Are restitution payments a business or nonbusiness deduction?
Taxpayer Says: The payments are an ordinary and necessary business expense, currently deductible. The loss generated can be carried back to prior years.
Internal Revenue Service Says: The payments are nonbusiness expenses, and cannot be carried back.
From Internal Revenue Code Section 162(a): In general there shall be allowed as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
From Internal Revenue Code Section 165(a) and (c): The general rule allows for losses not compensated by insurance, limited by (1) losses incurred in a trade or business; and (2) losses incurred in any transaction entered into for profit, though not connected with a trade or business.
From Internal Revenue Code Section 172: Allows taxpayers to sometimes claim a net-operating-loss (NOL) carryback.
From Internal Revenue Code Section 172(b)(2),(d)(4): Most nonbusiness deductions, like those under section 165(c)(2), can be used only to reduce income that isn’t from a trade or business and only in the year incurred – they cannot be carried back.
THE CAUSE OF THE DISPUTE
When your business expenses exceed your income from the business, you may have a net operating loss that can be carried back to offset against prior years, generating a refund.
Generally, only business losses can be carried back as a net operating loss. The deductibility of nonbusiness losses is limited to gross income not derived from the trade or business, leading to more limited tax relief.
In this case, the taxpayer, a sole-proprietor dentist, made restitution to an insurance company for money his wife obtained through false claims. The payments had been recorded as business income in prior years, and the dentist deducted the restitution as a business expense, resulting in a loss that he carried back to those prior years. He contends he would have lost his business had he not reimbursed the insurance company.
The IRS agrees the payments are deductible, but only as a nonbusiness loss in the current year. The Service says the restitution was an expense of committing fraud and the dentist is not in the business of fraud.
WHAT WOULD YOU DECIDE?
Make your selection, then see “The Court’s Decision” below for a full explanation
THE COURT’S DECISION
HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.
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