Provisions Denying a Deduction for Illegal Expenses and Expenses of an Illegal Business Should be Repealed

The federal income tax law denies a deduction for illegal expenses, for any expense (legal or otherwise) of an illegal business that is trafficking in controlled substances, for losses incurred in an unlawful activity, and for bribes, kickbacks, and rebates connected with the Medicare or Medicaid program. In this Article, the authors first describe the current treatment of those items by the tax law. The Article next explains that the current treatment constitutes a penalty for the taxpayer whose deduction is denied, and then explores why such a penalty is bad policy and conflicts with the traditional purposes and goals of punishing wrongful behavior. The principal objection to the penalty imposed by the tax law’s denial of deductions for business and profit-oriented expenses is that the manner in which the size of the tax law’s penalty is determined is completely arbitrary and bears no relationship to the seriousness of the crime or the conditions under which it was committed. Another objection to the penalty is that it would be litigated in a civil tax suit in which the taxpayer would lack the protections and rights accorded to criminal defendants even though it constitutes a punishment for criminal behavior. The penalty is especially harsh as applied to the legal expenses of a marijuana business under a more stringent Code provision given the decriminalization of marijuana by many states. The Article also contends that the denial of a deduction for unlawful medical expenses conflicts with the principle allowing the patient a deduction for whatever treatment the patient chooses so long as it is based on a bona fide effort to deal with the illness. The authors recommend that Congress act to eliminate all of these tax penalties