United States

Court ruling on SEC fines may have tax implications

TAX ALERT  | 

The U.S. Supreme Court has found that SEC-required ‘disgorgement’ of profits is a penalty for securities law purposes. See Kokesh v. SEC, (June 5, 2017). Technically, the issue only involved determining the applicable non-tax statute of limitations, but it could mean that disgorgement is also a penalty for tax purposes, meaning that amounts disgorged could not be deducted, under the stricture of section 162(f) of the Internal Revenue Code. Importantly, this conclusion could apply retroactively to open tax years.

Under the securities laws, certain unlawful conduct results in a requirement to disgorge profits or proceeds. If that requirement were viewed as akin to civil damages, a disgorgement payment would normally be tax deductible. If it were viewed as a civil penalty, it would normally be non-deductible.

In a unanimous ruling, the U.S. high court reversed the 10th Circuit Court of Appeals, which had held that disgorgement was neither a penalty nor a forfeiture and thus not subject to a statute of limitations. Delivering the opinion for the court, Justice Sonia Sotomayor stated that disgorgement should be viewed as a penalty since it, “bears all the hallmarks of a penalty: It is imposed as a consequence of violating a public law and is intended to deter, not to compensate.” The court went on to say that as such, disgorgement is subject to a five-year statute of limitations similar to ‘any civil fine, penalty or forfeiture.’

Although this ruling does not directly address tax law, its logic may be followed by the IRS and the courts for tax purposes. Thus, it may unfavorably impact any taxpayers that have previously deducted disgorgement payments under the view that disgorgement is not a penalty and is therefore not subject to tax rules that deny deductions for penalties.

Specifically, this decision by the Supreme Court appears to establish that disgorgement is, in fact, a penalty. Since section 162(f) generally denies a deduction for any fine or penalty paid to a government for violation of a law, this ruling suggests that disgorgement payments would be non-deductible under section 162(f) of the Internal Revenue Code. Indeed, the ruling seems to support the IRS’ 2016 position on the subject of disgorgement outlined in Chief Counsel Advice Memorandum 2016-19-008. In that document, the IRS stated that certain disgorgement payments made to the SEC were non-deductible expenses under section 162(f).

Taxpayers that have deducted disgorgement payments in past open years may find it prudent to consider these deductions and the potential that they may now be subject to challenge under audit. In some cases, financial statements reporting the tax effect of such payments may also be affected.

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