Definition — Fines and Penalties

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You already know section 162(a) of the Internal Revenue Code lets you deduct the ordinary and necessary expenses you pay while carrying on your trade or business. An ordinary expense is one that is common and acceptable in your business. A necessary expense is appropriate and helpful in carrying on your business.

Image source: Johnacastro2012 via Wikimedia Commons

Image source: Johnacastro2012 via Wikimedia Commons

You may also know that section 162(f) says you get no deduction under 162(a) for any fine or similar penalty paid to a government for the violation of any law, and that the disallowance is not limited to criminal fines and penalties.

The taxpayer in T.C. Memo. 2013-285 (Chaganti), an attorney, deducted three separate fines on his 2006 and 2007 tax returns, all of which the IRS denied.

    • The first fine was $262 of fees and charges a district court ordered the taxpayer to pay because his client failed to appear at a deposition. This fine was paid to the opposing attorney.
    • The second fine was a late fee of $2,300, also ordered by the district court when the taxpayer failed to pay the $262 fine. The taxpayer paid this fine to the Clerk of the District Court.
    • The third fine was $18,125 for the “taxpayer’s willful and unreasonable protraction of the litigation”, and was paid to the opposing attorney to reimburse that attorney’s client for the extra fees attributed to the taxpayer’s misconduct.

The tax court disallowed two of the fines because they were not ordinary and necessary to the practice of law, and said a genuine dispute of fact existed for the remaining fine.

Which two do you think were disallowed?

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It is unknown at this time under which statute the taxpayer was ordered to pay the $262 sanction to opposing counsel. It is similarly unknown what criteria were required to impose this sanction and whether such an imposition in and of itself would indicate that the expense was not ordinary or necessary to the practice of law. A genuine dispute of material fact exists.

It is clear that the $2,300 fine imposed on the taxpayer was for the violation of his duties as an officer of the court in being held in contempt and failing to timely pay the $262 sanction. This amount was paid to the Clerk of the Court for the District Court, a governmental agency responsible for collecting such fines and penalties. Accordingly, the taxpayer is not entitled to deduct the $2,300 sanction as an ordinary and necessary business expense for tax year 2007.

The mere fact that the taxpayer was ordered to pay opposing counsel attorney’s fees demonstrates that those amounts were not ordinary and necessary to the practice of law. The District Court’s analysis in removing the amounts attributable to typical legal expenses confirms that the remaining $18,125 that the taxpayer was ordered to pay was not common to the practice of law, nor was it appropriate or helpful to his business. Accordingly, the taxpayer is not entitled to deduct the $18,125 fine levied against him as an ordinary and necessary business expense for tax year 2007.

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