The tax code provides specific rules for when taxpayers can claim deductions for losses. These are rules enacted by Congress. <\/p>\n
There are other so-called \u201cjudicial doctrines\u201d that allow the courts to override the rules set by Congress. There are several of these that frequently come up in tax disputes, such as the economic substance doctrine<\/strong><\/a> (which was codified into law), the step transaction doctrine<\/a><\/strong>, etc. We have covered many of these doctrines in prior articles. We have not addressed the public policy doctrine. <\/p>\n The \u201cpublic policy doctrine\u201d allows courts to deny tax deductions that would otherwise be perfectly legal under the tax code when allowing such deductions would \u201cfrustrate\u201d public policy. <\/p>\n The U.S. Tax Court recently applied this doctrine in Hampton v. Commissioner<\/em>, T.C. Memo. 2025-32, to disallow a tax loss when the government seized assets of a business for the wrongdoing of the owner. This gets into issues of separation of powers, and how far the courts can go in overriding the rules set by Congress.<\/p>\n The taxpayer in this case was a stock broker. He operated as an S corporation, and was 100% owner of the S corporation. <\/p>\n In 2009, the taxpayer worked out an arrangement with his high school friend who had been appointed as the deputy treasurer of the State of Ohio. The arrangement involved the deputy treasurer directing trading business from the State of Ohio to the taxpayer, with the taxpayer sharing portions of his commissions with the deputy treasurer and two associates. The payments were aledged to have been disguised as legal fees or business loans. The taxpayer received approximately $3.2 million in commissions from these trades and paid about $524,000 to the conspirators.<\/p>\n In 2013, the taxpayer pleaded guilty to charges of bribery, fraud, and money laundering. In 2014, he was sentenced to 45 months in prison and ordered to forfeit approximately $2.2 million. In 2016, while he was incarcerated, the U.S. Marshals Service seized $1,182,543.71 in funds from seven bank accounts held in the name of either the taxpayer or his S corporation.<\/p>\n On its 2016 Form 1120S, the S corporation claimed a deduction of $855,882 for the forfeiture of its seized accounts. As the S corporation\u2019s sole shareholder, the taxpayer reported this loss on his individual tax return. The IRS audited the tax return<\/a><\/strong> and disallowed the deduction for the tax loss. The taxpayer filed a petition with the tax court<\/a><\/strong> for review.<\/p>\n The public policy doctrine is a judicial doctrine the courts have cited for denying tax deductions that would \u201cfrustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.\u201d This principle was articulated by the Supreme Court in Tank Truck Rentals, Inc. v. Commissioner<\/em>, 356 U.S. 30, 33-34 (1958).<\/p>\n This is not a rule created by Congress through legislation. Instead, it was developed by judges who decided that some tax deductions, though technically allowed by the tax code, should nevertheless be denied on public policy grounds. This represents a significant judicial encroachment on what would normally be the legislative domain of determining which deductions are allowable.<\/p>\n The doctrine is particularly applicable to tax penalties imposed by the government\u2013in addition to income tax due resulting from the denial of tax deductions. As the Supreme Court explained, the \u201c[d]eduction of fines and penalties uniformly has been held to frustrate state policy in severe and direct fashion by reducing the \u2018sting\u2019 of the penalty prescribed by the state legislature.\u201d The underlying rationale is that allowing a tax deduction for a government-imposed penalty would effectively reduce the financial impact of that penalty, thereby undermining its deterrent effect.<\/p>\n Section 165(a) of the tax code allows a deduction for \u201cany loss sustained during the taxable year and not compensated for by insurance or otherwise.\u201d For individual taxpayers, the deduction is limited to losses incurred in a trade or business, in transactions entered into for profit, or in certain cases of casualty or theft. Notably, the text of Section 165 contains no exception for losses resulting from criminal forfeitures or other penalties.<\/p>\n In 1969, Congress partially codified the public policy doctrine by amending Section 162 of the tax code (which is the general provision that allows for business tax deductions) to explicitly disallow deductions for fines and penalties paid to a government for violation of law. However, Congress did not make similar amendments to Section 165 (which is the provision for deducting tax losses). This raises the question: Did Congress intend to limit the public policy doctrine to Section 162 deductions, leaving Section 165 free from such judicial restrictions?