While most fans of professional football, NFL-style, have been debating the appropriateness of the fines imposed on the New England Patriots and their coach Bill Belichick for violating NFL filming rules, the tax world has been pondering the tax implications of the Commissioner’s decision. One commentator, in
Goodell Misses a Big Tackle gives this take on the Belichick fine: "Now, certainly, $500,000 is nothing to sneeze at. It's a big number, and reportedly about 12 percent of Belichick's annual salary. But it is tax-deductible."
Is it? Are the fines imposed on the Patriots and on Belichick deductible for federal income tax purposes?
The easiest piece of the analysis to undertake is the application of section 162(f), which prohibits deductions for fines and similar penalties. That provision does not apply, however, because the fines and similar penalties that it makes nondeductible are those imposed by governments. The NFL, despite what some might think, is not a government.
The determination, therefore, turns on the application of section 162(a). That provision allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” For the NFL fines to be deductible, they need to be ordinary and necessary, they need to be expenses, they need to be paid or incurred during the taxable year, and they need to be paid or incurred in carrying on a trade or business.
There’s not much disagreement among those who have commented on the question that the fines are expenses, in contrast to being capital expenditures, that they have been or will be paid or incurred during the taxable year, and that they are paid or incurred in carrying on a trade or business. The Patriots are in the business of operating an NFL franchise, and Belichick is in the business of being employed as an NFL head coach.
The critical portion of the analysis involves the interpretation of the phrase “ordinary and necessary.” In other words, is the payment of an NFL fine by a franchise and by a head coach for violating filming rules an ordinary and necessary expense? Or is it something else?
The Supreme Court, in Deputy v. DuPont, 308 U.S. 488, 495 (1940), has defined ordinary as “normal, usual, or customary.” Courts have defined necessary as “appropriate and helpful in the taxpayer’s business.” Note that the judicial approach to the definition bifurcates the phrase into two defined terms. Ultimately, according to the courts, the definition will turn on the facts and circumstances of each particular case.
When trying to apply a legal definition to a set of facts, it helps if there are other situations, either identical or similar in detail, where the same question has arisen. Though there are no cases or rulings dealing with fines imposed by professional sports leagues, there is a case dealing with fines imposed by a mercantile trading exchange.
In Rothner v. Commissioner, the Tax Court held that fines paid by a trader to a mercantile exchange for violating certain trading rules was deductible by the trader. A close look at this case is instructive, because in both Rothner and the Patriots/Belichick situation the fine was imposed by a private organization under contract law, not by a government under a statute.
Rothner and several other traders were fined by the exchange for violating its rules. The Patriots and Belichick were fined by the NFL for violating its rules. Rothner and the other traders had been warned and had previously been fined. The Patriots and Belichick had been warned. Rothner and the other traders were suspended, but Belichick was not.
If Rothner did not pay the fine, he would have been denied the right to trade on the exchange's floor. The exchange would also have the right to forfeit his seat and sell it, using the proceeds to pay the fine. It is unclear what the NFL would do if Belichick does not pay the fine. Presumably he would be suspended but that's a guess.
In Rothner's case, "it was a common occurrence for the [exchange] to fine members for violations of its rules, and a list of persons fined was issued weekly." In 1987, 87 fines were imposed, in 1988, 141, and in 1989, 139. The number of fines imposed by other exchanges were at least in the “several hundreds” annually. The number of fines imposed by the NFL is something I haven't ascertained, but it is nowhere near being in the thousands annually. The number of fines imposed by the NFL for violation of filming rules appears to be two: the Patriots and Belichick.
According to the Rothner court, the
”principal function of the term 'ordinary' * * * is to clarify the distinction, often difficult, between those expenses that are currently deductible and those that are * * * capital expenditures". Additionally, the term "ordinary" has been defined as "normal, usual, or customary" [citing Deputy v DuPont]. A payment of an expense is "normal" if it arises from an action that is ordinarily to be expected of one in the taxpayer's position [citing Commissioner v. Heininger]. Although an expense may be incurred only once in a taxpayer's lifetime, it is ordinary if the transaction that gives rise to it is "of common or frequent occurrence in the type of business" in which the taxpayer is engaged [citing Deputy v. DuPont, Welch v. Helvering, Lilly v. Commissioner]. As respondent concedes that petitioner's payment of the CME fine was not a capital expenditure within the meaning of section 263, we need not further consider that aspect of the term "ordinary".
The Rothner court then concluded that "a private wrongdoing in the course of conducting a business is not extraordinary." How can that be? Whether something is ordinary or extraordinary depends on the facts. The court should have said that "a private wrongdoing in the course of conducting a business is not FOR THAT REASON ALONE extraordinary" --- a conclusion which makes perfect sense. But then the court backs up:
Moreover, even if improper conduct were extraordinary in business, the payment of a settlement or judgment attributable to the conduct is generally expected to be made by the person in the course of whose business the conduct occurred.
