Sullivan ran an illegal
gambling establishment. He filed a tax return claiming some of his
expenses as business deductions under 26 U.S.C. § 23(a)(1)(A) (now 26 U.S.C. §162).
There was a law making
gambling earnings taxable, in order to make illegal gambling a Federal
offense (and thus allow the FBI to get involved), so Sullivan was trying
to comply with the law.
The IRS denied the deduction.
The IRS argued that running
a business that is totally illegal cannot possibly qualify for a
deduction. The IRS argued that found that it is never ordinary and
necessary to violate the law.
Therefore, there must be an implicit policy limitation that would deny a
deduction for violating the law.
The US Supreme Court found for
Sullivan and allowed the deductions.
The US Supreme Court found
that the expenses in question did not constitute a penalty. They were
normal business expenses (salaries to employees, lease on the building,
etc.) that would otherwise normally be deductible.
The Court noted that if
Sullivan had been fined by the State, then the fines would not be
deductible, but this wasn't a fine or a punishment, so it was within the
boundaries of an ordinary and necessary business expense.
The Court looked to Commissioner
v. Heininger, (320 U.S. 467) which
said that the "fact that an expenditure bears a remote relation to
an illegal act" does not make it nondeductible.
Conversely, see Tank
Truck Rentals, Inc. v. Commissioner
(356 U.S. 30 (1958)), which found that fines and penalties are not
deductible as business expenses under §162.