The Internal Revenue Code allows the deduction of business expenses, but it disallows the deduction of criminal fines and penalties, even those related to one’s business. A trucking company cannot deduct parking fines and speeding citations, even if incurred during the operation of its trucks for business purposes. The Tax Cuts and Jobs Act of 2017 (TCJA) codified a surprising tax deduction for some white-collar criminal defendants – and a new obligation for prosecutors. Proposed Treasury regulations, issued in 2020, clarify and implement the TCJA.
Under Internal Revenue Code §162(f)(2), a defendant ordered to pay restitution to a victim may deduct that payment under certain conditions. First, the payment must relate to the business of the defendant. For example, if a defendant were convicted of embezzling from his employer and ordered to pay restitution of $100,000, the amount embezzled, he may be able to deduct that payment. On the other hand, driving under the influence defendant ordered to pay $100,000 of restitution for medical expenses to a victim, could not deduct the payment.
The second criterion is called the “establishment” requirement by proposed Treasury regulation §1.162-21(b)(3)(i). A document from the criminal case must contain three elements under this rule. A – a legal obligation to pay restitution. B – the amount; and C - the date on which the amount was paid or incurred.
The third condition is that there must be an order (or agreement) that identifies the amount paid as restitution. The IRS calls this the “identification” requirement. In California state court, the second and third requirements could be satisfied by the use of the Order for Restitution (Form CR-110).
The next requirement is that the restitution be for harm caused to the victim by the violation. This requirement is to exclude restitution which is a payment for the defendant’s unjust enrichment. The distinction is intended to focus on the difference between a loss incurred by the victim and an ill-gotten gain achieved by the defendant. Only the former qualifies for a deduction.
The fifth criterion is that the restitution not be to reimburse a government agency for the costs of its investigation. For example, under Business & Professions Code §12015.5, a company convicted of weights and measures violation can be ordered to pay restitution to the government for the cost of the investigation. Although related to the business of the defendant, the restitution would not be deductible.
The sixth and final requirement is that the restitution is paid. Defendants could deduct qualifying amounts starting in 2018.
Restitution in many business-related criminal cases will meet these standards. As an example, consider a clothing company with two sides to its business: selling shirts and selling counterfeit name-brand apparel. If it is convicted of criminal counterfeiting and ordered to pay restitution to the trademark owner, it might be able to deduct that payment.
Some victims may view allowing a tax deduction as a benefit to the wrongdoer. This might cause them to resent the deduction. This is not correct. The less the cost of restitution to a defendant, the more restitution a defendant can pay. A deduction lowers the cost of restitution and may enable a defendant to pay more restitution.
Not surprisingly, where there is a new taxable event (the deduction) there is a new reporting requirement. The TCJA places the tax form reporting burden on the government. The proposed regulations clarify the TCJA by specifying that the reporting obligation starts in 2022. Although the statute allows a threshold reporting requirement as low as $600, it gives the IRS the discretion to change that threshold. In the proposed regulations, the threshold is $50,000. Though much higher, this amount still sweeps in many cases for mandatory reporting by prosecutors.
Reporting is done using Form 1098-F. This form is due regardless of whether the restitution has been paid. A copy must be provided to the criminal defendant. A curious aspect of Form 1098-F is that it requires the taxpayer identification number of the prosecution office (the filer), but not the victim (the recipient of payment). Ordinarily, the IRS focuses on the recipient of income, but not in this case. Perhaps the IRS is more suspicious of a defendant taking a deduction than of a victim not declaring the income.
Each prosecutor’s office will have to decide what approach to take. Will the office determine if a restitution order meets the first five criteria for deductibility and only report then? This approach would require more care in reporting. Alternatively, will an office report every restitution order of $50,000 or more? This path requires more reports, but less thought.
Defendants will want to make sure they can support their tax deduction with their copy of Form 1098-F. There is a tool to help them achieve that. That tool is penalties on prosecutors for failing to file Form 1098-F. Effective 2016, the IRS increased penalties for improper filing of income report statements, including Form 1098. The IRS has two types of penalties for reporting. The penalties are based upon whether the government filed the correct return and whether it provided the other party on Form 1098-F (the defendant) the correct statement. If a prosecutor’s office fails to do either it receives one penalty, if it fails to do both, it receives two penalties. The IRS has wide discretion with fines: penalties begin at $50 and go to $500, perform. The penalty ceiling in Internal Revenue Code section 6721 is high: three million dollars.
Why would a prosecutor care about a discretionary penalty that can be waived or start as low as $50? Perhaps the prosecutor’s office would not care. On the other hand, if it were a large office with hundreds or thousands of qualifying cases and it had not filed any 1098-F forms, one tip to the IRS could lead to large penalties for many violations.
Since defendants will want Form 1098-F, it follows that, in state criminal cases, they will also want the other necessary piece to support a tax deduction: an Order for Restitution (Form CR-110). Although this form was implemented in criminal cases a long time ago, it is still common to have a court order restitution without the use of this form. If there is no Order for Restitution in a case, it is very difficult for a victim to enforce the restitution order against a defendant. Now that defendants also need an Order for Restitution, it is likely to increase the frequency with which these forms are issued in cases, a second significant benefit to victims.
Financially sophisticated white-collar defense counsel may now require the prosecution to file Form 1098-F as part of plea agreements. This will protect their client’s right to a tax deduction for restitution.
The TCJA is the rare tax law which empowers a defendant to expose a prosecutor to penalties and aligns the interests of crime victims and defendants in several ways.
Antonio R. Sarabia II practices law in Redondo Beach with a focus on contracts, trademarks, copyrights and the apparel business. He also testifies as an expert witness. John Palermo is a CPA and a shareholder of Palermo, Kissinger, and Associates P.C.