Stephens v. C.I.R.
| Decision Date | 11 June 1990 |
| Docket Number | D,No. 824,824 |
| Citation | 905 F.2d 667 |
| Parties | , 66 A.F.T.R.2d 90-5147, 59 USLW 2008, 90-2 USTC P 50,336 Jon T. STEPHENS and Susanne Stephens, Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee. ocket 89-4116. |
| Court | U.S. Court of Appeals — Second Circuit |
Richard B. Cooper, New York City (Stanley C. Ruchelman, Steven C. Greene, Cooper, Brown & Behrle, New York City, on the brief), for petitioners-appellants.
Teresa E. McLaughlin, Washington, D.C. (Shirley D. Peterson, Asst. Atty. Gen., Gary R. Allen, Jonathan S. Cohen, Washington, D.C., on the brief), for respondent-appellee.
Before NEWMAN and ALTIMARI, Circuit Judges, and CONBOY, District Judge. *
Petitioners Jon T. Stephens and Susanne Stephens 1 appeal from the decision of the Tax Court, Stephens v. Commissioner, 93 T.C. 108 (1989), determining a deficiency in their federal income tax for the year 1984 in the amount of $28,397.34. The sole issue before us on appeal is whether the Tax Court correctly determined that Stephens was not entitled to a loss deduction, pursuant to Section 165 of the Internal Revenue Code of 1954, 26 U.S.C. Sec. 165 (1982), 2 for a restitution payment he made in 1984 to the Raytheon Company ("Raytheon"), on the ground that allowance of the deduction would frustrate public policy.
In September of 1981, Stephens and other defendants were indicted for participating in a scheme to defraud Raytheon, a Delaware corporation doing business in the United States and in foreign countries. Following a jury trial, Stephens was convicted in December of 1982 of four counts of wire fraud, in violation of 18 U.S.C. Sec. 1343; one count of transportation of the proceeds of fraud in interstate commerce, in violation of 18 U.S.C. Sec. 2314; and one count of conspiracy in violation of 18 U.S.C. Sec. 371.
Stephens was sentenced on December 3, 1982. Before sentence was pronounced, the Assistant United States Attorney recommended to the court that Stephens be ordered to make restitution to the Raytheon Company. Pointing out that the funds which Stephens had embezzled from the Raytheon Company were frozen in a bank account in Stephens' name in Bermuda, the prosecution suggested that, in addition to whatever custodial and fine requirements the court decided to impose, it sentence Stephens to an additional consecutive period of incarceration and suspend that additional incarceration on condition that restitution to the Raytheon Company be made.
In pronouncing sentence, the sentencing judge agreed that Stephens ought to make restitution to Raytheon. After emphasizing that she "believe[d] a period of imprisonment is absolutely necessary in this case not only for the protection of the public but because we cannot ignore the seriousness of the crimes for which you stand convicted," and "that [Stephens was among] the most culpable," the judge added,
On each of the counts of wire fraud, Stephens was sentenced to a concurrent 5-year prison term and a $1,000 fine. On the conspiracy count, he was sentenced to a concurrent prison term of 5 years and a $10,000 fine. On the count of interstate transportation of the proceeds of fraud, Stephens was sentenced to a consecutive 5-year prison term and a $5,000 fine; execution of this consecutive prison term, but not the fine, was suspended, and Stephens was placed on 5 years of probation, on the condition that he make restitution to Raytheon in the amount of $1,000,000.
The $1,000,000 represented $530,000 in principal, the amount which was initially embezzled from Raytheon, and $470,000 in interest. Stephens was taxed upon his receipt of the $530,000 in 1976. 4 In 1984, as part of a settlement agreement with Raytheon in connection with two civil actions Raytheon had brought against Stephens, Stephens turned over to Raytheon the $530,000 fund, and executed a $470,000 promissory note, representing the interest. In an Amended 1984 Tax Return, Stephens claimed as a deduction the $530,000 restitution payment. The Commissioner denied this deduction, and Stephens appealed.
