On January 12, 2021, the IRS issued final regulations on Internal Revenue Code section 162(f), as amended by the TCJA,1 concerning the deduction of certain fines, penalties, and other amounts.2 The final regulations revise Treas. Reg. section 1.162‑21, clarify the scope of IRC section 162(f), and add Treas. Reg. section 1.6050X, which covers new section 6050X information related to reporting requirements. The final regulations affect taxpayers that pay or incur amounts to, or at the direction of, governments, governmental entities, or certain nongovernmental entities treated as governmental entities (collectively, "governmental entities") in relation to the violation of a law or investigations or inquiries by these governmental entities into the potential violation of a law (collectively, "violation of a law").
The final section 162(f) regulations apply to tax years beginning on or after the date of publication in the Federal Register, except that these rules do not apply to amounts paid or incurred under any order or agreement pursuant to a suit, agreement, or otherwise that became binding under applicable law before such date. The final regulations under IRC section 6050X apply only to orders and agreements that become binding under applicable law on or after January 1, 2022.
TCJA amendments to section 162(f)
The general rule of section 162(f)(1) provides that no deduction shall be allowed for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a governmental entity in relation to the violation of a law or the investigation or inquiry by that governmental entity into the potential violation of a law. Section 162(f)(2) provides an exception that allows a taxpayer to deduct certain amounts paid or incurred that are otherwise allowable for restitution or remediation or paid to come into compliance with a law (hereinafter collectively, "restitution"). Section 162(f)(3) provides an exception to the general rule for amounts paid or incurred with respect to private-party suits, and section 162(f)(4) provides an exception for certain taxes due. Sections 162(f)(2)(A)(i) and (ii) permit a deduction for amounts that (i) the taxpayer establishes were paid or incurred as restitution (including remediation of property) or to come into compliance with a law ("Establishment requirement") and (ii) are identified in the court order or settlement agreement as restitution ("Identification requirement").
Highlights of the final regulations
The most significant changes in the final regulations include the following:
Disgorgement or forfeiture
- The final regulations will not treat disgorgement or forfeiture of net profits as, per se, nondeductible under section 162(f)(1). Instead, a deduction for amounts paid or incurred through disgorgement or forfeiture will be allowed if the amount is otherwise deductible; the order or agreement identifies the payment, not in excess of net profits, as restitution; the taxpayer establishes this; and the origin of the claim is restitution. However, amounts paid or incurred through disgorgement or forfeiture will be disallowed if, pursuant to the order or agreement, the amounts are disbursed to the general account of the government or governmental entity for general enforcement efforts or other discretionary purposes.
Restitution and remediation
- A deduction is now permitted for an amount paid or incurred for restitution of the environment, wildlife, or natural resources if it is paid or incurred for the purpose of conserving soil, air, or water resources, protecting or restoring the environment or an ecosystem, improving forests, or providing a habitat for fish, wildlife, or plants and has the requisite nexus to the harm that the taxpayer has caused or is alleged to have caused.
- A singular rule concerning qui tam cases has not been adopted, but certain principles apply to determine whether a deduction will be allowed. In general, a government or governmental entity is the real party in interest in the suit and receives any funds paid pursuant to the order or agreement, including any share ultimately paid by the government or governmental entity to the relator, whether or not the government or governmental entity intervenes in the suit. Thus, any amount paid or incurred to a government or governmental entity as a result of the suit will likely be disallowed, unless an exception to section 162(f)(1) applies.
Violation of any law
- The section 162(f) limitation will not apply to a government's recovery of vendor overcharge errors. Similarly, a violation of any law does not include any order or agreement in a suit in which a government or governmental entity enforces rights as a private party.
Investigation or inquiry into the potential violation of any law
- Amounts paid or incurred for routine investigations or inquiries, such as audits or inspections, required to ensure compliance with rules and regulations applicable to the business or industry that are not related to any evidence of wrongdoing or suspected wrongdoing are not amounts paid or incurred relating to the potential violation of any law. Therefore, otherwise deductible ordinary and necessary business expense for amounts paid or incurred for routine investigations or inquiries will not be disallowed.
- The total payment amount does not have to be allocated in an order or agreement for "restitution" for it to meet the identification requirement under section 162(f)(2)(A)(ii). Instead, the final regulations modify the proposed rule for payment amounts not identified so that it applies to orders or agreements that impose lump-sum-payment judgments for "restitution, remediation, and coming into compliance" or that involve multiple taxpayers or multiple damage awards. They also clarify that the identification requirement may be met even if the order or agreement does not provide an estimated payment amount.
- An order or agreement will meet the identification requirement, despite not using the words "restitution," "remediation," "remediate," "come into compliance," or "comply," if the nature and purpose of the payment, as described in the order or agreement, is clearly and unambiguously to restore the injured party or property or to correct the noncompliance. An order or agreement will also meet the identification requirement if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law and describes the action required of the taxpayer to (i) restore, in whole or in part, the party, property, environment, wildlife, or natural resources harmed, injured, or damaged by the violation or potential violation of that law or (ii) perform services, take action, provide property, or do any combination thereof to come into compliance with that law.
- Section 162(f)(2)(A)(i) requires that a taxpayer establish that an amount was paid as restitution or remediation or that the amount was paid to come into compliance with a law. The final regulations clarify that the establishment requirement is met if the documentary evidence submitted by the taxpayer proves that the taxpayer was legally obligated to pay the amount identified in the order or agreement as restitution and that it was paid or incurred for the nature and purpose identified.
- The list of documentary evidence that may be used to meet the establishment requirement has been expanded. In addition, documentary evidence in a foreign language may be used to satisfy the establishment requirement if a complete and accurate certified English translation of the documentary evidence is provided.
Government, governmental entity, or nongovernmental entity treated as a governmental entity
- It is clarified that a political subdivision of a government includes a local-government unit.
- The proposed regulations defined "a nongovernmental entity treated as a governmental entity" as an entity that exercises self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange or exercises self-regulatory powers, including adopting, administering, or enforcing laws and imposing sanctions, as part of performing an essential governmental function. The final regulations revise the definition to clarify that self-regulatory powers include enforcing rules, not laws.
1 The Tax Cuts and Jobs Act was enacted on December 22, 2017.
2 The authors of this client alert have successfully represented clients in section 162(f) disputes against the IRS administratively and in court, involving billions of dollars of deductions.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.