This article provides a technical analysis of the recent Tax Court Memorandum decision, Hampton v. Commissioner, T.C. Memo. 2025-32, which addressed the application of the public policy doctrine to the disallowance of a loss deduction claimed by a shareholder of an S corporation following the forfeiture of the corporation’s assets. This case offers valuable insights for tax practitioners regarding the limitations on loss deductions when those losses are intertwined with illegal activities.

Factual Background

Douglas E. Hampton, the petitioner, pleaded guilty in 2013 to bribery, fraud, and money laundering stemming from a scheme devised with a Deputy Treasurer of the State of Ohio. As part of this scheme, Hampton received approximately $3.2 million in commissions for securities trades conducted on behalf of the State of Ohio between 2009 and 2010, and subsequently paid approximately $524,000 of these earnings to the deputy treasurer and others. In 2014, the U.S. District Court for the Southern District of Ohio sentenced Hampton and ordered him to forfeit approximately $2.2 million of the income and wealth resulting from his criminal activities. A Consent Order of Forfeiture was signed, outlining that Hampton would forfeit property derived from the violations, up to the $2,202,259.91 forfeiture money judgment.

During the period of his criminal activity (2009-2013), Hampton operated a financial services business through his wholly owned S corporation, Hampton Capital Management, Inc. (HCM). Hampton received commissions in his personal capacity but then reported these amounts as gross receipts on his Schedule C, simultaneously deducting the same amount as "AMOUNTS ASSIGNED TO HAMPTON CAPITAL MANAGEMENT," resulting in zero net profit on his Schedule C. HCM then reported these "assigned" commissions as its gross receipts on its Form 1120S. HCM maintained brokerage accounts, including one with First Allied Securities and another with Pioneer Investments.

In May 2016, the district court issued warrants, and the U.S. Marshals Service seized funds from several bank accounts held in the name of either Douglas Hampton or HCM. The total amount seized from accounts held in HCM’s name (First Allied and Pioneer Investments) was $865,229.57. In June 2016, the United States moved for forfeiture of these assets as "substitute property" under 21 U.S.C. § 853(p). The district court granted the motion, and the forfeiture was finalized in February 2017.

Taxpayer’s Request for Relief

On its 2016 Form 1120S, HCM claimed a loss deduction of $855,882 related to its portion of the seized funds. This deduction was based on Internal Revenue Code (I.R.C.) § 165, arguing that the loss of the account balance constituted a loss from its trade or business (financial advising and sale of financial products). As the sole shareholder of HCM, Hampton reported a corresponding passthrough loss of $849,335 on his 2016 Form 1040 via Schedule E, pursuant to I.R.C. § 1366(a).

The Commissioner of Internal Revenue (the Commissioner) disallowed HCM’s $855,882 deduction, consequently increasing Hampton’s Schedule E income by the same amount. Hampton petitioned the Tax Court for review, challenging this increase in Schedule E income. The central issue before the court was whether Hampton was entitled to reduce his Schedule E income by $855,882 due to the seizure of HCM’s bank account balances.

Court’s Analysis of the Law: The Public Policy Doctrine

The Tax Court began its analysis by noting the general presumption of correctness afforded to the Commissioner’s determinations and the taxpayer’s burden of proving entitlement to a claimed deduction under Rule 142(a)(1) and Welch v. Helvering, 290 U.S. 111, 115 (1933). The court also reiterated that deductions are allowed only when specifically provided for in the Code and are to be strictly construed, citing INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992).

The court then addressed the public policy doctrine, which, prior to 1969, allowed courts to deny deductions under I.R.C. §§ 162 and 165 if allowing the deduction would frustrate sharply defined national or state policies, as established in Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30, 33-34 (1958). The Supreme Court in Tank Truck Rentals clarified that the doctrine virtually always forbids the deduction of governmentally imposed fines and penalties because such deductions would reduce the "sting" of the penalty.

The Tax Reform Act of 1969 codified the public policy doctrine under I.R.C. § 162(f), disallowing deductions for ordinary and necessary business expenses that constitute "any fine or similar penalty paid to a government for the violation of any law". However, the court emphasized that the judicial public policy doctrine retains its vitality in the context of loss deductions under I.R.C. § 165, citing several circuit court and Tax Court cases, including Nacchio v. United States, 824 F.3d 1370, 1374 (Fed. Cir. 2016); Hackworth v. Commissioner, 155 F. App’x 627, 629-30 (4th Cir. 2005), aff’g T.C. Memo. 2004-173; King v. United States, 152 F.3d 1200, 1202 (9th Cir. 1998); Stephens v. Commissioner, 905 F.2d 667, 672 (2d Cir. 1990); Wood v. United States, 863 F.2d 417, 420-22 (5th Cir. 1989); Medeiros v. Commissioner, 77 T.C. 1255, 1262 (1981); Sestak v. Commissioner, T.C. Memo. 2022-41, at *9-10; and Bailey v. Commissioner, T.C. Memo. 1989-674, 58 T.C.M. (CCH) 1030, 1033, aff’d per curiam, 929 F.2d 700 (6th Cir. 1991) (unpublished table decision).

The court highlighted the uniform holding by courts that forfeitures in connection with a criminal conviction are precisely the type of penalties for which a deduction would frustrate public policy by diminishing the penalty’s "sting," referencing Tank Truck Rentals, 356 U.S. at 35-36, and citing cases such as Nacchio, 824 F.3d at 1377-81; Hackworth, 155 F. App’x at 632; King, 152 F.3d at 1202; Wood, 863 F.2d at 420-22; Sestak, T.C. Memo. 2022-41, at *11-12; and Bailey, 58 T.C.M. (CCH) at 1033. The Supreme Court in Libretti v. United States, 516 U.S. 29, 39 (1995), characterized criminal forfeiture as "an aspect of punishment imposed following conviction of a substantive criminal offense".

