The U.S. Supreme Court’s decision last month in Liu v. SEC raises the question of whether disgorgement payments in SEC enforcement actions should now be deductible for federal income tax purposes. The Court held that a disgorgement award that does not exceed a wrongdoer’s net profits and is ordered for the benefit of victims is equitable relief, and therefore available to the SEC under the Securities Exchange Act. Thus, for purposes of the SEC’s remedial powers under the Exchange Act, disgorgement is not a penalty, but rather, is akin to restitution. The Court determined that this result was not foreclosed by its 2017 decision in Kokesh v. SEC, in which it held that SEC disgorgement orders constitute penalties for purposes of the applicable statute of limitations in 28 U.S.C. § 2462. Justice Sotomayor, writing for the majority in Liu, was careful to distinguish the two cases, noting that Kokesh was focused on the specific language of § 2462, involved a form of disgorgement that exceeded the limitations the Court articulated in Liu, and therefore left open the question of whether disgorgement was otherwise a permissible remedy for the SEC.
Liu raises new questions about the deductibility of disgorgement payments. Generally, fines or penalties paid to a government (whether U.S., State, or foreign) are not deductible under Internal Revenue Code Section 162(f). However, compensatory payments, including amounts paid as “restitution,” generally are deductible expenses under 162(f), even when ordered by a court in a criminal or civil case. In the wake of Kokesh, the IRS issued proposed regulations reflecting the view that SEC disgorgement payments amount to non-deductible fines or penalties, rather than restitution. Liu now calls this position into question. As the Court noted in its decision, “a remedy tethered to a wrongdoer’s net unlawful profits, whatever the name, has been a mainstay of equity courts.” Justice Sotomayor also observed that the terms “disgorgement” and “restitution” are often used interchangeably. In light of Liu, the IRS may reverse course when finalizing the 162(f) regulations and acknowledge that SEC disgorgement payments are equitable restitution, compensatory in nature, and thus, deductible.
Proposed regulations such as those under 162(f), which deem SEC disgorgement payments non-deductible penalties, generally do not have the full force and legal effect that final regulations have. The IRS, however, generally follows proposed regulations when making determinations during audits or taking positions in litigation. It is a rare occurrence for a Supreme Court decision to unsettle the landscape surrounding a basic tax issue such as expense deductibility as starkly as Liu may have done. Given the IRS’s previous stance on this issue, taxpayers facing SEC disgorgement should consult their tax advisers and carefully consider the implications of this case.