Wednesday, January 6, 2010

Tax Court Decides that Restitution Payments Related to a Trade or Business are Deductible

In Cavaretta v. Commissioner, T.C. Memo. 2010-4, the Tax Court held that contractual restitution paid by a Dentist to an insurance company to compensate for overcharges are deductible as ordinary and necessary business expenses rather than losses. This resolution permitted the taxpayer (the Dentist) to carry the current year losses generated by the deduction of the restitution payments back to an earlier tax year to obtain a refund.

The holding is not a broad holding that restitution payments are ordinary and necessary business expenses or are always deductible in some manner under the Code. Let's address the holding in the context of the facts.

The taxpayer was a dentist. His wife worked in his dental office. His wife began charging an insurance company for services that were not rendered to the insured patients. Under the contract between the dentist and the insurance company, the dentist was obligated to repay overpayments for services rendered. The wife was prosecuted and pled to one count of health-care fraud. The husband contractually agreed to restitution with the insurance company, and the wife asserted that restitution in seeking leniency in the sentence. At sentencing, the judge referred to the contractual restitution commitment, but did not impose any fine or restitution.

The taxpayer / dentist, who had included the wrongful charges in income in the years he received it, then paid the restitution and sought to deduct it as an ordinary and necessary business expense. The key points in the Tax Court's holding that the restitution payments to the insurance company were ordinary income were:

1. The parties agreed that the payments were deductible. The taxpayer argued they were deductible as ordinary and necessary business expenses, thus permitting carryback to an earlier year. The IRS argued that they were section 165(c)(1) losses incurred in a trade or business which could not be carried back. (Note that this key nexus between the trade or business and the payment or loss often is not present; most prominently in the context of federal tax crimes, although restitution to the IRS in tax cases is not permitted, plea agreements often contain contractual restitution to the IRS (and, of course, is a count of conviction is outside Title 26, court imposed restitution to the IRS may be permitted); there is usually, however, no nexus between the restitution payments and a trade or business.)

2. The payments were, in fact, restitution although the sentencing court did not award restitution.  The court thus would appear likely to reach the same result with court imposed restitution.  Note that, since the offense was not a tax offense and the victim had been defrauded, the court could have incorporated the agreement into a court ordered restitution.

3. Restitution payments with the required nexus to a trade or business are deductible. Often when a defendant defrauds another, it may not be in connection with a trade or business. For example, an embezzler is usually not considered to be in a trade or business, and thus restitution of embezzlement proceeds would not be a trade or business expense. (Thus, the wife could not have claimed the expenses as ordinary and necessary expenses related to her fraudulent conduct of overcharging; but the taxpayer / dentist could claim them as related to his trade or business of a dental practice.)

4. The court distinguished cases which held that payments that are punitive might be nondeductible as business expenses under § 162(f). The court noted most immediately that these particular restitution payments were not punitive but compensatory. ("[W]we have little trouble concluding that the payments are noncriminal, compensatory restitution.") The court reached this conclusion without necessarily relying on the taxpayer's contractual commitment to repay in the operative agreements with the insurance company over the period of the false charges. They still had the required nexus to the taxpayer's trade or business.

5. Finally, the court held that, given the novelty of the particular issue in the context presented and uncertainty in the law, even if the court were wrong in the ordinary and necessary business expense holding, it would not impose an accuracy related negligence penalty.

So, that is the guts of the opinion.

My comments are:

1. From a technical tax perspective, I would have thought that the concepts of Arrowsmith v. Commissioner, 344 U.S. 6 (1952) and its progeny might have played some role in the court's exegesis. In very broad strokes, the holding of Arrowsmith and its progeny is that expenses related to income take on the character of the income. The Arrowsmith fight is often about whether the character of the expense is ordinary or capital, but I am not aware that those concepts cannot be used in further characterizing the nature of the ordinary expense. That type of inquiry seems to the what the court actually did without citing Arrowsmith and its progeny. The related income here was clearly trade or business ordinary income and, at a gut level, denying a trade or business offsetting loss (albeit in a later year) just does not strike the gut -- at least my gut -- as wrong. Apparently, it did not strike Judge Holmes' gut as wrong either.

2. The court discussed an earlier case, Stephens v. Commissioner, 905 F.2d 667 (2d Cir. 1990), distinguishing between punitive and compensatory restitution. I had generally thought that restitution is compensatory rather than punitive even when imposed at sentencing.  I did a quick LEXIS-NEXIS search and located perhaps some differences, which I think may be semantical, over this the distinction between punitive and compensatory restitution. See United States v. Leahy, 438 F.3d 328, 334 (3d Cir. 2006) (citing the opposing holdings on the issue, which I think may be reconciled by context; it just goes to show that what appear to be sweeping holdings in cases need to be filtered through the context in which they are made); see also Brian Kleinhaus, Serving Two Masters: Evaluating the Criminal or Civil Nature of the VWPA and MVRA Through the Lens of the ex Post Facto Clause, the Abatement Doctrine, and the Sixth Amendment, 73 Fordham L. Rev. 2711 (2005) (arguing for a general rule that restitution is criminal in nature, but again I think that a more refined approach evidenced by Judge Holmes in Cavaretta gets the right tax result rather than glittering generalities about criminal v. civil or compensatory).

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