Talley Industries Inc. v. C.I.R., 96-70061

• Decision Date: 16 June 1997
• Docket Number: No. 96-70061,96-70061
• Citation: 116 F.3d 382
• Parties: -3096, 97-1 USTC P 50,486, 41 Cont.Cas.Fed. (CCH) P 77,116, 97 Cal. Daily Op. Serv. 4539, 97 Daily Journal D.A.R. 7529 TALLEY INDUSTRIES INC.; Consolidated Subsidiaries, Petitioners-Appellees, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellant.
• Court: U.S. Court of Appeals — Ninth Circuit

Page 382

116 F.3d 382

79 A.F.T.R.2d 97-3096, 97-1 USTC P 50,486,

41 Cont.Cas.Fed. (CCH) P 77,116,

97 Cal. Daily Op. Serv. 4539,

97 Daily Journal D.A.R. 7529

TALLEY INDUSTRIES INC.; Consolidated Subsidiaries, Petitioners-Appellees, v. COMMISSIONER INTERNAL REVENUE SERVICE, Respondent-Appellant.

No. 96-70061.

United States Court of Appeals, Ninth Circuit.

Argued and Submitted May 6, 1997.

Decided June 16, 1997.

Gary R. Allen and Steven W. Parks, United States Department of Justice, Washington, DC, for respondent-appellant.

James G. Phillipp, Gibson, Dunn & Crutcher, Los Angeles, CA, for petitioners-appellees.

Appeal from a Decision of the United States Tax Court; L.W. Hamblen, Jr., Tax Court Judge, Presiding. Tax Ct. No. 27826-92.

Before: THOMPSON and T.G. NELSON, Circuit Judges, and FITZGERALD, District Judge. ^*

DAVID R. THOMPSON, Circuit Judge:

OVERVIEW

The Commissioner of Internal Revenue (Commissioner) appeals the tax court's summary judgment in favor of Talley Industries, Inc. (Talley) and one of its subsidiaries, Stencel Aero Engineering Corp. (Stencel). The parties dispute whether a portion of a settlement that Talley paid to the United States is deductible as an ordinary and necessary business expense under 26 U.S.C. § 162(a).

The Commissioner contends the disputed portion is a "fine or similar penalty" and, thus, is not deductible pursuant to 26 U.S.C. § 162(f). The tax court disagreed, determining the portion was intended to compensate the government for its losses. We have jurisdiction pursuant to 26 U.S.C. § 7482, and we reverse.

FACTS

Stencel is a leading manufacturer of ejection seats for military aircraft. Stencel had obtained several government contracts with the Department of Defense and the Department of the Navy for the production of ejection seats and for research and development projects.

In March 1985, Stencel and three of its officers were indicted on forty-three counts of fraudulent conduct relating to Stencel's billing practices for work performed under its government contracts. In June 1985, pursuant to a plea agreement, Stencel pleaded guilty to ten counts of making false and fraudulent statements, in violation of 18 U.S.C. § 1001.

The counts alleged that, in August 1984, Stencel submitted falsified employee time cards to the United States. Specifically, Stencel altered employee time cards so that labor costs which should have been allocated to fixed-price contracts were allocated to government contracts which did not have a fixed price. The district court accepted the plea and required Stencel to pay a fine of $10,000 on each count, for a total fine of $100,000, and to make full restitution to the federal government, in an amount to be determined by the Navy at a later date.

Prior to Stencel's guilty plea, in April 1985, the Defense Contract Administration Service notified Stencel that any invoices which had been submitted but not yet paid, and any invoices submitted in the future, would not be paid unless Stencel submitted sworn certificates attesting to the validity of the amounts charged in the invoices. Stencel was unable to submit the certificates because the extent to which the time cards had been altered was unknown.

Also, in May 1985, the Navy suspended Talley and Stencel from further government contract work. The suspension of Talley was lifted in July 1985 after the conclusion of the criminal proceedings. The suspension of Stencel remained in effect while the parties negotiated a settlement of Stencel's potential civil liability.

Stencel faced potential civil liability under the False Claims Act (FCA), 31 U.S.C. § 3729; the Truth in Negotiation Act (TINA), 10 U.S.C. § 2306a; and common law claims for breach of contract. Settlement discussions began immediately.

There was some urgency to reaching a settlement. The outstanding invoices submitted by Stencel totalled approximately $2.3 million and the Navy was its primary customer. Also, Stencel was one of three companies that could manufacture the ejection seats and Navy fighter planes had been grounded because the Navy could not obtain new seats or repair existing seats.

In January 1986, the Navy, Talley, and Stencel entered into an "Interim Agreement." Pursuant to this agreement, Stencel agreed to pay the Navy $600,000 and to continue negotiations with the Navy to settle its potential civil liability.

