Can Judge-Made Doctrine Override Tax Deductions Allowed by Congress? – Houston Tax Attorneys

The tax code provides specific rules for when taxpayers can claim deductions for losses. These are rules enacted by Congress.

There are other so-called “judicial doctrines” that allow the courts to override the rules set by Congress. There are several of these that frequently come up in tax disputes, such as the economic substance doctrine (which was codified into law), the step transaction doctrine, etc. We have covered many of these doctrines in prior articles. We have not addressed the public policy doctrine.

The “public policy doctrine” allows courts to deny tax deductions that would otherwise be perfectly legal under the tax code when allowing such deductions would “frustrate” public policy.

The U.S. Tax Court recently applied this doctrine in Hampton v. Commissioner, T.C. Memo. 2025-32, to disallow a tax loss when the government seized assets of a business for the wrongdoing of the owner. This gets into issues of separation of powers, and how far the courts can go in overriding the rules set by Congress.

Facts & Procedural History

The taxpayer in this case was a stock broker. He operated as an S corporation, and was 100% owner of the S corporation.

In 2009, the taxpayer worked out an arrangement with his high school friend who had been appointed as the deputy treasurer of the State of Ohio. The arrangement involved the deputy treasurer directing trading business from the State of Ohio to the taxpayer, with the taxpayer sharing portions of his commissions with the deputy treasurer and two associates. The payments were aledged to have been disguised as legal fees or business loans. The taxpayer received approximately $3.2 million in commissions from these trades and paid about $524,000 to the conspirators.

In 2013, the taxpayer pleaded guilty to charges of bribery, fraud, and money laundering. In 2014, he was sentenced to 45 months in prison and ordered to forfeit approximately $2.2 million. In 2016, while he was incarcerated, the U.S. Marshals Service seized $1,182,543.71 in funds from seven bank accounts held in the name of either the taxpayer or his S corporation.

On its 2016 Form 1120S, the S corporation claimed a deduction of $855,882 for the forfeiture of its seized accounts. As the S corporation’s sole shareholder, the taxpayer reported this loss on his individual tax return. The IRS audited the tax return and disallowed the deduction for the tax loss. The taxpayer filed a petition with the tax court for review.

About the Public Policy Doctrine

The public policy doctrine is a judicial doctrine the courts have cited for denying tax deductions that would “frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.” This principle was articulated by the Supreme Court in Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 33-34 (1958).

This is not a rule created by Congress through legislation. Instead, it was developed by judges who decided that some tax deductions, though technically allowed by the tax code, should nevertheless be denied on public policy grounds. This represents a significant judicial encroachment on what would normally be the legislative domain of determining which deductions are allowable.

The doctrine is particularly applicable to tax penalties imposed by the government–in addition to income tax due resulting from the denial of tax deductions. As the Supreme Court explained, 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.” The underlying rationale is that allowing a tax deduction for a government-imposed penalty would effectively reduce the financial impact of that penalty, thereby undermining its deterrent effect.

How Does the Public Policy Doctrine Override Section 165?

Section 165(a) of the tax code allows a deduction for “any loss sustained during the taxable year and not compensated for by insurance or otherwise.” For individual taxpayers, the deduction is limited to losses incurred in a trade or business, in transactions entered into for profit, or in certain cases of casualty or theft. Notably, the text of Section 165 contains no exception for losses resulting from criminal forfeitures or other penalties.

In 1969, Congress partially codified the public policy doctrine by amending Section 162 of the tax code (which is the general provision that allows for business tax deductions) to explicitly disallow deductions for fines and penalties paid to a government for violation of law. However, Congress did not make similar amendments to Section 165 (which is the provision for deducting tax losses). This raises the question: Did Congress intend to limit the public policy doctrine to Section 162 deductions, leaving Section 165 free from such judicial restrictions?

The courts have not followed this distinction. The courts have applied the public policy doctrine to Section 165 deductions. For example, the Federal Circuit did so in Nacchio v. United States, 824 F.3d 1370, 1374 (Fed. Cir. 2016). In that case, the court explicitly stated that “§165 is subject to a ‘frustration of public policy’ doctrine.”

When Can Courts Override the Plain Language of the Tax Code?

How far courts are willing to go and should they be allowed to go in applying the public policy doctrine–even when doing so requires overriding the plain language of the tax code?

Under a strict reading of Section 165 and the S corporation flow-through rules under Section 1366, the taxpayer here would appear to be entitled to deduct his share of the S corporation’s loss from the asset forfeiture (there was an assignment issue for assigning income thath the court didn’t get to, which may also have been a problem had the court gotten to that issue–but that is beyond the scope of this article).

Section 165 allows deductions for “any loss” with certain limitations that don’t explicitly exclude criminal forfeitures. Section 1366(a) provides that an S corporation shareholder “shall take into account” his pro rata share of the corporation’s income or loss. Nothing in the text of either provision suggests an exception for losses resulting from criminal activity.