Application of the Law to the Facts

Hampton argued that the public policy doctrine should not apply because HCM was never indicted or charged with wrongdoing and therefore was entitled to the loss deduction. He contended that if HCM could claim the loss, he, as the sole shareholder, should be able to claim his passthrough share under I.R.C. § 1366(a).

The court rejected this argument. Even assuming HCM was entitled to the deduction (a point the court did not decide), the court held that Hampton was barred by the public policy doctrine from reporting his 100% passthrough share of HCM’s loss. Allowing the deduction would frustrate the sharply defined policy against the criminal conduct Hampton pleaded guilty to: conspiring to commit offenses against the United States, including federal program bribery, honest services fraud, and money laundering, as codified in 18 U.S.C. § 371, § 666, §§ 1343 and 1346, and § 1956. The court reasoned that the seized assets were directly derived from Hampton’s criminal activity, and allowing him a deduction through his S corporation would reduce the "sting" of the penalty imposed for his wrongdoing, citing Tank Truck Rentals, 356 U.S. at 35-36.

The court further stated that the public policy doctrine is not so limited as to apply only when the convicted individual directly pays the penalty. It cited Holmes Enterprises, Inc. v. Commissioner, 69 T.C. 114, 115 (1977), where a corporation’s deduction for the criminal forfeiture of its vehicle (used by the sole owner for illegal drug transportation) was disallowed because the corporation was not a "wholly innocent bystander". Similarly, in Hampton’s case, the court concluded that the fact that HCM was not charged or convicted did not prevent the application of the public policy doctrine to the forfeiture of its assets, which were ill-begotten due to Hampton’s criminal conduct.

The court also addressed Hampton’s argument that the seizure of HCM’s assets violated due process and was "over-zealous." The court disagreed, finding no legal impropriety in the seizure of HCM’s assets to satisfy Hampton’s forfeiture liability. It drew an analogy to United States v. Parenteau, 647 F. App’x 593, 594-95 (6th Cir. 2016), where the Sixth Circuit held that a corporation wholly owned and controlled by a defendant in a criminal conspiracy was not a person "other than the defendant" for purposes of petitioning for a hearing regarding forfeited property under 21 U.S.C. § 853(n)(2). Following this reasoning, the Tax Court concluded that HCM was not a separate person from Mr. Hampton for the purposes of the substitute forfeiture provisions of 21 U.S.C. § 853(p). The court emphasized Hampton’s sole ownership and control of HCM, the minimal evidence of corporate formalities, and the fact that HCM’s income was solely derived from commissions "assigned" by Hampton, which were the source of the criminal activity. Therefore, the United States’ seizure of HCM’s bank accounts was authorized under 21 U.S.C. § 853(p).

Finally, the court dismissed Hampton’s argument regarding the illegality or over-zealousness of the asset seizure, stating that such arguments should have been raised during the forfeiture proceedings, citing Hackworth v. Commissioner, 155 F. App’x at 632 and Hackworth, 88 T.C.M. (CCH) at 46. The Tax Court lacks jurisdiction to entertain a collateral attack on the forfeiture.

The court explicitly stated that because the public policy doctrine disallowed Hampton’s claimed deduction, it was unnecessary to address the Commissioner’s alternative arguments regarding Hampton’s basis in his HCM shares, whether HCM was a sham entity, or whether the asset seizures constituted a distribution or compensation payment.

Court’s Conclusion

Based on the application of the public policy doctrine, the Tax Court sustained the Commissioner’s disallowance of the loss deduction claimed by Hampton. The court held that allowing Hampton to deduct the passthrough loss from the forfeiture of his wholly owned S corporation’s assets, which were derived from his criminal activities, would frustrate clearly defined public policy against such illegal conduct by reducing the financial penalty imposed.

Implications for Tax Practitioners

Hampton v. Commissioner serves as a crucial reminder for tax practitioners that the public policy doctrine continues to limit the deductibility of losses, even when those losses are incurred by a separate legal entity like an S corporation. Key takeaways include:

The public policy doctrine extends beyond fines and penalties to encompass forfeitures linked to criminal activity, even when the forfeited assets are held by an entity related to the wrongdoer. The court’s reliance on Holmes Enterprises highlights that the "innocent bystander" status is critical for a related entity to claim a deduction for forfeited assets.
The passthrough nature of S corporations does not shield shareholders from the application of the public policy doctrine at the shareholder level. Even if a loss technically passes through under I.R.C. § 1366(a), the character of that loss is determined as if the shareholder incurred it directly, as per I.R.C. § 1366(b).
Collateral attacks on the validity of a forfeiture are not within the purview of the Tax Court. Taxpayers disputing a forfeiture must pursue remedies within the jurisdiction of the courts overseeing the forfeiture proceedings.
Practitioners should carefully analyze the nexus between a claimed loss and any illegal activities of the taxpayer or related parties. When a loss is closely connected to criminal conduct, the public policy doctrine is likely to be invoked by the IRS to disallow the deduction.

This case underscores the importance of considering the underlying circumstances leading to a loss, particularly when dealing with forfeitures and entities controlled by individuals involved in illegal activities. A thorough understanding of the public policy doctrine and its continued application is essential for providing accurate and effective tax advice.

Prepared with assistance from NotebookLM.