The recent tax reform law, known as the Tax Cuts and Jobs Act of 2017 (Tax Act), amended 26 U.S.C. § 162(f), the provision governing the tax-deductibility of settlement and judgment payments to governmental entities. 1 Section 162(f) applies to a broad range of settlements that resolve both federal and state matters, including False Claims Act (FCA) cases, securities actions, environmental enforcement, and consumer protection matters.
As before the Tax Act, the Internal Revenue Code of 1986, as amended, continues to set forth a general rule of tax deductibility for "all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." 2 But under § 162(f) as amended by the Tax Act, government settlements will be deductible only where three preconditions are satisfied. First, the settlement agreement itself must identify the payment as restitution or as an amount paid to come into legal compliance. 3 Second, when claiming the deduction, the taxpayer must independently establish that the payment is restitution or compliance-related. 4 Third, the payment cannot be deducted if it reimburses the government's investigation or litigation costs. 5
Just as importantly, a newly created provision, 26 U.S.C. § 6050X, requires that the settling government must, at the time of settlement, notify both the US Internal Revenue Service (IRS) and the taxpayer of how the government characterizes the settlement payment (e.g., whether for restitution or remediation). Settlements are routinely paid out from earned income that has already been taxed, but historically, the federal government—particularly in FCA matters—complicated taxpayers' ability to deduct those payments by refusing to characterize the payments in the agreement. But now, § 6050X will force the government to take a position.
These changes raise more questions than they answer, especially because it is unclear how settling governments will leverage the new requirement that they characterize payments at the time of settlement. Regardless, anyone who negotiates a settlement with the government should understand the new law well ahead of any resolution.
I. The Old Law
Before the Tax Act amendments, § 162(f) contained a seemingly simple exception to the general rule permitting deductions for ordinary business expenses: "No deduction shall be allowed . . . for any fine or similar penalty paid to a government for the violation of any law." 6 Treasury regulations and case law fleshed out that provision's meaning. Compensatory damages paid to the government were deductible, 7 including funds paid to compromise claims without admitting liability. Conversely, fines, penalties, and amounts paid "in lieu of" such fines or penalties were non-deductible. 8
For example, when executing federal FCA settlement agreements, the internal policies of the U.S. Department of Justice (DOJ) required its civil fraud attorneys to use tax-neutral language. As a result, determining deductibility became a fact-intensive inquiry for both the settling party (in deciding what position to take for purposes of its tax return and financial statements) and the IRS (in examining the tax treatment on audit).
The IRS used to treat the FCA's basic loss value of "single" damages as compensatory and therefore deductible (if incurred in the ordinary course of business). 9 The IRS also took the position that FCA relator's fees were compensatory and thus deductible expenses. 10 But the FCA authorizes the federal government to recover up to treble damages and penalties, and courts held that additional amounts beyond single damages and certain costs could be either punitive or compensatory, depending on the parties' intent. 11 Accordingly, if the facts showed that the parties intended for double or treble damages to be punitive, that portion of the payment was typically deemed non-deductible. 12
Thus, under the old law, the first step in establishing the deductibility of any government settlement was to determine whether the parties expressly allocated the settlement funds between compensatory and punitive payments. But, in the FCA context, DOJ policies instructed its attorneys to avoid any language that would let the private party argue to the IRS that the settlement was compensatory and thus deductible. Without such an allocation in the text of the settlement agreement, both the settling payor (in determining its position for tax purposes) and the IRS (if examining the treatment on audit) would then examine the calculated damages amount, the parties' negotiating history, and the government's claims in the underlying investigation or litigation to determine the parties' intent.
