The new tax law changed the deductibility of settlements with government agencies in some circumstances thereby increasing the cost to companies to settle these cases. The deduction arose from the section in the Internal Revenue Code1 that allows “as a deduction all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” 26 U.S.C. § 162(a). A payment made in settlement of a claim against a business, like a False Claims Act (FCA) matter, can constitute such an ordinary and necessary expense. See, e.g., Comm’r v. Pacific Mills, 207 F.2d 177, 180 (1st Cir. 1953). However, the statute historically excluded from the category of ordinary and necessary business expenses “any fine or similar penalty paid to a government for the violation of any law.” 26 U.S.C. § 162(f). Treasury regulations define a “fine or similar penalty” under 26 U.S.C. § 162(f) to include amounts “[p]aid as a civil penalty imposed by Federal, State, or local law” and amounts “paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).” 26 C.F.R. § 1.162-21(b)(1). However, “[c]ompensatory damages ... paid to a government do not constitute a fine or penalty.” 26 C.F.R. § 1.162-21(b)(2).
Because income tax deductions “are matters of legislative grace [,] the taxpayer bears the burden of proving entitlement to any deduction or credit claimed.” MedChem (P.R.), Inc. v. Comm’r, 295 F.3d 118, 123 (1st Cir. 2002) (citing INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992)). Under this historical approach by the IRS, persons settling FCA claims could not treat fines and penalties as a tax deduction, even if they were resolving the allegations in an effort to carry on with ordinary day-to-day business matters., Typically, payments made to the government to resolve an FCA matter, were made pursuant to a settlement agreement that was expressly silent as to any tax consequences or deductibility of payments made in settlement. Anecdotally, and pursuant to the case law, a settling person could deduct the single damages portion of any settlement (as a compensatory amount) plus whatever additional compensatory amounts paid in excess of single damages the taxpayer could establish (while bearing the burden of proof). These included payments to Relators and their counsel, estimated government expenses to undertake investigation and prosecution, and foregone interest, among other factors. That has now changed.
Under new Code Sec. 162(f), as amended by 2017 Tax Cuts and Jobs Act §13306(a)(1) in December 2017, and generally effective for amounts paid or incurred on or after Dec. 22, 2017, and subject to the restitution exception provided below, no otherwise allowable deduction will be allowed under Section 162(f) for any amount paid or incurred (whether by suit, agreement, or otherwise) 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. (Code Sec. 162(f)(1) as amended by 2017 Tax Cuts and Jobs Act §13306(a)(1)). This rule applies only where a government (or other entity treated in a manner similar to a government, see below) is a complainant or investigator with respect to the violation or potential violation of any law. Therefore, in addition to denying deductions for the payment of any fine, etc., to a government (as under prior law), the provision denies deductions for payments to, or at the direction of, a government or governmental entity (as this term has been expanded under the Tax Cuts and Jobs Act, as described below).2
Although the statute denies a deduction for any such payments, it also provides an exception for amounts constituting restitution (compensatory amounts). The Section 162(f)(2)(A) exception applies to any amount that:
is restitution (which term includes the 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
is paid to come into compliance with any law that was violated or otherwise involved in the subject investigation or inquiry;
is identified as restitution, or as an amount paid to come into compliance with the law discussed in (A) above, in the court order or settlement agreement; and,
is restitution for failure to pay any tax imposed under the Code in the same manner as if that amount were that tax), would have been allowed as a deduction under Chapter 1 of Subtitle A of the Code if it had been timely paid.
Meeting the identification requirement, highlighted above, alone in Section 162(f)(2)(A)(ii) is expressly stated in the statute not to be sufficient to satisfy the “establishment” element required in Section 162(f)(2)(A)(i), and is a significant change to the strategic approach historically taken in many of these settlements. Finally, pursuant to Section 162(f)(2)(B), the restitution exception detailed above, “shall not apply to any amount paid or incurred as reimbursement to the government or entity for the costs of any investigation or litigation.” As such, the restitution exception applies to payments the taxpayer can establish are either restitution (including remediation of property) or amounts required to come into compliance with any law that was violated or involved in the investigation or inquiry and that are expressly identified as such in the court order or settlement agreement as restitution, remediation, or amounts required to come into compliance.
The Conference Committee report expressly states that the IRS remains free to challenge the characterization of an amount so identified, but no deduction is allowed unless the identification is made. (Sec. 13306 of the Senate amendment, Joint Committee Conference Report page 278)
Additionally, under Section 162(f)(3) the Section 162(f)(1) deduction limitation does not apply to any amount paid or incurred by reason of any order of a court in a suit in which no government or governmental entity is a party; and under Section 162(f)(4), the deduction denial does not apply to any amount paid or incurred as taxes due.
Additionally, section 162(f)(5) addresses the treatment of certain nongovernmental, regulatory entities, identifying certain nongovernmental entities as being treated as governmental entities for purposes of applying the deduction denial. Finally, these new rules will be subject to their own information reporting requirements.
The Department of Justice has applied these Code changes to FCA settlements, and for settlements mandating payment after December 22, 2017, the agreements expressly state which portion of the settlement amount is restitution, versus which is owed as a fine or penalty. This breakdown will enable readers to determine penalty amounts and multipliers assessed in settled FCA cases, and will provide guidance about DOJ and other government agencies’ priorities.
Therefore, it is incumbent on the taxpayer—settling party to ensure that there is protective language in any future DOJ/FCA, FINRA or SEC settlement. To be safe, at the very least, one might add the specific language from the statute—“The following portion of the settlement is identified as restitution, or as an amount paid to come into compliance with the law pursuant to Section 162(f)(2)(A), in order to preserve the settling party’s tax deduction.” Additional language may be desired as well on a case by case basis such as the following: “This does not establish an amount to be deducted but rather a ceiling. Further, the IRS remains free to review, audit and/or challenge the characterization of an amount so identified and by this inclusion the U.S. Department of Justice is not agreeing to, consenting or binding the IRS from challenging any deduction taken by the settling party.” Each case should be reviewed and such language considered based on the facts of that case, although, based on experience, the inclusion of the latter may be a condition of acquiring agreement to include the former.
1 All Code or Section references are to the Internal Revenue Code of 1986, as amended, and the regulations thereunder.
2 In any case where the United States does not intervene or is not a party, litigation counsel for the defendant should analyze under the specific circumstances of that case whether the Section 162(f)(1) limitation and related requirements for deductibility are a factor or not. The legislative history suggests that there are circumstances where the limit may apply even where the government is not directly involved, but this is certainly not the case in all matters.