tax analysis of deductions

Our client spent $1 million this year to upgrade its manufacturing plant, which had received several warnings from the state environmental agency about releasing pollution into the local river.  Late in the year, Snidely received an assessment of $700,000 for violating the state's Clean Water Act.  After the client negotiated with the state, which cost $135,000 in legal fees, the client promised to spend another $200,000 next year for pollution control devices, and the fine was reduced to $450,000.

Law & Analysis

Fees paid lawyers and accountants for services in representing taxpayer before IRS in connection with asserted liabilities for income and excess profits taxes, civil and criminal fraud penalties. Controversy was settled by compromise. There was no frustration of public policy because law favors compromise settlement to end litigation and the tax laws authorize IRS to settle liabilities by compromise.  Greene Motor Co. (1945) 5 TC 314.
Prosecution for State anti-trust law violations settled by compromise. Deduction for legal expenses allowed.  Longhorn Portland Cement Co., et al. (1944) 3 TC 310, not acq 1964-2 CB 8, rev'd on other grounds (1945, CA5) 33 AFTR 921, 148 F2d 276, 45-1 USTC P 9242, cert den (10-8-45).

How much of the client’s costs in connection with the upgrade of the plant, legal fees, pollution control devices, and fine are deductible for tax purposes?
1. Legal Fees
In Commissioner v. Tellier, 383 U.S. 687, 688 (1966), the Supreme Court addressed the issue of "whether expenses incurred by a taxpayer in the unsuccessful defense of a criminal prosecution may qualify for deduction from taxable income under section 162(a) * * *." Tellier was in the business of underwriting the public sale of stock offerings and purchasing securities for resale to customers. He was indicted on charges of securities fraud, mail fraud, and conspiracy, and he incurred over $22,000 in legal expenses in the unsuccessful defense of this criminal prosecution. Commissioner v. Tellier, 383 U.S. at 688
Applying the "origin and character of the claim" test established in United States v. Gilmore, 372 U.S. 39 (1963), the Supreme Court found that the legal expenses clearly qualified as expenses paid or incurred in carrying on a trade or business within the meaning of section 162(a). Commissioner v. Tellier, supra at 689. The Commissioner, conceding that Tellier's legal fees qualified as ordinary and necessary expenses within the meaning of section 162(a), argued that a deduction for these legal fees should be disallowed on the ground of public policy. Commissioner v. Tellier, supra at 689, 690. The Supreme Court expressed its approval of the public policy exception for fines and penalties (Tellier was decided before the enactment of section 162(f)), but noted that "No public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense. That is not 'proscribed conduct.' It is his constitutional right." Commissioner v. Tellier, supra at 694 (citing Chandler v. Fretag, 348 U.S. 3 (1954)). 
In 1969, the Congress codified the public policy exception for "fines and similar penalties" in section 162(f). Sec. 903, Tax Reform Act of 1969, Pub. L. 91-172, sec. 902, 83 Stat. 487. "The provision for the denial of the deduction for payments in these situations which are deemed to violate public policy is intended to be all inclusive. Public policy, in other circumstances, generally is not sufficiently clearly defined to justify the disallowance of deductions." S. Rept. 91-552 (1969), 1969-3 C.B. 423, 597. As in Tellier, the regulations promulgated under section 162(f) do not treat legal fees and expenses as a fine or penalty. Sec. 1.162- 21(b)(2), Income Tax Regs.
2. Fines
Civil penalties assessed against taxpayer for violations of Clean Air Act and Clean Water Act were neither remedial nor compensatory in nature, but were "similar" to a fine and thus, under Internal Revenue Code section, were not deductible by taxpayer as ordinary, trade or business expense. Clean Air Act, § 113(b), as amended, 42 U.S.C.A. § 7413(b); Federal Water Pollution Control Act Amendments of 1972, § 309(d), 33 U.S.C.A. § 1319(d); 26 U.S.C.A. § 162(f).  (Colt Industries, Inc. v. U.S. 11 Cl.Ct. 140., Cl.Ct., 1986.)

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