Yet the tax court determined that the public policy doctrine overrode these statutory provisions. The court held that even if the S corporation was entitled to claim a deduction (a question the court did not decide), the taxpayer as an individual was barred by the public policy doctrine from reporting his 100% passthrough share of the S corporation’s resulting loss on his individual return.

The court’s rationale was that allowing the taxpayer to deduct the loss would frustrate the sharply defined policy against conspiring to commit offenses against the United States. The taxpayer was the Purported wrongdoer, and the S corporation’s assets were somehow seized as part of a penalty for his wrongdoing. The court did not get into how the denial of a deduction is not a tax penalty, and the code already provides for tax penalties–no doubt which also applied. Thus, apparently the taxpayer should be double penalized–with a tax penalty (probably more than one) and then again by the loss of his tax deduction. According to the court, allowing the taxpayer a deduction would unquestionably reduce the “sting” of the penalty (which a forfeiture is not a penalty), regardless of what the tax code actually says about such tax deductions.

How Far Can Courts Extend the Public Policy Doctrine?

The tax court emphasized that the public policy doctrine is not constrained by formalistic distinctions between legal entities. This is similar to the rules that apply when a taxpayer transfers assets to a spouse to avoid IRS collections. The court cited Holmes Enterprises, Inc. v. Commissioner, 69 T.C. 114 (1977), where a corporation claimed a deduction for the criminal forfeiture of a car it owned after its sole owner and president was convicted on illegal drug charges.

In Holmes, the tax court concluded that although the corporation was a “separate, taxable entity, distinct from its employee,” the public policy doctrine forbade it from claiming a deduction because it was not a “wholly innocent bystander.” Due to the convicted person’s role as the corporation’s sole owner and president, the corporation “knew of and fully consented to the illegal use of its automobile.”

This reasoning shows how courts have expanded the public policy doctrine to deny deductions not just to convicted individuals, but also to closely related entities, even when those entities themselves haven’t been charged with any crime. This judicial expansion extends the doctrine well beyond what Congress explicitly codified in Section 162(f).

Can a Taxpayer Challenge Judicial Overreach Through a Tax Deduction?

The taxpayer in this case argued that the application of the public policy doctrine should be limited because the United States’ seizure of the S corp’s assets violated due process and was “over-zealous” given that the S corp was not the wrongdoer. However, the tax court found no legal impropriety in the seizure of the S corp’s assets to satisfy the taxpayer’s forfeiture liability.

The court relied on the Sixth Circuit’s decision in United States v. Parenteau, 647 F. App’x 593 (6th Cir. 2016), which held that a corporation wholly owned by an individual convicted of a criminal conspiracy was not a person “other than the defendant” for purposes of forfeiture proceedings. The Sixth Circuit cited relevant factors including that the defendant wholly owned and controlled the corporation, that the corporation did not follow corporate formalities, and that the defendant used the corporation’s property in his criminal scheme.

By analogy, the tax court concluded that the S corporation in this case was not separate from the taxpayer as an individual for purposes of the substitute forfeiture provisions. The taxpayer wholly owned and controlled the S corp, offered minimal evidence that corporate formalities were followed, and the S corp’s sole source of business income was the commissions generated by the taxpayer that were “assigned” to the S corp—the very commissions that led to the criminal indictment, plea, and forfeiture. This is consistent with the court’s prior rulings that apply various judicial doctrines to S corporations.

Is There Any Limit to Judicial Override of Tax Code Provisions?

The tax court also rejected the taxpayer’s argument that the public policy doctrine’s application should be affected by alleged illegality or over-zealousness on the government’s part in seizing the assets. Both the Fourth Circuit and the tax court have previously indicated that the alleged illegality of a criminal forfeiture need not prevent the public policy doctrine from disallowing a deduction for the forfeited property.

In Hackworth v. Commissioner, 155 F. App’x 627, 632 (4th Cir. 2005), the Fourth Circuit stated: “If the taxpayers believe that the forfeiture was invalid, the proper remedy is for them to sue the [relevant government unit] and seek return of the funds [rather than claim a tax deduction].” Similarly, in the tax court’s decision in Hackworth, the court stated: “This Court lacks jurisdiction over [the taxpayers’] collateral attack on the forfeiture.”

This principle further demonstrates the power of the public policy doctrine as a judicial override of tax code provisions. Even if a taxpayer believes that a forfeiture was illegal or improper, courts will not allow them to deduct the loss under Section 165. Instead, they must challenge the forfeiture directly in another forum—a requirement found nowhere in the text of the tax code itself.

The Takeaway

This case shows how the judge-made public policy doctrine can override explicit provisions of the tax code. Despite clear statutory language allowing deductions for business losses and requiring S corporation shareholders to report their share of corporate losses, the tax court denied the taxpayer’s deduction based on a doctrine created by judges, not legislators. The tax law as written by Congress can be trumped by judicial doctrines when courts determine that public policy would be frustrated by allowing certain deductions. Taxpayers facing criminal forfeitures should understand that the public policy doctrine enables courts to disallow deductions that would otherwise be permitted under a plain reading of the tax code, particularly when there is a direct connection between criminal activity and the forfeited assets.