II. The Revised Law
The Tax Act substantially revised § 162(f). Those revisions are generally effective as to all amounts "paid or incurred on or after" the Tax Act's enactment on December 22, 2017. 13 As amended, § 162(f) generally prohibits tax deductions for money paid "to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law." 14 Although the statute does not define "a government," the prior version also used the phrase "a government," and Treasury regulations made clear that this included the United States' federal, state, and local governments as well as governments of foreign countries. 15 Under the amended version of § 162(f), a "governmental entity" can also include nongovernmental regulatory bodies that "exercise[] self-regulatory powers (including imposing sanctions) in connection with a qualified [trade] board or [securities] exchange," or even potentially "as part of performing an essential governmental function." 16
Despite the amended statute's default prohibition on deducting government settlement payments, it also makes an exception for "amounts constituting restitution or paid to come into compliance with law." 17 Three preconditions must be satisfied. First, the settlement agreement itself must identify the payment "as restitution or as an amount paid to come into compliance with [the] law" that was allegedly violated. 18 Second, when claiming the deduction, the taxpayer must establish that the payment "constitutes restitution (including remediation of property) for damage or harm which was or may be caused by the violation of any law or the potential violation of any law," or "is paid to come into compliance with any law which was violated or otherwise involved in the [underlying] investigation or inquiry." 19 This requires that the taxpayer do more than cite the agreement's "identification" of the payments as restitution or compliance-related. 20 Third, the payments cannot be made to reimburse "the government or entity for the costs of any investigation or litigation." 21
The Tax Act also created a new reporting requirement for a settlement's governmental party, codified at 26 U.S.C. § 6050X. This new provision requires that the "appropriate official of any government" submit a report to the IRS that identifies both the total settlement amount and the portions paid as restitution or for compliance-related purposes. 22 "Appropriate official" is defined as "the officer or employee having control of the suit, investigation, or inquiry" or someone "appropriately designated." 23 In the federal context, this may often be an enforcement attorney at DOJ or another agency; at the state level, this may often be a member of the state attorney general's office.
The new governmental reporting requirement is triggered if the settlement equals or exceeds $600 (although that amount may be adjusted "as necessary in order to ensure the efficient administration of the internal revenue laws"). 24 The report must be filed "at the time the agreement is entered into"; the report must identify the total settlement amount; and the report must also identify the settlement amounts "which constitute[] restitution" and which are "for the purpose of coming into compliance with any law which was violated or involved in the investigation or inquiry." 25 At the time of the report's submission, every party to the settlement must also receive "a written statement" showing the amounts reported for the total settlement and whether they relate to restitution or compliance purposes26
III. Implications
If taxpayers hope to claim tax deductions for government settlements (and have such deductions upheld by the IRS on audit), the Tax Act now forces the issue onto the negotiating table. For heated negotiations, these new statutory provisions could raise significant hurdles to closing the deal.
Before settlement, the parties must now negotiate how the agreement will characterize payment. If the agreement does not characterize a payment as restitution or compliance-related, the payment cannot be deducted. There is no explicit requirement that the government must agree to include a payment characterization in a settlement agreement. Thus, taxpayers seeking to claim deductions must potentially negotiate not just the characterization, but also negotiate to include the final negotiated characterization in the agreement itself. Fortunately, the new reporting requirement effectively forces the governmental party to negotiate about the payment's characterization, because it must ultimately report a characterization to the IRS and the settling taxpayer. Therefore, taxpayers might consider insisting upon reviewing the government's proposed submissions to the IRS and the taxpayer before agreeing to the substantive settlement.
If a taxpayer will not be admitting liability or non-compliance, but wishes to later claim a tax deduction, the safest settlement language should hew closely to the statute. One possibility is to characterize the payment as "restitution for damage or harm which . . . may be caused by . . . the potential violation of" the laws in dispute. 27 However, it is unclear whether the IRS or other parties may interpret such language as an admission, notwithstanding any disclaimers elsewhere in the agreement.
Moreover, characterizing the payment's purpose is necessary but not sufficient to establish its deductibility. The government's report to the IRS might be helpful evidence of deductibility, but as before the Tax Act, the IRS may require that taxpayers present additional materials. Therefore, the taxpayer should continue to clearly document their negotiations with the government about the restitution amount, as well as the government's pre-settlement allegations and calculations of damages.
And although the Tax Act now prohibits deductions for payments to cover the government's legal costs, it is silent about similar payments to cover related third-party legal costs. In particular, the FCA authorizes relators to recover their reasonable attorney's fees and costs from FCA defendants, even when the case ends through settlement. 28 Such payments to relators are explicitly authorized by statute, so they arguably do not fall within the general prohibition on deducting payments to "to, or at the direction of, a government or governmental entity."29
As with many of the tax changes made by the Tax Act, it remains an open question how the IRS will actually apply and enforce the new deductibility provisions. But at a minimum, taxpayers who are negotiating or on the verge of signing government settlement agreements should be careful not to ignore the new preconditions for later claiming deductibility. And as a practical matter, taxpayers should begin addressing these issues and creating supporting documentation even before entering negotiations.
Footnotes
1 See generally Pub. L. No. 115-97, H.R. 1 (Dec. 22, 2017), §13306.
2 26 U.S.C. § 162(a).
