What Is Disgorgement and Is It Tax Deductible?

Disgorgement is a legal remedy compelling an individual or entity to surrender profits obtained through illegal or wrongful actions. The purpose is to ensure misconduct is not profitable by removing the financial gains that resulted from it. This remedy is often applied in securities law and is a civil action, not a criminal one, focused on recovering improperly acquired funds.

The process begins when a party profits from acts such as securities fraud, insider trading, or other forms of illegal conduct. A court or regulatory agency can order the surrender of these profits to restore the financial situation to its prior state. The scope of disgorgement is limited only to the gains made from the misconduct.

Preventing Unjust Enrichment

The principle behind disgorgement is the prevention of unjust enrichment, which holds that no one should profit from their own wrongdoing. It is an equitable remedy designed to achieve fairness rather than to punish. The objective is to strip away the financial benefits of illicit behavior so the wrongdoer does not end up in a better financial position.

This remedy is distinct from fines or penalties, which are punitive and intended to penalize a defendant. Disgorgement is remedial, requiring the return of money that never rightfully belonged to the person who acquired it. The focus is on the ill-gotten gain, not on imposing additional financial punishment.

Governmental bodies like the Securities and Exchange Commission (SEC) use disgorgement in enforcement actions. When the SEC identifies financial misconduct, it can seek a court order to recover the proceeds. This action deprives the wrongdoer of their gains and deters others by showing that securities law violations will not be profitable, thereby upholding the integrity of financial markets.

Calculating the Disgorgement Amount

Calculating the disgorgement amount requires identifying the “ill-gotten gains,” which are the profits causally connected to the misconduct. It must be demonstrated that the profits would not have been realized without the illegal activity. The regulatory agency has the burden of proof to establish a reasonable approximation of these profits.

The Supreme Court’s decision in Liu v. SEC held that a disgorgement award should be limited to the wrongdoer’s net profits. However, the legal landscape shifted in 2021 when Congress passed legislation granting the SEC statutory authority to seek disgorgement.

This legislation has led to a division among federal courts. Some find this statutory power is not limited by the Liu decision, while others maintain that its limitations, like deducting legitimate business expenses, still apply. This debate creates uncertainty in how disgorgement amounts are calculated in SEC cases. Under the Liu framework, tainted expenses, such as payments to co-conspirators, cannot reduce the disgorgement amount.

Tax Deductibility of Disgorgement

Fines and penalties paid to a government for a violation of law are not tax-deductible as business expenses. This rule prevents wrongdoers from receiving a tax benefit for payments that are punitive. The tax treatment of disgorgement payments depends on their classification.

The Tax Cuts and Jobs Act of 2017 specifies the conditions for deducting such payments. The law allows deductions for amounts that constitute restitution or are paid to come into compliance with a law. For a disgorgement payment to be deductible, the taxpayer must establish that it is for restitution to a specific harmed party. Furthermore, a legal agreement or court order must identify the payment as restitution, and the taxpayer must have a legal obligation to pay it.

Distribution to Harmed Parties

After an agency like the SEC collects disgorged funds, the process shifts to distributing the money to harmed individuals, such as defrauded investors. The primary objective is to return the ill-gotten gains to these victims. However, due to recent legal developments, whether disgorged funds must always be returned to victims is a subject of ongoing court debate.

To facilitate this process, the SEC often establishes a “Fair Fund,” authorized by the Sarbanes-Oxley Act of 2002. A Fair Fund allows civil penalties to be combined with disgorgement amounts and distributed to harmed investors. This increases the total money available to compensate victims.

Administering a Fair Fund involves developing a distribution plan, which must be approved by the court. This plan outlines the process for identifying eligible victims, calculating their losses, and distributing the funds. The SEC may hire a third-party fund administrator to manage the claims process, which includes notifying claimants and disbursing payments. While the goal is to make victims whole, the recovery often represents only a portion of their total losses.