The Navy later determined it suffered $1,885 in losses resulting from just the ten counts to which Stencel pleaded guilty. The Defense Contract Audit Agency estimated the Navy's losses from all the falsified invoices submitted in 1984 to be from $240,000 to $358,000. The government also believed Stencel began submitting falsified invoices as early as 1979. After an audit, the government estimated its total actual loss, for years 1979 through 1984, to be $1.56 million.

In February 1986, the United States, the Navy, Talley, and Stencel entered into a settlement agreement. Pursuant to this agreement, Stencel and Talley agreed to pay the United States a total of $2.5 million, minus the $600,000 already paid by Stencel pursuant to the Interim Agreement; the government agreed to pay Stencel's invoices; and Stencel's obligation to provide restitution in the amount of $1,885 as ordered in the criminal judgment was satisfied.

For tax year 1986, Talley and its subsidiaries, including Stencel, deducted the $2.5 million paid to the government pursuant to the settlement. They claimed this deduction as an ordinary and necessary business expense. The Commissioner disallowed the deduction and determined a tax deficiency of $853,042. Talley and Stencel filed a petition for redetermination before the tax court.

Talley and the Commissioner filed cross-motions for summary judgment. The tax court determined there was no genuine issue of material fact and granted Talley's summary judgment motion. The tax court determined the $1,885 paid in restitution pursuant to the criminal judgment was a "fine or similar penalty" under section 162(f) and not deductible. The tax court determined the remaining portion of the $2.5 million payment was intended to compensate the Navy for its losses and, thus, was deductible. The tax court rejected the Commissioner's argument that $940,000 of this amount, which was the portion over and above the government's estimated loss of $1.56 million, was intended as punishment and, consequently, not deductible. The Commissioner appeals.

DISCUSSION

The only issue in this appeal is whether the $940,000 portion of the settlement is deductible. Talley does not challenge the tax court's determination that the $1,885 payment in restitution is not deductible. The Commissioner does not challenge the tax court's determination that the $1.56 million portion of the settlement (minus the $1,885 restitution payment) constitutes compensation for the government's losses and is deductible.

We review de novo the tax court's grant of summary judgment. Sierra Club Inc. v. Commissioner, 86 F.3d 1526, 1530 (9th Cir.1996). We review "the record in the light most favorable to the Commissioner to determine whether there is a genuine issue of fact and whether the [t]ax [c]ourt applied the substantive law correctly." Id. (quotations and citation omitted). We conclude the tax court erred by granting summary judgment because a genuine issue of fact exists as to the nature and purpose of the disputed portion of the settlement.

A. Overview

Section 162(a) allows a deduction for "all the ordinary and necessary expenses" incurred by a taxpayer "in carrying on any trade or business." 26 U.S.C. § 162(a). Section 162(f) provides an exception:

No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.

26 U.S.C. § 162(f). The Treasury Regulations define a "fine or similar penalty" as including amounts:

(ii) Paid as a civil penalty imposed by Federal ... law .... [or]

(iii) Paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal)....

26 C.F.R. § 1.162-21(b)(1)(ii), (iii). The Treasury Regulations provide: "Compensatory damages ... paid to a government do not constitute a fine or penalty." 26 C.F.R. § 1.162-21(b)(2).

Whether a civil penalty is deductible depends upon "the purpose which the statutory penalty is to serve." Southern Pac. Trans. Co. v. Commissioner, 75 T.C. 497, 653, 1980 WL 4591 (1980). The following test determines whether a civil penalty is a "fine or similar penalty" under section 162(f):

If a civil penalty is imposed for purposes of enforcing the law and as punishment for the violation thereof, [the payment is not deductible]. However, if the civil penalty is imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another Southern Pac., 75 T.C. at 652; see also Waldman v. Commissioner, 88 T.C. 1384, 1987 WL 49332 (1987), aff'd, 850 F.2d 611 (9th Cir.1988); Huff v. Commissioner, 80 T.C. 804, 824, 1983 WL 14824 (1983); Stephens v. Commissioner, 905 F.2d 667, 673 (2d Cir.1990); True v. United States, 894 F.2d 1197, 1203-04 (10th Cir.1990); Bailey v. Commissioner, 756 F.2d 44, 46-47 (6th Cir.1985). If the "payment ultimately serves each of these purposes, i.e., law enforcement (nondeductible) and compensation (deductible)," the tax court must "determine which purpose the payment was designed to serve." Waldman, 88 T.C. at 1387.

party for expenses incurred as a result of the violation, it [is deductible because it] does not serve the same purpose as a criminal fine and is not "similar" to a fine within the meaning of section 162(f).

B. Characterization and Purpose of the $940,000

The Commissioner argues the government's actual loss, resulting from Stencel's fraudulent conduct from 1979 to 1984, was $1.56 million and the remaining portion ($940,000) of the $2.5 million settlement constitutes a payment of double damages under the FCA. The...