Rev. Rul. 67-48

Advice has been requested whether the amount of liquidated damages paid to a former employer for breach of contract is deductible under the following circumstances and whether the provisions of section 1341 of the Internal Revenue Code of 1954 are applicable.

The taxpayere who utilizes the cash receipts and disbursements method of accounting entered into a contract with his employer to render services and receive training for a period of 1, 2, or 3 years at the option of his employer. The taxpayer agreed that if the time spent in training status amounted to 6 months but not more than 15 months, he would tender 12 months of obligated service as a full-time employee after the expiration of the training period. If the training period was more than 15 months but not more than 27 months the obligated service time as a full-time employee would be 18 months. If the training period was more than 27 months but less than 36 months, the obligated service time would be 24 months. As the result of agreeing to the period of obligated future service, the taxpayer received a salary during the training period which was substantially in excess of what he would otherwise have received.

The contract provided that in the event of failure on the part of the taxpayer to render the entire period of obligated service, he would be liable in liquidated damages in the amount of 400 x dollars for each month or portion of a month remaining in the period of obligated service. The amount of liquidated damages was the approximate equivalent of the excess salary to be paid during the training period and was set by the employer for the purpose of reimbursing the employer for such excess in the event of failure to complete the obligated service.

The taxpayer broke the contract after rendering 3 months of a required 12 months of obligated service. Thus, under the terms of the contract, he became liable in liquidated damages in the amount of 400 x dollars for each of 9 months. He paid this amount during the taxable year. The amounts received by the taxpayer pursuant to the contract were reported as salary for the years in which received.

Section 165(c)(1) of the Code provides that in the case of an individual, there shall be allowed as a deduction any loss incurred in a trade or business during the taxable year, not compensated for by insurance or otherwise.

Since the amount of liquidated damages paid by the taxpayer to his employer in this case is attributable to compensation received for services rendered, such amount qualifies as a business loss under section 165(c)(1) of the Code. The deduction is allowable in the year paid, but only if the taxpayer itemizes his deductions. See Rev. Rul. 65-254, C.B. 1965-2, 50.

Section 1341(a) of the Code provides rules for the computation of tax where a taxpayer is entitled to a deduction in excess of $3,000 as the result of restoring an amount included in gross income for a prior taxable year (or years) because it appeared that the taxpayer had an unrestricted right to such amount. However, section 1341 of the Code is not applicable where the taxpayer did, in fact, have an unrestricted right to receive the amount and where the obligation to repay arose as the result of subsequent events. See Rev. Rul. 58-226, C.B. 1958-1, 318. Accordingly, in the instant case, the provisions of section 1341 of the Code do not apply.