
cost capitalization requirements varied between types of property and among industries.
Congress enacted section 263A in part due to its belief that “a single, comprehensive
set of rules should govern the capitalization of costs of producing, acquiring, and
holding property….” S. Rep. No. 99-313, at 140 (1986). Additionally, Congress believed
TAM-122851-21 24

that a single, comprehensive set of capitalization rules would make the income tax more
neutral in its effect on business decisions.

Section 263A(a)(2) provides that “[a]ny cost which (but for this subsection) could not be
taken into account in computing taxable income for any taxable year shall not be treated
as a cost described in this paragraph.” The regulations under section 263A clarify this
by stating:

     Any cost which (but for section 263A and the regulations thereunder) may not be
     taken into account in computing taxable income for any taxable year is not
     treated as a cost properly allocable to property produced . . . under section 263A
     and the regulations thereunder.

Treas. Reg. section 1.263A-1(c)(2); see Patients Mutual Assistance Collective
Corporation v. Commissioner, 151 T.C. 176, 207-09 (2018); Lord v. Commissioner, T.C.
Memo. 2022-14, 3-6 (capitalization under section 263A is not permitted for costs
otherwise proscribed by section 280E).

Accordingly, the legislative history of section 263A indicates that Congress intended
section 263A to provide a uniform approach to determining the types of costs that must
be capitalized to property produced by a taxpayer, and within that uniform approach,
costs could not be capitalized under sections 263(a) or 263A unless they may be taken
into account in determining taxable income under another provision of the Code. This
interpretation of section 263A is consistent with the legislative history of section
263A(a)(2), which indicates that the flush language of section 263A(a)(2) was added to
clarify “that a cost is subject to capitalization….only to the extent it would otherwise be
taken into account in computing taxable income.” H. R. Rep. No. 100-795, at 98 (1988).
Indeed, the legislative history of section 263A(a)(2) clarifies that an amount that is not
otherwise allowable in determining taxable income may not be capitalized and
recovered through depreciation or amortization deductions, as a cost of sales, or in any
other manner. Id. This reasoning prohibits the Taxpayer from including in the basis of
assets ----------------under section 263A any portion of the costs that represents an
amount analogous to a fine or similar penalty, the deduction of which is prohibited by
section 162(f). This reasoning also extends to section 263(a), which would similarly
result in an addition to basis, thus permitting these amounts to be depreciated,
amortized, and eventually be recovered upon the property’s disposition.

B. ---------------------

We find that the ----------------------required the Taxpayer to pay $--------------------------------

-------------------------------------------------. Additionally, we find that the amounts incurred to
-------------------------------------are disallowed pursuant to section 162(f) because they are
TAM-122851-21 25

imposed as fines or similar penalties for the violation of laws, and are paid at the
direction of the government.

     1. ------------------------------------------------------------------------------------

Before discussing the applicability of section 162(f), we must first determine whether ---

---------------------------------------------------------------------------------------------------------------------

Generally, taxpayers are taxed on net income and may deduct under section 162(a) all
ordinary and necessary expenses paid or incurred in carrying on a trade or business,
including judgments, settlements, and similar payments. It is axiomatic that, before a
refund may be deducted, a corresponding amount must have been included in a
taxpayer’s gross income. Section 61 provides, generally, that gross income means all
income from whatever source derived. The term “income” is broadly defined as
“instances of undeniable accessions to wealth, clearly realized, and over which the
taxpayers have complete dominion.” Commissioner v. Glenshaw Glass Co., 348 U.S.
426, 431 (1955).

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 26

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

TAM-122851-21 27

---------------------------------------------------------------------------------------------------------------------

--------------------------------------------------------------------------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

     2. Section 162(f)

Having concluded --------------------------------------------------------------------------------------------
------------------------, the next step in our analysis is to determine whether section 162(f)
bars a deduction for the amount of -------------------incurred in Year 2.

Subsidiary’s violations of law as determined in the ----------------------, and the imposition
of ---------------------------as a consequence for those violations, serve as the origin of the
Taxpayer’s liability for amounts to be paid -------------------------------------------------------------
------------------------------------------------------------------------------------------------------------.

As with the ------------------------------------------------, we conclude State Agency’s primary
purpose for the ----------------------was punitive. ----------------------------was imposed
pursuant to the State Agency’s authority under State Code sections d and e, which
provide State Agency with the ----------------------------------------------------------------------------

------------------. State Agency generally characterized -------------------as a component
piece of the comprehensive penalty arrangement imposed on the Taxpayer as a
consequence of the violations of law determined by ---------------------------, including its
failure to --------------------------------------------------------------------------------------------------------

TAM-122851-21 28

We do not agree with the Taxpayer’s argument that ------------------------------------------------

---------------------------------------------------------------------------------------------------------------------

--------------------------------------. As noted previously, the facts indicate that the ---------------
---------was intended to serve as a punishment for Subsidiary’s violations of law and to
deter future failures to comply with State’s safety mandates.

