## Facts

- Jon T. Stephens embezzled $530,000 from Raytheon and was federally indicted in 1981 for a scheme to defraud the company.
- In 1976, Stephens reported the embezzled $530,000 as income and paid federal income tax on it.
- In 1982, after a jury trial, Stephens was convicted of wire fraud, transporting proceeds of fraud in interstate commerce, and conspiracy.
- As part of the criminal sentencing process, the court required restitution to Raytheon.
- In 1984, Stephens paid Raytheon $530,000 and executed a promissory note for additional interest, resolving related civil litigation and satisfying the restitution obligation.
- On an amended 1984 federal return, Stephens claimed a $530,000 loss deduction under I.R.C. § 165 for the restitution payment.
- The Commissioner disallowed the deduction on the ground that allowing it would frustrate public policy; the Tax Court agreed and sustained a deficiency.

## Issues

1. Whether a restitution payment to the victim of an embezzlement scheme qualifies as a deductible loss under I.R.C. § 165 when the embezzled funds were previously included in income.
2. Whether the deduction is barred because allowing it would “severely and immediately” frustrate a clearly defined public policy against fraud and embezzlement.

## Decision

- The Second Circuit reversed the Tax Court.
- The court held Stephens was entitled to a § 165 loss deduction for the $530,000 restitution payment.
- The case was remanded with instructions to allow the deduction.

## Legal Principles

- Public-policy disallowance of otherwise allowable deductions is narrow and applies only when a clearly defined governmental policy would be “severely and immediately” frustrated by the deduction.
- Restitution paid to a private victim is generally compensatory in character and is distinct from fines or penalties paid to the government.
- Where embezzled funds were previously included in taxable income, a later compelled repayment to the victim may be treated as a loss in the year paid under § 165.
- Absent explicit statutory denial, courts should not expand nondeductibility based on generalized deterrence concerns; the mere fact that restitution arises in a criminal context does not alone make it nondeductible.

## Conclusion

The court concluded that deducting a restitution payment to the victim of an embezzlement scheme, after the embezzled funds were already taxed as income, does not meaningfully weaken criminal sanctions and therefore is not barred by public policy; it is a deductible § 165 loss in the year paid.


Stephens v. Comm'r, 905 F.2d 667 (2d Cir. 1990)