For the Defense - Vol. 4, Issue 3 - 21

Exception for amounts constituting restitution or
paid to come into compliance with law
(A) In general Paragraph (1) shall not apply to
any amount that-
(i) the taxpayer establishes-
(I) constitutes restitution (including
remediation of property) for damage
or harm which was or may be caused
by the violation of any law or the
potential violation of any law, or
(II) is paid to come into compliance with
any law which was violated or
otherwise involved in the investigation
or inquiry described in paragraph (1),
(ii) is identified as restitution or as an amount
paid to come into compliance with such
law, as the case may be, in the court order
or settlement agreement, and
(iii) in the case of any amount of restitution
for failure to pay any tax imposed under
this title in the same manner as if such
amount were such tax, would have been
allowed as a deduction under this chapter
if it had been timely paid.
1. The identification under clause (ii) alone
shall not be sufficient to make the
establishment required under clause (i)
(B) Limitation
Subparagraph (A) shall not apply to any
amount paid or incurred as reimbursement
to the government or entity for the costs of
any investigation or litigation.4
Although the Internal Revenue Code does
not define the term "restitution," the Treasury
Regulations provide that compensatory damages paid
to a government body are not classified as fines or
penalties and may be deductible.5 Payments to third
parties can also qualify as restitution.6 For this reason,
when negotiating a plea or other settlement with a
prosecutor or a third party, a criminal defense lawyer
should attempt to classify any required payment as
"restitution and compensatory in nature." Of course,
a prosecutor may not be accommodating to your
client's tales of tax woe.

Explore Indemnification Rights
Regardless of the deductibility of your client's
payment of a fine or penalty, your client may be
entitled to a reimbursement from his company, either

by statute or agreement. Indemnification rights
vary by type of business entity.
For example, the Pennsylvania Uniform
Limited Liability Act of 2016 contains expansive
indemnification rights. The Act provides that
"[a] limited liability company shall indemnify
and hold harmless a person with respect to any
claim or demand against the person and any
debt, obligation or other liability incurred by the
person by reason of the person's former or present
capacity as a member or manager..." unless the
claim arises from excessive distributions, breaches
of management responsibility, standards of
conduct for members, and standards of conduct for
managers.7
However, a client's indemnification rights
are not unlimited. The LLC Act provides that an
individual is not entitled to indemnification if the
act giving rise to the claim for indemnification is
determined by a court to constitute recklessness,
willful misconduct or a knowing violation of law.8
Absent a determination by a court that your client
engaged in these types of behavior, your client
may still be entitled to indemnification.
Similar indemnification rights are available to
partners, shareholders, officers, and employees of
partnerships9 and corporations.10 These rights are
subject to similar qualifications and limits.11
If a company agrees to indemnify your client,
then the company's reimbursement will make
your client whole and he or she will have no tax
loss. If your client does not receive a required
indemnification payment then the client may be
able to take a bad debt deduction as discussed in
greater detail below.

Transforming an Unreimbursed,
Nondeductible Fine or Penalty into a
Federal Bad Debt Deduction
A client's contractual or statutory indemnification
obligation is a debt for federal income tax purposes.
Section 166 of the Internal Revenue Code provides
that, in computing taxable income, a deduction
shall be allowed for bad debts owed to the taxpayer.12
The Treasury Regulations further provide that
only bona fide debts qualify for a deduction.13
A bona fide debt is a debt which arises from a
debtor-creditor relationship based upon a valid
and enforceable obligation to pay a fixed or
determinable sum of money.14
Vol. 4, Issue 3

l

For The Defense

21
For the Defense - Vol. 4, Issue 3

Table of Contents for the Digital Edition of For the Defense - Vol. 4, Issue 3
