On June 22, in Liu v. SEC, No. 18-1501, the U.S. Supreme Court issued the latest of its opinions reining in the SEC’s use of disgorgement in civil cases. Significantly, the Court’s rationale-that disgorgement must be limited to the net gain by the wrongdoer-also undermines to some extent the Internal Revenue Service’s proposed rule prohibiting companies from deducting disgorgement.

The IRS’s proposed rule, issued in May, prohibits companies that settled enforcement actions from deducting from their taxes not only fines and penalties-or their equivalents under alternative resolution mechanisms – but also disgorgement and forfeiture. (85 Fed. Reg. 28,524 (May 13, 2020).) At the same time, it allowed deductions for amounts ordered paid in restitution to victims or in upgrading and implementing remedial compliance programs. In doing so, however, the Service ignores the very different legal underpinnings of disgorgement and forfeiture from fines and penalties and imposes concealed additional penalties upon settling companies by both depriving the settling companies of their ”illicit” gains or property while keeping the taxes paid on such gains or property in previous tax years-thus, in contrast to the Liu rule, the Service’s proposed rule effectively allows the government collectively to take more than the net gain from the offense through disgorgement. This approach is a step too far.

Since 1969, Internal Revenue Code Section 162(f) prohibited taxpayers from deducting fines and similar penalties. In more recent times, the Department of Justice has required companies to agree in deferred prosecution and non-prosecution agreements to apply the same treatment to the payments” required under such agreements. In 2017, Congress amended the language of Section 162(f) to disallow deductions for amounts paid or incurred to, or at the direction of, certain governmental and nongovernmental entities.

The issue here turns on a fundamental question of ”what is disgorgement” and whether a recent Supreme Court re-characterizing the purpose of disgorgement as used by the SEC in particular cases applies in different contexts for and for different purposes. Put simply, disgorgement is a requirement that a wrongdoer disgorge ”illicit gains,” on the theory that wrongdoers should not profit from their crime. Historically, disgorgement was viewed as an equitable remedy to restore the status quo ante by returning the wrongdoer to his economic position before having committed the wrong, and thus, no matter how painful, it was not punitive-even when the amount of disgorgement vastly outweighed the civil monetary penalties authorized by a particular statute. In more recent years, however, a series of Supreme Court cases, culminating (for now) in Kokesh v. SEC, called that view into question, with the court repeatedly finding that the imposition of disgorgement in particular cases could constitute ”punishment” and thus was subject to rules applicable to punishment such as statutes of limitations.

In its proposed rules, the IRS mechanically takes those pronouncements from the Court- pronouncements that the government contested in Kokesh and continues to contest in non-tax contexts and that are the subject of various proposed legislative ”fixes”-and applies them to the deduction question as if the statute still referred to fines and similar penalties. Disgorgement, however, even if punitive, poses very different conceptual issues than a penalty or fine. As the Supreme Court recognized in Kokesh, disgorgement is a form of restitution that is distinguishable from fines and penalties. Thus, while unlawful gain may be a critical element in determining the amount of penalties and fines, other factors also figure in, including criminal history, deterrence, cooperation, and, of course, punishment. Disgorgement, on the other hand, is solely based on the goal of denying the wrongdoer unlawful gain-it cannot be increased to punish recalcitrant defendants more severely and it cannot be reduced to recognize remorseful ones-and, no matter what gain a defendant might have hoped for, the disgorgement is keyed to what he actually realized-if there was no gain, then there is no disgorgement. Just last month, in Liu v. SEC, the Supreme Court reaffirmed that disgorgement must be limited to the ”net profits from the wrongdoing . . . ‘when both the receipts and payments are taken into account.’ ”

As a practical matter, disgorgement has two financial elements. First, the government requires the wrongdoer to ”disgorge” its net gains from its wrongful conduct- i.e., its profits after deducting legitimate costs of sales and manufacturing (but not, of course, illicit costs such as bribes related to realizing those sales). Then, the government adds on so-called pre-judgment ”interest,” to deny the wrongdoer the benefit of having had use of the illicit gain from the inception. In other words, as far as the government is concerned, the wrongdoer was never entitled to any gain from its conduct. Disgorgement thus returns the wrongdoer to where he was before the wrongdoing, while penalties and fines punish him for the wrongdoing.

The problem with the Service’s proposed rule, however, is that it ignores the fact that the wrongdoer may well have reported its (now illicit) gain and paid taxes on it. The proposed rule simply ignores this fact, suggesting that the IRS intends that the government has its cake and eat it too-forcing the wrongdoer to disgorge illicit gains while keeping the taxes already paid on it. The government, however, cannot-or should not- have it both ways; it cannot keep tax on gain that was never, under its theory, realized by the wrongdoer. Either the wrongdoer did not realize gain and thus owes no tax, or it did and must pay the tax, but it can’t be both. To have it any other way essentially imposes a third financial element to disgorgement-the amount of the illicit gain, the pre-judgment ”interest,” and the taxes already paid and retained by the government.

The proposed rules apply the same treatment to forfeiture,another mechanism by which the government seeks to deprive a wrongdoer of property obtained through criminal activity or tainted by its use in criminal activity. Under settled forfeiture law related to the medieval doctrine of deodands, the wrongdoer never acquired any right to such property or lost it through its involvement in the crime, and thus all interest in the property reverts to the government. Although in many cases, forfeiture relates to property used in or related to the crime, it may also include the proceeds of the crime. Where those proceeds have been declared and taxed (such as fees charged by tax consultants who markete a tax evasion scheme), the disallowance of forfeiture effectively taxes property that the government insists the taxpayer never owned.

There are essentially two potential fixes for this selfcreated problem. First, the Service can revise the proposed rule to recognize the different goals of disgorgement and forfeiture-something more akin to restitution for which deductions are allowed-and thus permit deduction of such amounts in appropriate circumstances in the tax year in which they are ”paid.” Second, the wrongdoer can negotiate with the enforcement agency to include taxes paid on the revenue as part of the legitimate costs that may be deducted from the gain in determining the final amount of the disgorgement or forfeiture-a position strengthened by the Court’s decision in Liu, which was issued after the proposed rules were published. To a non-tax practitioner (such as one of the authors), a third alternative might be to amend the tax returns of previous years in which the gain was initially declared. Such an approach, however, would run counter to the ”claim of right” doctrine, which requires the taxpayer to report the income in the year that it claims entitlement to the income and only take the deduction in the year of the disgorgement. See I.R.C. Section 1341. Thus, the second option, although perhaps not as pure from a tax policy standpoint, may be the most practical of the three options.

If the proposed rules disallowing deductions for disgorgement and forfeiture are retained in the final rules, those disallowances will become yet another, albeit hidden, penalty amongst the plethora of other penalties already being imposed-fine, forfeiture, disgorgement, and interest, not to mention the two categories of settlement expenses that are deductible under the proposed rules-remediation expenditures and restitution to injured parties. This would contravene sound public policy and the plain language of the statutory exception for restitution. Companies negotiating settlements with the government must be aware of these costs and seek to account for them in determining the ultimate amount of disgorgement or forfeiture or take their chances with the IRS.