What happened to the court's statement "it is ordinary if the transaction that gives rise to it is "of common or frequent occurrence in the type of business" in which the taxpayer is engaged." Isn't that the test?
Well, that's the test the court applied. It pointed out that there were 356 disciplinary proceedings that resulted in fines, of which 53 involved the type of infraction in which Rothner and the other traders engaged. The parties also had stipulated that other exchanges "imposed monetary sanctions on their members for alleged violations of their rules several hundred times per year." So based on these facts, the court concluded that "payments of fines pursuant to disciplinary proceedings by securities and commodities exchanges were a common and frequent occurrence in the type of business in which petitioner was engaged."
So that leaves the question of whether what Belichick and the Patriots did was a transaction "of common or frequent occurrence" in the NFL. At the moment, allegations of filming rule violations appears limited to the Patriots. To me, this is the distinction between ordinary ("everybody does it") and extraordinary (Belichick and the Patriots are alone in their transgressions). Belichick and the Patriots stand alone for the type of infraction for which they have been fined, a far cry from 53 fines in a 3-year period (or more, counting the other exchanges). They are among a very very rare (dare I say extraordinary) group of select persons and clubs fined by the NFL generally (perhaps dozens, but surely not the 356 (hundreds or even thousands counting the other exchanges) in a 3-year period.
Next, the Rothner court explained that an expense was necessary if it met "the minimal requirement that it be appropriate and helpful for the development of the taxpayer's business." I suppose Belichick and the Patriots would argue that breaking the rules was appropriate and helpful. Appropriate? Hmm. Helpful? Of course. If it wasn't helpful to cheat, only the pathological would cheat. I'm not quite ready to label all cheaters as pathological because that would mean we're living in an asylum. Why do I doubt it is appropriate? The clients of the traders don't seem to care if their traders violate a trading limit on the floor of the exchange. NFL fans do care if the NFL's integrity is impugned, and if the reaction has a negative economic impact on the NFL or the Patriots, then Belichick's actions will directly or indirectly HURT --- not help --- the business operated by the New England franchise, and thus would not have been an appropriate thing to do. In other words, for the Patriots, acting honestly had a value that was of a higher order than it appears to have had for mercantile exchange traders.
This analysis compels me to conclude that the Rothner case is distinguishable from the Patriots/Belichick situation. Someday perhaps it will lose its distinction, but that will be a day when violations of filming rules and fines for those infractions are an everyday occurrence in the NFL much as they were (and hopefully no longer are) in the exchanges. Pity that day ever arrives.
The notion that the ordinary and necessary requirement precludes deduction of expenses that are extraordinary, unusual, not normal, or not customary is troubling. Consider what happened in Trebilcock v. Commissioner. The taxpayer, a business entrepreneur, paid an ordained minister to minister spiritually to the taxpayer and his employees, through prayer meetings designed to raise their spiritual awareness level, and through counseling with respect to personal and business problems. When presented with a business problem the minister would pray and then propose a solution based on prayer. The Trebilcock court relied on the outcome in another case, Amend v. Commissioner, in which the taxpayer paid a Christian Science practitioner for assistance in raising the taxpayer’s spiritual awareness. According to the Trebilcock court, “The Amend court conceded that the consultations promoted the taxpayer’s spiritual balance and thus allowed him to cope more easily with the strain of running a large business.” The court then noted that the assistance did not sharpen business skills and was no different from that provided by any minister, making the payments personal rather than business expenses. The Trebilcock court, analyzing the portion of the payments for counseling, concluded that they were not ordinary because the taxpayer did not offer evidence to show that these sorts of payments were ordinary in his type of business. In other words, he failed to prove that the transaction giving rise to the expense, the retention of a minister to inject spiritual awareness into business problem solving, was “of common or frequent occurrence” in his business. Trebilcock reinforces the basis for distinguishing Rothner.
The outcome in Trebilcock makes sense. What Trebilcock was doing was extraordinary. He was a pioneer. Not long after, American business owners concerned about the then-seemingly dominance of the Japanese business economy, adopted some of the techniques used by Japanese businesses. The idea that worker productivity improved when employees were spiritually grounded (and note that in this sense, spiritually does not necessarily mean religiously) caught on. Today, it is not uncommon for businesses to spend money to bring spiritual values into the workplace. An interesting analysis of this phenomenon, including a list of large companies now using the Trebilcock and Amend approach, can be found in
Spirituality and Ethics in Business. Ironically, I doubt that the IRS is challenging the deductions claimed by the companies noted in the article.
