A minor provision concerning deductibility in Public Law 115-97, commonly known as the Tax Cuts and Jobs Act (Act),1 may have significant impacts on administrative and judicial settlements between companies and the U.S. Environmental Protection Agency (EPA) and the U.S. Department of Justice (DOJ). The provision changes the law and narrows the potential availability of tax deductions for costs paid by defendants in connection with settlements with government entities, including environmental settlements involving local, state, and federal governments. Moreover, the new provision also adds a notable and potentially problematic layer of red tape, as government entities must now provide a report to the Internal Revenue Service (IRS) identifying settlement amounts that are eligible for deduction.2 The new law does not affect the deductibility of expenses related to environmental settlements between private parties.
Old Tax Law
Since 1969, Section 162(f) of the Internal Revenue Code (Code) has barred companies from deducting any payments constituting fines or penalties paid to the government for the violation of any law. While there was controversy and litigation regarding the scope of "fines or penalties" under this old exclusion, the deductibility of business expenses in environmental cases generally was relatively clear. For example, EPA and DOJ routinely included language in civil judicial environmental settlements barring the deductibility of civil penalties and stipulated penalties paid pursuant to settlements. Other "ordinary and necessary" business expenses associated with environmental litigation and settlement generally were not subject to the bar on deductibility in Section 162(f) as long as they did not constitute a fine or penalty.
New Tax Provisions
Following the Act, only certain amounts may be deducted and only if they are expressly identified in a court order or settlement agreement with the government. The Code now generally disallows deductions for any amount (not just amounts constituting a fine or penalty) paid or incurred when paid to, or at the direction of, a government or government entity in relation to the violation of any law or the investigation or inquiry by a government or government entity into the potential violation of any law.3 Congress carved out two significant exceptions to the exclusion, allowing deductions for amounts: (1) constituting restitution (including remediation of property) for damage or harm that was or may be caused by the violation of any law or the potential violation of any law; or (2) that are paid to come into compliance with any law that was violated or involved in the investigation or inquiry.4 In order for a taxpayer to take a deduction with respect to either of these exceptions, the court order or settlement agreement must expressly identify the specific amounts constituting restitution or amounts paid to come into compliance with the law.5
Uncertainty in Environmental Cases
The revisions to the Code create a number of challenges and uncertainties for parties entering into environmental settlements. While it appears that a number of environmental expenses previously available for tax deductions may still be allowable, the IRS, EPA, and/or DOJ may need to issue guidance to better define the scope of the exclusion and the two exceptions to the exclusion as they apply to environmental settlements.
In settlements with the government, expenses associated with defendant-initiated remediation of hazardous substances under the Comprehensive Environmental Response, Compensation, and Liability Act (CERCLA) or hazardous wastes under the Resource Conservation and Recovery Act (RCRA) appear to be eligible for deductions as expenses associated with "restitution." Likewise, expenses associated with injunctive relief, which are often the most important and costly elements of major Clean Air Act and Clean Water Act environmental settlements with the government, also generally appear to qualify as deductible expenses incurred "to come into compliance" with the law.6 Environmental expenses associated with unilateral administrative orders or court orders from the government also would appear to be costs incurred "to come into compliance" with the law and are potentially deductible as long as the governmental entity identifies the costs associated with the order.
Costs associated with civil penalties, criminal penalties, and stipulated penalties remain non-deductible.7 Likewise, costs associated with supplemental environmental projects (SEPs), are probably still not deductible to the extent these SEPs are used to offset penalties in environmental settlements. The new tax law also now appears to bar recovery of costs associated with government-sponsored environmental investigations and possibly government cleanups under CERCLA and other environmental laws. Because Congress specified that government investigative and litigation costs cannot be construed as "restitution" or "costs of compliance," the costs associated with a government cost recovery suit under Section 107 of CERCLA (or a state or local government equivalent) may not be deductible under the new Code provision.8 Further clarification from the IRS may be necessary to determine whether all government costs potentially recoverable under Section 107 are not deductible, or whether government entities will need to differentiate between Section 107 costs associated with investigation and litigation and costs associated with site remediation (with only the latter being potentially deductible).
Evidentiary and Reporting Requirements
In addition to potential confusion regarding the deductibility of certain settlement and environmental business expenses, the new tax provision continues to require that taxpayers bear the burden to establish that costs are deductible. But the Act also includes a new provision, Section 6050X, requiring government agencies involved in suits or agreements to report information to the IRS, together with a statement to each person who is a party to the suit or settlement, if the aggregate amount involved is $600 or more.9 The government reports must state the overall amount of the settlement, as well as specific amounts attributable to restitution or to correct noncompliance.
Because the costs of environmental projects can be difficult to predict and can change over time, the new reporting requirements raise the prospect for conflict and litigation between environmental defendants, government agencies, and the IRS. For instance, if a party underestimates the costs of an environmental project at the time of settlement and the project subsequently goes over budget, will the party be permitted to deduct the additional costs? Or, if a party overestimates the costs of an environmental project in a settlement, will EPA, DOJ, or other government parties claim the party has breached the settlement terms and insist that the unspent money be used on other environmental injunctive relief or be paid to the government entity?
The new law raises a number of other troubling questions for environmental defendants entering into environmental settlements with federal, state, and local government entities. For example, in environmental negotiations with government entities, will government entities be permitted to use deductibility provisions and IRS reporting as leverage to extract more favorable terms from private parties? Will courts proactively step in and modify or reject judicial environmental settlements where the parties have agreed that costs are deductible, but there is little support for characterizing the costs as "restitution" or necessary "to come into compliance" with the law? What cause of action might a private party have against a government entity for failing to fulfill its reporting obligations? Will the IRS take positions that conflict with EPA or other federal agencies in determining when settlement costs are not deductible?
The Department of Treasury plans to issue additional guidance on these new provisions, but defendants are likely going to have to wait until at least later this year for further clarity. Until then, parties should carefully consider the federal tax implications in any near-term environmental settlements with government entities.
Footnotes
1 See Section 13306(a) of P.L. 115-97, adding new 26 U.S.C. § 162(f) to the Code.
2 See Section 13306(b) of P.L. 115-97, adding new 26 U.S.C. § 6050X to the Code.
5 See new Section 162(f)(2)(A)(ii).
6 Although some injunctive relief required in environmental settlements might only be loosely tied to a defendant's past noncompliance, the parties to a settlement may still agree it is needed "to come into compliance" with the law. But environmental mitigation projects may not qualify for tax deductions to the extent these projects are not "restitution" or required "to come into compliance" with environmental laws.
7 Expenses associated with supplemental environmental projects (SEPs), to the extent still permitted in EPA and DOJ settlements, may be deductible under the definition of restitution. (EPA and DOJ have previously barred the deductibility of SEPs because they are paid in lieu of civil penalties.)
8 See new Section 162(f)(2)(B)
9 See new Section 6050X(a)-(b).
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