Tax Court in Brief | Ziroli v. Commissioner | Is a Disgorgement Payment a Deductible Business Expense under Section 162?

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Tax Litigation:  The Week of July 11th, 2022, through July 15th, 2022

Ziroli v. Comm’r, T.C. Memo. 2022-75 | July 14, 2022 | Nega, J. | Dkt. No. 1041-20


Short SummaryThis case regards deficiencies determined for Clement and Dawn Ziroli (Zirolis) for adjustments regarding “Other Gains or Losses from Form 4797 – Disgorgement” for taxable year 2016. Specifically, the case focuses on whether the disgorgement of payment to the U.S. Securities and Exchange Commission by Mr. Ziroli constitutes a “fine or similar penalty” within the meaning of section 162(f) of the Code. Mr. Ziroli reached a settlement with the SEC on a federal securities violation. In an underlying Consent with the SEC, Mr. Ziroli made various concessions with respect to the alleged securities violations, which included orders of disgorgement of funds. The Consent also stated that Mr. Ziroli “further agrees that he shall not claim, assert, or apply for a tax deduction or tax credit with regard to any federal, state, or local tax for any penalty amounts that Defendant [Mr. Ziroli] pays pursuant to the Final Judgment, regardless of whether such penalty amounts or any part thereof are added to the distribution fund or otherwise used for the benefit of investors.” Mr. Ziroli paid the disgorgement and related amounts ordered in the SEC proceeding. Then, the Zirolis filed a Form 1040, U.S. Individual Income Tax Return, for the 2016 taxable year, claiming a deduction of $411,422 for “Other gains or (losses).” They attached a Form 4797, Sales of Business Property, reporting that the claimed loss deduction was for the disgorgement portion of the amount Mr. Ziroli paid to the SEC.  The IRS determined that the Zirolis were not entitled to a deduction for the disgorgement.

Key Issues

  • Whether the Zirolis are entitled to a deduction under section 162(a) for the disgorgement Mr. Ziroli paid to the SEC in settlement of his potential civil liability for alleged federal securities violations?

Primary Holdings:

  • The Zirolis failed to satisfy their burden of proving their entitlement to the deduction claimed. Specifically, the Zirolis failed to show that the disgorgement in the SEC proceeding and Consent was imposed as a remedial measure to compensate another party.

Key Points of Law:

  • The IRS’s determinations set forth in a notice of deficiency are presumed correct, and the taxpayer bears the burden of proving them erroneous. Rule 142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
  • Section 162(a) provides the general rule that taxpayers are allowed a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. As an exception to this general rule, however, section 162(f) provides that “[n]o deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.”
  • A “fine or similar penalty” is defined, in relevant part, as follows: (1) For purposes of this section a fine or similar penalty includes an amount— . . . . (ii) Paid as a civil penalty imposed by Federal, State, or local law . . .; [or] (iii) Paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal). See Treasury Regulation § 1.162-21(b).
  • Treasury Regulation § 1.162-21(b)(2), on the other hand, provides that “[c]ompensatory damages . . . paid to a government do not constitute a fine or penalty.”
  • Whether section 162(f) disallows deduction of the disgorgement in the instant case depends on “the purpose which the statutory penalty is to serve.” Pac. Trans. Co. v. Commissioner, 75 T.C. 497, 653 (1980). Civil penalties “imposed for purposes of enforcing the law and as punishment for the violation thereof” are “similar” penalties under section 162(f). Id. at 652; see Huff v. Commissioner, 80 T.C. 804, 824 (1983). Some civil payments, although labeled “penalties,” remain deductible if “imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party.” Huff, 80 T.C. at 824; S. Pac. Trans. Co., 75 T.C. at 652. “Where 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 v. Commissioner, 88 T.C. 1384, 1387 (1987).
  • Courts have long recognized disgorgement of profits from wrongful conduct as an equitable remedy available to the SEC under 15 U.S.C. § 78u(d)(5). Disgorgement can serve both a compensatory and a punitive purpose, operating both as potential compensation to victims and as a financial sanction meant to deter securities fraud.
  • Deductions are a matter of legislative grace, and taxpayers bear the burden of proving entitlement to any deduction claimed and must show that they come squarely within the terms of the law conferring the benefit sought. See Rule 142(a); INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992); New Colonial Ice Co. v. Helvering, 292 U.S. 435, 440 (1934); Welch v. Helvering, 290 U.S. at 115.
  • The taxpayer bears the burden to demonstrate that the payment for disgorgement was intended to be compensatory, rather than penal. See Talley Indus. Inc. v. Commissioner, 116 F.3d 382, 387 (9th Cir. 1997).
  • Any post hoc exercise of discretion by the government to use disgorged funds to compensate victims does not transform the payment from a penalty into compensatory damages.
  • The denial of a deduction is not a punishment and thus does not violate the Eighth Amendment. Cal. Small Bus. Assistants, Inc. v. Commissioner, 153 T.C. 65, 71–72 (2019); see, e.g., Alpenglow Botanicals, LLC v. United States, 894 F.3d 1187, 1202 (10th Cir. 2018); Murillo v. Commissioner, T.C. Memo. 1998-13, aff’d, 166 F.3d 1201 (2d Cir. 1998); Bermingham v. Commissioner, T.C. Memo. 1994-69; King v. United States, 949 F. Supp. 787, 791 (E.D. Wash. 1996).

Insights: The Zirolis had the burden of proving that the disgorgement paid to the SEC was not a “fine or similar penalty” within the meaning of section 162(f). They failed to do so. Disgorgement can serve both a compensatory and a punitive purpose, and the Zirolis failed to show that the disgorgement they paid was compensatory only. Note: The IRS has recently promulgated and adopted new rules addressing the deductibility of disgorgement under section 162. See Treas. Reg. § 1.162-21(e)(4)(B) (as amended by T.D. 9946, 86 Fed. Reg. 4970, 4984 (Jan. 19, 2021)). Those rules apply to taxable years beginning on or after January 19, 2021 (unless paid or incurred under any order or agreement pursuant to a suit, agreement, or otherwise, which became binding under applicable law before such date).

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