Gray Chemical Company manufactured pesticides that were toxic. Over the course of several years, the toxic waste contaminated the air and water around the company's plant. Several employees suffered toxic poisoning, and the Environmental Protection Agency cited the company for violations. In court, the judge found Gray guilty and imposed fines of $15 million. The company voluntarily set up a charitable fund for the purpose of bettering the environment and funded it with $8 million. The company incurred legal expenses in setting up the foundation and defending itself in court. The court reduced the fine from $15 million to $7 million.

Gray Chemical Company deducted the $8 million paid to the foundation and the legal expenses incurred. The IRS disallowed both deductions on the grounds that the payment was, in fact, a fine and in violation of public policy.

Gray's president, Ted Jones, has contacted you regarding the deductibility of the $7 million fine, the $8 million payment to the foundation, and the legal fees. Write a letter to Mr. Jones that contains your advice and prepare a memo for the tax files.

Research aids:

162 (a) and (f)

Reg. 1.162-21 (b)