You Paid a Penalty You'd Like to Deduct; Well If Its Another's Penalty Then You're In Luck

By Gerald S. Deutsch, Esq.  

Glen Head, NY

No deduction shall be allowed for any fine or similar penalty paid to a government for the violation of any law.  So says §162(f). But what about a penalty paid by the taxpayer for another?

In GCM 39465, the IRSe concluded that, to the extent that the payment of a penalty by the taxpayer related to the liability of taxpayer's employees, such payment would not be a nondeductible penalty but rather compensation to the employees, includible in their income and not deductible by them. To the extent the compensation was reasonable, it would be deductible by taxpayer as compensation.

A similar result followed in First National Bank of Duncanville v. U.S., 481 F. Supp. 633 (N.D. Tex. 1979), where the court found that a contractual agreement to indemnify another converted an otherwise non-deductible penalty into a deductible bad debt.

Of course, the facts of the situation are always important. In Foxworthy Inc. v. Comr., T.C. Memo 2009-203, the Tax Court stated that the disallowance rule of §162(f) would apply to amounts paid by taxpayer to satisfy SEC fines levied against employees finding that the taxpayer was the employees' "alter ego."

For more information, in the Tax Management Portfolios, see Maule, 504 T.M., Deduction Limitations: General,  and in Tax Practice Series, see ¶2230, Fines and Penalties.