In the Tax Court, Stephens contended that the restitution payment was a deductible loss under Section 165. 5 The Commissioner argued that deduction of the payment was barred by Section 162(f). 6 Stephens, 93 T.C. at 111. In the alternative, the Commissioner argued that if deductibility was governed by Section 165, rather than by Section 162(f), the deduction of the court-ordered restitution was precluded on public policy grounds. Id. The Commissioner also contended that the repayment constituted a personal expense, deductibility of which is barred by Section 262, and that, in any event, Stephens had not established a loss, because he was entitled to seek contribution from his fellow defendants. Id. 7
The Tax Court determined that the allowability of the deduction for the restitution payment was governed by Section 165. In the court's view, such a payment constituted a loss in a "transaction entered into for profit" under Section 165(c)(2), rather than an "ordinary and necessary business expense" described in Section 162(a). Id. Because the deductibility of the payment was not governed by Section 162, the court concluded that Section 162(f), which precludes the deduction of fines and similar penalties as trade or business expenses, was also inapplicable. Id. at 112. Nevertheless, the court determined that the public policy considerations embodied in Section 162(f) were relevant in determining whether the payment to Raytheon was deductible under Section 165, reasoning that "it does not follow that the standards, which have been established for the application of section 162(f) to payments which would otherwise be allowable under section 162(a), should not be utilized to determine whether a taxpayer should be denied a deduction for a payment which might otherwise be allowable under section 165(c)(2)." Id.
The Tax Court then considered whether the restitution payment made by Stephens was equivalent to "any fine or similar penalty paid to a government for the violation of any law" within the meaning of Section 162(f). As an initial matter, the court determined that "the fact that the payment in question was made to a private person as restitution rather than to a Government agency in and of itself does not preclude the application of section 162(f)." Id. at 113 (citing Waldman v. Commissioner, 88 T.C. 1384, 1389 (1987), aff'd, 850 F.2d 611 (9th Cir.1988)). The court found significant the definition of "fine or similar penalty" in Section 1.162-21(b)(1)(i) of the Treasury Regulations on Income Tax (26 C.F.R.), as including an amount "[p]aid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding." Id. Although the court acknowledged that the payment "had the effect of reimbursing Raytheon for all or part of its loss and, therefore, had a civil aspect," it determined that "[t]he reimbursement-of-loss aspect was merely incidental to the consequences of [taxpayer's] criminal activities." Id. Emphasizing that the payment "was ordered in lieu of an additional prison term and as a condition of probation," id., the court concluded that the restitution payment was not a deductible loss under Section 165(c)(2). Id.
Stephens appeals from the Tax Court's interpretation of the public policy exception to deductibility under Section 165. Stephens argues that allowing the deduction would not "severely and immediately frustrate" a "sharply defined national or state policy," the test for nondeductibility on public policy grounds under Section 165. Moreover, Stephens asserts, disallowing the deduction results in a tax on his gross income, whereas Congress intended the income tax to be a tax on net income. Finally, Stephens argues that, even assuming Section 162(f) is relevant to deductibility of losses under Section 165, the Tax Court mischaracterized the restitution payment as a fine or similar penalty paid to the government. Because we agree that allowing the deduction would not severely and immediately frustrate a sharply defined national or state policy, we reverse the decision of the Tax Court, and remand for further proceedings.
As Stephens and the Commissioner agree, Stephens' restitution payment is deductible, if at all, pursuant to Section 165(c)(2) of the Tax Code, which permits an individual to deduct any uncompensated loss sustained during the taxable year, incurred in any transaction entered into for profit, though not connected with a trade or business. 26 U.S.C. Sec. 165(c)(2). Indeed, "[t]he decided cases establish that a restitution payment, such as is involved herein, is not an 'ordinary and necessary' business expense as required by section 162(a) but rather gives rise to a loss in a 'transaction entered into for profit' under section 165(c)(2)." Stephens, 93 T.C. at 111 (citing Mannette v. Commissioner, 69 T.C. 990, 992-94 (1978)). Deductions under Section 165 have been disallowed by the courts, however, where "the allowance of a deduction would 'frustrate sharply defined national or state policies proscribing particular types of conduct'...." Commissioner v. Tellier, 383 U.S. 687, 694, 86 S.Ct. 1118, 1122, 16 L.Ed.2d 185 (1966) (quoting Commissioner v. Heininger, 320 U.S. 467, 473, 64 S.Ct. 249, 253, 88 L.Ed. 171 (1943)). Thus, "the 'test of nondeductibility always is the severity and immediacy of the frustration resulting from allowance of the deduction.' " Id. (quoting Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 35, 78...
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