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Taxpayer Can't Deduct $400,000 Restitution Payment Made as Part of Criminal Sentence

(Parker Tax Publishing August 2018)

The Tax Court held that a taxpayer was not entitled to a miscellaneous itemized deduction for a $400,000 restitution payment made in 2014. The court concluded that (1) the taxpayer did not show that the restitution payment promoted or protected his trade or business of being an employee; (2) the taxpayer did not present any evidence that the primary purpose or motive for the payment was other than that he was required to make the payment as part of a criminal sentence; and (3) the taxpayer did not enter into the restitution transaction with the intention of making a profit. Washburn v. Comm'r, T.C. Memo. 2018-110.


Martin Washburn founded FoodPro International, Inc. (FoodPro) and was its president. FoodPro owned 50.46 percent of Golden Sierra Partners, LLC (GSP). Two other entities owned the remaining interests in GSP. Washburn was the corporate secretary of GSP. Washburn and four other individuals (the "codefendants") participated in a scheme to defraud the Overseas Private Investment Corporation (OPIC) to obtain a loan of about $9.4 million for GSP. In March 2003, Washburn, in his capacity as the corporate secretary of GSP, submitted an application to OPIC for the loan to fund GSP's milling and bakery operation in Estonia. FoodPro was GSP's U.S. sponsor for purposes of the OPIC loan. The loan application stated that GSP would be capitalized with approximately $16.5 million. Slightly more than one-half of GSP's milling and bakery operation would be funded by the loan from OPIC and the remaining amount would be funded by investment contributions to GSP by FoodPro, as represented by Washburn in his capacity as president of FoodPro, and GSP's two other owners. In September 2003, OPIC and GSP signed a loan agreement in which OPIC agreed to lend GSP about $9.4 million to construct milling and bakery operations in Estonia. OPIC made two loan disbursements, totaling almost $8 million by wire transfers in 2003 and 2004 to GSP's bank account.

Subsequently, during the course of certain disputes, OPIC discovered that GSP had misrepresented certain facts in its loan application. Contrary to the statements in the loan application, the investment contributions to GSP by FoodPro and one other GSP owner were in substance a disguised loan from one of the codefendants participating in the scheme. Washburn and his codefendants withheld bank statements from OPIC that showed that the investment contributions by FoodPro and one other GSP owner were immediately distributed to the codefendant who made the loan.

The loan application also misstated the estimated equipment prices and reported that FoodPro did not own any related companies. The estimated equipment prices reported in the loan application were seriously overstated, and GSP purchased the equipment from companies that were related to FoodPro. Washburn and his codefendants: (1) submitted falsified invoices to OPIC that listed the overstated equipment prices, (2) concealed the close relationship between FoodPro and the companies from which the equipment was purchased, (3) made false assurances to OPIC with respect to the progress of the project, and (4) falsely affirmed the accuracy of their disclosures to OPIC.

In 2011, Washburn pled guilty to one count of conspiring to commit mail and wire fraud and to one count of conspiring to commit money laundering. He was subsequently sentenced to 12 months in prison. Washburn was also ordered to pay $750,000 in restitution. The district court expressly declined to impose a fine on Washburn. In 2014, Washburn made $400,000 in restitution payments and sought to deduct those payments as a miscellaneous itemized deductions. The IRS disallowed any deduction for the restitution payments.

Taxpayer's Arguments

Washburn originally argued that a deduction for the restitution payments was allowed under one of the following three theories: (1) under Code Sec. 162(a) as ordinary and necessary trade or business expenses; (2) under Code Sec. 165(c)(1) as a loss incurred in a trade or business; or (3) under Code Sec. 165(c)(2) as a loss incurred in a transaction entered into for profit. With respect to the deductions under Code Sec. 162(a) and Code Sec. 165(c)(1), Washburn asserted that either of these deductions could be taken above-the-line, effectively as a negative other income amount. The court, however, noted that Washburn's arguments that he was entitled to an above-the-line-deduction were contrary to the parties' stipulations before the court and Washburn did not argue that he should be relieved of the stipulations or that enforcing the stipulations would result in manifest injustice. Thus, Washburn was bound by the stipulations and the Tax Court only considered whether Washburn was entitled to a Schedule A miscellaneous itemized deduction (i.e., a below-the-line-deduction) for the restitution payments.

Tax Court's Decision

The Tax Court held that Washburn could not deduct the restitution payments as a miscellaneous itemized deduction in 2014. The court began by noting that the restitution payments would be deductible as a miscellaneous itemized deduction if they constituted expenses attributable to the performance of services as an employee under Code Sec. 162(a), losses related to the performance of services as an employee under Code Sec. 165(c)(1), or losses incurred in a transaction entered into for profit under Code Sec. 165(c)(2).

With respect to whether the restitution payments constituted expenses attributable to the performance of services as an employee, the court said that assuming that Washburn, as an employee of either FoodPro or GSP, was able to prove that either FoodPro or GSP would not have reimbursed him for the restitution payments, he did not prove that the restitution payments were ordinary and necessary expenses or represented losses incurred as an employee of FoodPro or GSP. However, the court noted, those payments were in substance a repayment of the loan that GSP obtained through fraudulent means from OPIC and a taxpayer cannot deduct a repayment of loan principal because the loan proceeds are not taxable income when they are received. Thus, Washburn's argument that the restitution payment constituted deductible expenses attributable to his performance of services as an employee was rejected by the court.

Citing several cases, the Tax Court observed that, under a limited exception, a taxpayer's payment of another party's business expense is deductible if: (1) the taxpayer's primary purpose or motive was to protect or promote his own trade or business, and (2) the expense is an ordinary and necessary expense of his trade or business. The court concluded that Washburn had not shown how the restitution payments promoted or protected his trade or business of being a FoodPro employee. He had not, the court said, shown that as GSP's corporate secretary he was an employee of GSP for income tax purposes and had not presented any evidence of his primary purpose or motive for making the restitution payments, other than that he was obligated to do so as part of his sentencing. Further, the court said, Washburn did not show that the restitution payments were ordinary and necessary expenses or losses of being an employee of FoodPro or the corporate secretary of GSP. Accordingly, the Tax Court concluded that Washburn could not deduct the restitution payments under Code Sec. 162(a) or Code Sec. 165(c)(1).

Finally, with respect to a potential deduction of the restitution payments under Code Sec. 165(c)(2), the court noted that before a taxpayer is entitled to deduct a loss under this provision, he must demonstrate that he has entered into a transaction the primary purpose of which is to make a profit. The restitution payment, the court observed, was intended to compensate OPIC for the loss related to the its loan. The court said that GSP, not Washburn, operated the businesses established in Estonia and Washburn had not shown that he was engaged in a transaction entered into for profit. Thus, the court held that Washburn was not entitled to claim a deduction for the restitution payments under Code Sec. 165(c)(2).

For a discussion of the deductibility of restitution, fines, and penalties, see Parker Tax ¶96,510.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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