3 See 26 U.S.C. § 162(f)(2)(A)(ii) (2018).
4 See 26 U.S.C. § 162(f)(2)(A)(i)(I) & (II) (2018).
5 See26 U.S.C. § 162(f)(2)(B) (2018).
6 26 U.S.C. § 162(f) (pre-Tax Act)
7 Treas. Reg. § 1.162-21(b)(2) ("Compensatory damages (including damages under section 4A of the Clayton Act (15 U.S.C. 15a), as amended) paid to a government do not constitute a fine or penalty.").
8 26 U.S.C. § 162(f); see, e.g., Allied Signal, Inc. v. Comm'r, T.C. Memo 1992-204 (Apr. 6, 1992), 1992 WL 67399 (amounts paid in lieu of fines or penalties nondeductible).
9 See I.R.S. Field Serv. Adv. (May 26, 1995), 1995 WL 1918241 ("(T)he 1/3 or 1/2 portion of the damages representing the Government's loss is compensatory damages expressly excluded from the definition of fines or penalties in section 162(f) . . . and is therefore deductible under section 162(a).").
10 See I.R.S. Coordinated Issue, False Claims Act Settlements with the Department of Justice (DOJ) (Sept. 5, 2008);see also Roco v. Comm'r, 121 T.C. 160, 165 (2003) (observing that relator's fees payments are "not a penalty imposed on the wrongdoer"); I.R.S. Chief Counsel Att'y Mem. 2007-015 (July 27, 2007) ("This conclusion is based upon the facts provided, one of which is that the settlement agreement clearly states that the relator would receive its fee and the agreed amount of that fee is specifically outlined in the settlement agreement.").
11 See I.R.S. Coordinated Issue, False Claims Act Settlements with the Department of Justice (DOJ) (Sept. 5, 2008); see also Waldman v. Comm'r, 88 T.C. 1384, 1387 (1987) ("Where a payment ultimately serves each of these purposes, i.e., law enforcement (nondeductible) and compensation (deductible), our task is to determine which purpose the payment was designed to serve.").
12 See Talley Industries, Inc. v. Comm'r, 116 F.3d 382, 387 (9th Cir. 1997); Cook Cnty., Ill. v. United States ex rel. Chandler, 538 U.S. 119, 130 (2003); Grossman & Sons v. Comm'r, 48 T.C. 15, 31 (1967).
13 See Pub. L. No. 115-97, H.R. 1 (Dec. 22, 2017), §13306(a)(2) (note). However, these revisions are not applicable for amounts paid or incurred under any binding order (with court approval, if required) or agreement that was entered into before December 22, 2017.
14 26 U.S.C. § 162(f)(1) (2018) (emphasis added).
15 26 C.F.R. § 1.162-1(a).
16 26 U.S.C. § 162(f)(5)(A) & (B) (2018).
17 26 U.S.C. § 162(f)(2) (2018) (capitalization omitted).
18 See 26 U.S.C. § 162(f)(2)(A)(ii) (2018).
19 See 26 U.S.C. § 162(f)(2)(A)(i)(I) & (II) (2018). If the restitution is for failing to pay taxes, that amount can be deducted if it would have been deductible if originally paid on time. Id.§ 162(f)(2)(A)(iii) (2018).
20 See 26 U.S.C. § 162(f)(2)(A) (2018).
21 See 26 U.S.C. § 162(f)(2)(B) (2018).
22 See 26 U.S.C. § 6050X(a)(1) (emphasis added).
23 26 U.S.C. § 6050X(c).
24 26 U.S.C. § 6050X(a)(2)(A)(ii) & § 6050X(a)(2)(B).
25 26 U.S.C. § 6050X(a)(3);See 26 U.S.C. § 6050X(a)(1)(A) (return must set forth "the amount required to be paid as a result of the suit or agreement" to which § 162(f)(1) applies)); 26 U.S.C. § 6050X(a)(1)(B) & (C).
26 See 26 U.S.C. § 6050X(b) ("Every person required to make a return under subsection (a) shall furnish to each person who is a party to the suit or agreement a written statement showing—(1) the name of the government or entity, and (2) the information supplied to the Secretary under subsection (a)(1). The written statement required under the preceding sentence shall be furnished to the person at the same time the government or entity provides the Secretary with the information required under subsection (a).")
27 See 26 U.S.C. § 162(f)(2)(A)(i)(I) (2018).
28 See 31 U.S.C. § 3730(d)(1) & (2).
29 See 26 U.S.C. § 162(f)(1) (2018).
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