As with the ------------------------------------------------, the fact that the ultimate payee of this
punitive sanction was not the government does not convert a non-deductible punitive
exaction into a deductible expense. See Bailey, 756 F.2d at 47; Waldman, 88 T.C. at
1389-1390. Accordingly, section 162(f) precludes the Taxpayer from deducting amounts
incurred to satisfy --------------------------.

C. ------------------------------

Finally, we must determine whether the Taxpayer is precluded from deducting costs
incurred to satisfy ------------------------------------pursuant to sections 162(f), 263(a), or
263A, or the public policy doctrine.

     1. -----------------------------------

Section 162(f) does not preclude a deduction for amounts incurred by the Taxpayer to
satisfy the -------------------------------to reimburse State Agency for costs associated with
the investigation of -------------------------and ------------------------------------------------------------
------------------. Pursuant to Treas. Reg. section 1.162-21(b)(2), a fine or penalty does
not include legal fees and related expenses related to a civil action arising from a
violation of the law imposing a civil penalty, nor compensatory damages paid to a
TAM-122851-21 29

government. These reimbursement amounts fall within the exception provided by Treas.
Reg. section 1.162-21(b)(2), and section 162(f) will not preclude a deduction for those
costs. As a corollary matter, the public policy doctrine does not serve to limit deductions
attributable to the ------------------------------------.

     2. --------------------------

Additionally, section 162(f) does not preclude a deduction for amounts incurred by the
Taxpayer to satisfy -------------------------------------------------------------------------------------------
-----------------------------------------------------------------------------------------------------------.

State Agency believed these --------------------------------------------------------to address or
cure the violations of law determined in the ---------Investigations. As a result, State
Agency’s primary purpose in directing Subsidiary to execute these ----------------------------
was to correct the violations determined in the -----------------------and to bring
Subsidiary’s operations into conformity with its pre-existing legal obligations; in other
words, to cure its violations of law.

This is distinct, for instance, from amounts required to be expended to satisfy of the -----
------------------------------------------------. State Agency considered the ----------------------------
as intended to correct the specified violations of law determined in the -----------------------
------------------. By contrast, the work completed to satisfy the ------------------------------------
----------------------------lacks such a direct connection to any specific violation of law
identified in the ----------------------.

Additional distinctions between costs incurred to satisfy-------------------------------------------
-------------------------------------, and costs incurred to satisfy ----------------------------------------
----------------------------------------, demonstrate the non-punitive aspect of ----------------------
--------------. For example, this order declines to fix an exact liability on the Taxpayer, but
instead simply directs -------------------------------------------------------------and supplies an
estimated cost of doing so; the State Agency acknowledged that some of the --------------

------------------ ------------. This is distinct from ----------------------------------------------------------
----------------------------- that fixed a defined monetary liability upon the Taxpayer.

Accordingly, we conclude the order directing Subsidiary to execute the ----------------------
--------------bears no indicia of a measure meant to punish or deter. Rather, the ------------
-------------- are meant to specifically cure Subsidiary’s violations of law. Accordingly,
amounts paid or incurred in executing the --------------------------are nonpunitive and not
subject to disallowance under section 162(f). See Treas. Reg. section 1.162-21(c),
Example 3 (concluding that a manufacture of motor vehicles found to have violated laws
regarding selling uncertified vehicles was prohibited under section 162(f) from deducting
amounts paid as a civil fine, but was not prohibited from deducting amounts it was
required to pay to remedy the vehicle’s non-conformity). As a corollary matter, the public
TAM-122851-21 30

policy doctrine, section 263(a), and section 263A do not serve to limit deductions or cost
recovery attributable to the --------------------------.

CAVEAT(S):

A copy of this technical advice memorandum is to be given to the taxpayer(s). Section
6110(k)(3) of the Code provides that it may not be used or cited as precedent.

Get today's answer for your situation

You just read what the IRS ruled for one taxpayer in 2024, and it can't be cited as precedent. Ezel checks the current Internal Revenue Code and IRS guidance and answers your specific situation, with citations.

Opens in Ezel Pro. Every answer cites the authority it relies on.

Apply this to your situation

This page covers one taxpayer's ruling from 2024, which can't be cited as precedent. Ezel answers your situation under the current Code and IRS guidance, with citations.

On this page

Document type

Technical Advice Memorandum

IRS subject

Fines, Penalties and Other Amounts

Topics

Income and deductions

Code sections

§ 61, § 162, § 263, § 263A, § 461, § 1012, § 1016, § 6110

Ruling dated

May 1, 2024

Publicly released

August 23, 2024

View Official PDF