<\/p>\n The courts have not followed this distinction. The courts have applied the public policy doctrine to Section 165 deductions. For example, the Federal Circuit did so in Nacchio v. United States<\/em>, 824 F.3d 1370, 1374 (Fed. Cir. 2016). In that case, the court explicitly stated that \u201c\u00a7165 is subject to a \u2018frustration of public policy\u2019 doctrine.\u201d <\/p>\n How far courts are willing to go and should they be allowed to go in applying the public policy doctrine\u2013even when doing so requires overriding the plain language of the tax code? <\/p>\n Under a strict reading of Section 165 and the S corporation flow-through rules under Section 1366, the taxpayer here would appear to be entitled to deduct his share of the S corporation\u2019s loss from the asset forfeiture (there was an assignment issue for assigning income thath the court didn\u2019t get to, which may also have been a problem had the court gotten to that issue\u2013but that is beyond the scope of this article).<\/p>\n Section 165 allows deductions for \u201cany loss\u201d with certain limitations that don\u2019t explicitly exclude criminal forfeitures. Section 1366(a) provides that an S corporation shareholder \u201cshall take into account\u201d his pro rata share of the corporation\u2019s income or loss. Nothing in the text of either provision suggests an exception for losses resulting from criminal activity.<\/p>\n Yet the tax court determined that the public policy doctrine overrode these statutory provisions. The court held that even if the S corporation was entitled to claim a deduction (a question the court did not decide), the taxpayer as an individual was barred by the public policy doctrine from reporting his 100% passthrough share of the S corporation\u2019s resulting loss on his individual return.<\/p>\n The court\u2019s rationale was that allowing the taxpayer to deduct the loss would frustrate the sharply defined policy against conspiring to commit offenses against the United States. The taxpayer was the Purported wrongdoer, and the S corporation\u2019s assets were somehow seized as part of a penalty for his wrongdoing. The court did not get into how the denial of a deduction is not a tax penalty<\/a><\/strong>, and the code already provides for tax penalties\u2013no doubt which also applied. Thus, apparently the taxpayer should be double penalized\u2013with a tax penalty (probably more than one) and then again by the loss of his tax deduction. According to the court, allowing the taxpayer a deduction would unquestionably reduce the \u201csting\u201d of the penalty (which a forfeiture is not a penalty), regardless of what the tax code actually says about such tax deductions.<\/p>\n The tax court emphasized that the public policy doctrine is not constrained by formalistic distinctions between legal entities. This is similar to the rules that apply when a taxpayer transfers assets to a spouse to avoid IRS collections<\/a><\/strong>. The court cited Holmes Enterprises, Inc. v. Commissioner<\/em>, 69 T.C. 114 (1977), where a corporation claimed a deduction for the criminal forfeiture of a car it owned after its sole owner and president was convicted on illegal drug charges.<\/p>\n In Holmes<\/em>, the tax court concluded that although the corporation was a \u201cseparate, taxable entity, distinct from its employee,\u201d the public policy doctrine forbade it from claiming a deduction because it was not a \u201cwholly innocent bystander.\u201d Due to the convicted person\u2019s role as the corporation\u2019s sole owner and president, the corporation \u201cknew of and fully consented to the illegal use of its automobile.\u201d<\/p>\n This reasoning shows how courts have expanded the public policy doctrine to deny deductions not just to convicted individuals, but also to closely related entities, even when those entities themselves haven\u2019t been charged with any crime. This judicial expansion extends the doctrine well beyond what Congress explicitly codified in Section 162(f).<\/p>\n The taxpayer in this case argued that the application of the public policy doctrine should be limited because the United States\u2019 seizure of the S corp\u2019s assets violated due process and was \u201cover-zealous\u201d given that the S corp was not the wrongdoer. However, the tax court found no legal impropriety in the seizure of the S corp\u2019s assets to satisfy the taxpayer\u2019s forfeiture liability.<\/p>\nFacts & Procedural History<\/span><\/h2>\n
About the Public Policy Doctrine<\/span><\/h2>\n
How Does the Public Policy Doctrine Override Section 165?<\/span><\/h2>\n
When Can Courts Override the Plain Language of the Tax Code?<\/span><\/h2>\n
How Far Can Courts Extend the Public Policy Doctrine?<\/span><\/h2>\n
Can a Taxpayer Challenge Judicial Overreach Through a Tax Deduction?<\/span><\/h2>\n
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