The Tax Cuts and Jobs Act of 2017 (TCJA) amended section 162(f) to disallow a deduction for certain amounts paid or incurred to, or at the direction of, a government entity. The Internal Revenue Service (IRS) Office of Chief Counsel recently released its first written advice addressing post-TCJA section 162(f). Chief Counsel Advice Memorandum 202439015 (June 13, 2024) (the CCA) concludes the taxpayer at issue failed to satisfy the identification and the establishment requirements of the section 162(f) exception for restitution and so could not deduct the amounts at issue. The CCA illustrates the breadth of post-TCJA section 162(f) and how important it is for a taxpayer that wants to rely on the section 162(f) restitution exception to include favorable language in dispositive documentation.

The CCA presents limited facts. The taxpayer is an individual with a wholly owned subchapter S corporation. A court order (likely from a U.S. district court) required the taxpayer to make payments to an unnamed government agency (likely the Federal Trade Commission) and the S corporation to forgive debt owed by the taxpayer's customers. The court order states that "[a]ll money paid to the [government agency] pursuant to this Order may be deposited into a fund administered by the [government agency] or its designee to be used for equitable relief, including consumer redress and any attendant expenses for the administration of any redress fund.... Any money not used for such equitable relief is to be deposited to the U.S. Treasury as disgorgement." The court order was dated after 2017 — thereby implicating post-TCJA section 162(f) — but before Treasury regulations under post-TCJA section 162(f) took effect (taxable years beginning after January 18, 2021). Thus, the CCA's analysis does not apply the final regulations.

The CCA begins by observing that the court order required the taxpayer to make payments and the S corporation to forgive debt with respect to a violation of law. The CCA concludes that, barring an exception, this means section 162(f) disallows the taxpayer's deduction for both 1) the taxpayer's payments to the government agency and 2) the S corporation's debt forgiveness. This latter conclusion is a reminder that post-TCJA section 162(f) applies to amounts incurred at the direction of a government (e.g., a bad debt loss) and shows how section 162(f) can apply to a passthrough entity to taint otherwise-deductible amounts that flow through to the entity's owners.

The CCA then turns to the restitution exception to section 162(f) and concludes it applies to neither the payments nor the debt forgiveness. The CCA's analysis regarding the payments is straightforward. The court order did not specifically identify the payments as restitution and so fails the identification requirement. In this regard, the CCA refused to concede that the court order's reference to "consumer redress" was sufficient to satisfy the identification requirement. Further, the taxpayer did not provide documentation to show that the government agency used the payments to provide restitution to the harmed victims, and so failed to satisfy the establishment requirement. That the court order gave the government agency discretion to deposit the payments into the Treasury's general account was particularly damaging for both requirements, as "[a]mounts paid to the government for its discretionary use do not constitute restitution."

In contrast to the CCA's analysis of the payments, the CCA's analysis regarding the debt forgiveness raises some questions. First, the CCA concludes the court order does not meet the identification requirement with respect to the debt forgiveness, but does not quote from the court order or otherwise explain what the court order says about the debt forgiveness. Requiring the S corporation to forgive debt owed by consumers seems plainly to have a restitutionary purpose. The CCA's silence regarding what the court order says in this regard makes it difficult to evaluate the strength of the CCA's conclusion. (Notably, much of the CCA's "Potential Hazards" section, which seems to focus on the final regulations, is redacted.) Second, the CCA concludes the taxpayer failed to satisfy the establishment requirement because the taxpayer did not provide documentation to establish that the debt forgiveness provided restitution to the harmed victims. Again, forgiving debt owed by consumers seems inherently restitutionary, but perhaps the facts were such that the taxpayer's actions harmed only some of the consumers whose debt was forgiven. Finally, it bears mentioning that much of the CCA's analysis focuses on the fact that the court order allowed the government agency to deposit the taxpayer's payments into the Treasury's general account. While damaging with respect to the restitutionary nature of the payments, this fact is irrelevant to the restitutionary nature of the debt forgiveness.

The taxpayer at issue in the CCA likely had no opportunity to negotiate more favorable section 162(f) language in the court order. Nevertheless, the CCA is a stark reminder of the specificity section 162(f) requires for a court order, settlement agreement, or other governing document to satisfy the identification requirement. Taxpayers should strive to anticipate section 162(f) issues early in the investigative process to maximize their ability to negotiate favorable language identifying amounts paid or incurred as restitution or as necessary to come into compliance with the law.

For more information, please contact:

James R. Gadwood, jgadwood@milchev.com, 202-626-1574
 

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