For me, the notion that pioneers get the short end of the tax stick because what they are doing is extraordinary rather than normal and usual doesn’t make sense. Ought not the tax law not impose a disadvantage on business entrepreneurs who are trying new and different methods? If the idea of allowing the Patriots and Belichick to deduct the fines is distasteful, it’s not because what they did is not ordinary. Yet despite the questionable wisdom of the ordinary requirement, the determination of whether the fines are deductible must be made under the law as it is, not the law as we would prefer it to be. There is a very good argument that under current law the fines are not deductible.
Most commentators disagree with the conclusion that the better argument supports nondeductibility. They base their conclusion on several analyses.
Some claim that the “ordinary” requirement is designed to prevent deduction of personal expenses. I disagree. Not only has no court or ruling so concluded, the statutory language supports the conclusion that personal expenses are blocked by something other than the “ordinary” requirement. They are blocked by the trade or business requirement. An ordinary and necessary expense of carrying on a personal endeavor isn’t deductible because it’s not an expense in carrying on a trade or business. If that’s not enough, section 262 disallows deductions for personal expenses. If the “ordinary” requirement did so, section 262 would be superfluous in that regard. The same rejoinder applies to the argument that the “necessary” requirement exists to push personal expenses out of section 162(a).
Some claim that the “ordinary” requirement exists to keep capital expenditures out of section 162(a). The courts, however, have given a dual meaning to “ordinary.” One is the requirement that the expense not be a capital expenditure. The other is the requirement that the underlying transaction be “of common or frequent occurrence” in the business. The first prong is the redundant one, because section 263 establishes the principle that capital expenditures are not deductible. It is not extraordinary to build a building in which to operate the business, but the cost of the building is not deductible as an ordinary and necessary expense because it is a capital expenditure. That leaves the “ordinary” requirement with some meaning other than “not a capital expenditure.”
Some have claimed that “ordinary” means reasonable or that it means not lavish or extravagant. However, Congress uses those terms in section 162(a) with respect to specific types of business expenses but not in the general definition. By having used the terms, Congress demonstrates that they have a meaning and that if Congress wanted that meaning to apply to the general definition it would have used those terms rather than “ordinary.” To put a “reasonable” or “not lavish” gloss on the general definition would make the Congress’ use of those terms with respect to specific expenses superfluous.
Some argue that the term “ordinary and necessary” is an indivisible phrase and that the individual words have no independent meaning. If this is so, why have the courts provided a definition of “ordinary” and a definition of “necessary” in ways that treat those words as separate words?
Some argue that “ordinary and necessary” was a general accounting phrase used to indicate payments that accountants treated as appropriate deductions in determining business profits, and that it now is a phrase with little or no meaning. This argument rests on the premise that an interpretation such as “appropriate and helpful” was intended to strip “ordinary and necessary” of meaning rather than to create a new substantive test. I disagree. The words are in the statute, the drafters intended to put them there, and there is nothing in the statute itself making those words or that phrase irrelevant. That’s not to say I disagree with the underlying view that the phrase ought not be in the statute, but trying to render it void of meaning, or to use it as a substitute for “not personal” or “not a capital expenditure” is inconsistent with its existence and the statutory construct.
Some argue that the cases denying deductions because an expense is not ordinary because no one else is engaged in the transaction are wrongly decided. From a policy perspective, I agree, because these decisions put business pioneers at a disadvantage. But from a doctrinal perspective, I disagree, because these cases are interpreting a requirement inserted into the statute by the Congress. The courts, in some respects, don’t have much choice because to reach the opposite result would require either ignoring the word ordinary or giving it a redundant meaning. Either approach would render the word ordinary irrelevant.
The more interesting, and probably more important, question is what to tell the Patriots and Belichick when they ask for advice when doing their tax returns. Although some have suggested that they would simply tell them the fines are deductible, I would be much more circumspect. I would share with them my analysis of the question, including an explanation of the outcomes in Rothner and Trebilcock. I would explain the advantages and disadvantages of claiming or not claiming the deduction. I would let them decide how much risk they were willing to incur and how much risk they wanted to avoid. My guess is that they would decide to claim the deduction. I would make it clear to them that if the IRS audited and challenged the deductions, then they would have no basis to complain that I had given them bad advice, because I would not be surprised if the IRS did challenge the deduction. I also would not be surprised if the IRS paid no attention to the deduction.
The cynic in me thinks that if the IRS challenged the deduction and prevailed, Congress would enact some sort of moratorium barring the IRS from challenging the deduction of fines imposed by the NFL. Not far behind would be special legislation making sports fines explicitly deductible no matter how common or rare the underlying transaction, unless the fine was imposed on account of violation of a government’s criminal law.
