Flowthrough forfeiture loss deduction denied

The Tax Court, for public policy reasons, denied a taxpayer a passthrough loss deduction for his wholly owned S corporation’s loss related to the seizure of funds from the corporation due to the taxpayer’s criminal conviction.

Facts: In 2003, Douglas Hampton incorporated Hampton Capital Management (HCM), an S corporation, and was a registered representative for three broker-dealers from 2004 to 2013. He provided financial services to retail and institutional clients, with the majority of his earnings stemming from commissions.

In 2009, Hampton’s high school friend, the deputy treasurer of the state of Ohio, devised a plan to ensure that Hampton was listed as a broker authorized to conduct securities trades on behalf of the state of Ohio and to funnel a large amount of trading business to him. Hampton would then send some of the commissions that he earned from those trades to the deputy treasurer and two other individuals, disguised as legal fees or business loans. Between 2009 and 2010, the scheme resulted in approximately $3.2 million in commissions for Hampton, out of which he paid approximately $524,000 to his co-conspirators. In 2013, having learned of the misappropriation, the government charged Hampton with conspiracy to commit bribery, wire fraud, and money laundering. Hampton pleaded guilty to the conspiracy charge, and a district court sentenced him to 45 months of imprisonment, three years of supervised release, a $100 penalty, and forfeiture of approximately $2.2 million.

During Hampton’s incarceration, in 2016, the district court issued warrants to seize seven bank accounts associated with him and HCM. Shortly thereafter, the U.S. Marshals Service executed the warrants and seized a total of $1,182,544. Upon expiration of the applicable period for third parties to file petitions asserting a legal interest in the seized assets, the district court finalized its order of forfeiture.

On its 2016 Form 1120-S, U.S. Income Tax Return for an S Corporation, HCM claimed a deduction of $855,882 and attached a statement that the amount was forfeited in a criminal case against Hampton “but not this taxpayer,” i.e., HCM, which “was not a party in the case nor was it identified as subject to the court’s consent order of forfeiture.” Because HCM, a trade or business, had generated the amount, according to the statement, HCM was deducting the forfeited amount under Sec. 165. Hampton then included the loss on Schedule E, Supplemental Income and Loss, of his 2016 Form 1040, U.S. Individual Income Tax Return.

The IRS issued a notice of deficiency disallowing HCM’s $855,882 deduction and adjusted Hampton’s Schedule E by the same amount. Hampton challenged the IRS’s determination in Tax Court.

Issues: Sec. 165(a) permits a deduction for any loss sustained during the tax year and not compensated for by insurance or otherwise. Sec. 165(c) narrows the deduction for individuals to losses incurred in a trade or business, transactions entered into for profit, or certain instances of casualty or theft. The court explained, however, that the judicial “public policy doctrine” has an extensive history of being applied to deny taxpayers a deduction for which they otherwise qualified under Sec. 165 or 162 (ordinary and necessary business expenses) if the deduction would “frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof” (Tank Truck Rentals, Inc., 356 U.S. 30, 33—34 (1958)). In particular, in Tank Truck Rentals, the Supreme Court stated that the “[d]eduction of fines and penalties uniformly has been held to frustrate state policy in severe and direct fashion by reducing the ‘sting’ of the penalty prescribed by the state legislature” (id. at 35—36). Directly related to Hampton’s case, the Tax Court noted, “Courts have uniformly held that forfeitures in connection with a criminal conviction are precisely the sorts of penalties for which the Supreme Court held […] that a deduction would frustrate public policy by reducing the ‘sting’ of the penalty.”

Hampton argued that because HCM was never indicted or charged with wrongdoing, the public policy doctrine did not apply. Specifically, he argued that because the doctrine did not prohibit HCM from claiming a 2016 loss on account of the asset seizures, he was entitled to take a passthrough deduction for the loss as HCM’s sole shareholder.

The Tax Court was not convinced. “Even if we assume that HCM was entitled to claim a deduction for the asset seizures (a question we need not decide here),” the court wrote, “Mr. Hampton is barred by the public policy doctrine from reporting his 100% passthrough share of HCM’s resulting loss.” It reasoned that permitting the deduction would frustrate the “sharply defined policy against conspiring to commit offenses against the United States.” The court further explained that “simply interposing HCM between him and (some of) the seized assets that came from the problematic ‘assigned’ commissions would violate the public policy doctrine as formulated by the Supreme Court.”

Furthermore, the court rejected Hampton’s argument that the public policy doctrine does not reach a deduction claimed under Sec. 1366(a), which provides that S corporation shareholders take into account their pro rata share of the corporation’s items of income, loss, deduction, or credit for the tax year. The court reasoned that this argument would be “directly contrary” to Sec. 1366(b), which provides that the character of an S corporation’s items of income and loss that pass through to a shareholder are determined as if they were “realized directly from the source from which [they were] realized by the corporation, or incurred in the same manner as incurred by the corporation.”

Holding: The Tax Court held that the IRS had properly disallowed Hampton’s deduction of the passthrough loss from HCM related to the funds that were seized from the company as a result of Hampton’s conviction, finding that allowing the deduction would frustrate public policy.

• Hampton, T.C. Memo. 2025-32

— Matthew Geiszler, Ph.D., is a lecturer in accounting in the Brooks School of Public Policy, and John McKinley, CPA, CGMA, J.D., LL.M., is a professor of the practice in accounting and taxation in the SC Johnson College of Business, both at Cornell University. To comment on this column, contact Paul Bonner, the JofA’s tax editor.