An individual convicted of engaging in unlawful activity is sometimes required to forfeit the profits from that activity as part of the sentence imposed on him. In such a case, the tax law’s policy of taxing income, but only once, is in tension with considerations of public policy underlying the criminal law, under which allowing a tax deduction for payments made by court order upon conviction of a crime would reduce the “sting” of such payments and make the U.S. Treasury an unwilling, if indirect, contributor toward the malefactor’s payment of the penalty. The provisions of the Internal Revenue Code (IRC) and related case law that govern this situation reflect that tension.
One major objective of the income tax laws is to measure a taxpayer’s income accurately, by the allowance of appropriate deductions for costs of earning that income and expenses incurred in the course of profit-seeking activities. Disallowing a deduction in respect of a forfeiture of gains would be inconsistent with this objective, because it would cause the taxation of amounts that were not retained by the taxpayer.1
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