In September and October 2008, the IRS issued two pronouncements that address when litigation settlement payments with governments are deductible. These settlements could occur under any government regulation, including for example the False Claims Act, Medicare billing, environmental laws, anti-trust laws, as well as any state law. This issue will likely arise more regularly under the more aggressive enforcement expected under an Obama administration. Under both pronouncements, the IRS indicates its intention to treat a greater portion of such settlement amounts as nondeductible penalties or fines.
IRS Office of Chief Counsel Memorandum Number 20084301F (Release Date: 10/24/2008) analyzes a hypothetical antitrust settlement with three states. The illustration included typical provisions that (i) the settling defendant admits no liability, claiming that the consent judgment could not be used in any other proceeding to show its guilt, and (ii) the settlement document does not explicitly allocate money as either damages or penalties. The IRS memorandum concludes that the settlement payment is a non-deductible penalty when (i) the complaint requested civil penalties exceeding the settlement amount, and (ii) the complaint did not specifically request compensatory damages.
In a similar pronouncement entitled “False Claims Act Settlements with Department of Justice (DOJ)” (LMSB-4-0908-045, dated September 5, 2008), the IRS concludes that all amounts measured as a multiple of damages are a nondeductible penalty. The IRS issue paper concludes:
“In many cases, a portion of the civil fraud settlement may represent a penalty that is not deductible for tax purposes. In [any government] settlement, if the government’s intent in assessing multiple damages was punitive and not compensatory, the portion of the payment that represents multiple damages, less certain relator fees, will be a penalty that is not deductible. The tax law is clear. The taxpayer bears the burden of proving that it is entitled to a full or partial deduction with regard to any settlement amount paid.”
Background Rationale for the IRS Position
Internal Revenue Code (IRC) §162(a) allows a deduction of "all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business." However, IRC §162(f) limits this deduction by providing that "No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law."
Treasury Regulation §1.162-21(b)(1) defines fines and penalties as an amount:
1. Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding;
2. Paid as a civil penalty imposed by Federal, State, or local law; or
3. Paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).
However, if the fine or penalty can be classified as “damages”, then a deduction is allowed. Specifically, Treasury Regulation §1.162-21(b)(2) allows the deductibility of payments classified as compensatory damages , as follows:
”The amount of a fine or penalty does not include legal fees and related expenses paid or incurred in the defense of a prosecution or civil action arising from a violation of the law imposing the fine or civil penalty, nor court costs assessed against the taxpayer…Compensatory damages paid to a government do not constitute a fine or penalty.”
The landmark case in this area is Talley Industries, Inc. v. Commissioner, 116 F.3d 382, 385-386 (9th Cir. 1997). The Talley case involved billing practices under the False Claims Act (FCA). The IRS determined from Department of Justice’s files that the government’s actual losses were $1.56 Million. The settlement amount was $2.5 million, or $940,000 more. The IRS concluded the $940,000 additional payment was a nondeductible fine. Because the FCA’s multiple damages provision can serve both compensatory and punitive purposes, the Ninth Circuit remanded the case to address a factual question regarding the government’s purpose of the $940,000 payment. On remand, the Tax Court concluded that Talley was not entitled to deduct the $940,000 because the government accepted the settlement based on the government’s belief that the payment in excess of the $1.56 Million of government losses was a penalty.
Under the Talley case, the taxpayer has the burden of establishing the deductibility of any payment. Whether a payment constitutes a nondeductible "fine" or "penalty" depends on the payment’s purpose. If the government intended a payment to be a penalty, the taxpayer fails its burden of proof, and the amount is a nondeductible fine or penalty.
Most settlement agreements are silent as to the apportionment of a lump-sum settlement amount between (i) repayment of government losses and (ii) penalties. Consequently, the typical settlement agreement is not helpful to the taxpayer. This is particularly true if (as normal) the negotiations include offers and counteroffers in which an estimate of damages and the total settlement amount are discussed. Throughout the settlement negotiations, the government typically adds a multiplier, demonstrating the government’s intention that an additional amount is a penalty.
Under the FCA, where relator fees are known and specific, they can be deducted as compensatory damages, even if not reflected in the settlement agreement. This conclusion comes from a July 2007 “Generic Legal Advice Memorandum” from the IRS Office of Chief Counsel. The IRS’s Technical Advice Memorandum 200502041, issued January 14, 2005, also provides additional detailed discussion of the law involving FCA settlements.
The bottom line is that taxpayers have a more difficult task in justifying a tax deduction in settlements with government entities. Since the IRS will respect specific amounts contained in settlement agreements, legal counsel should spend additional effort in obtaining specific settlement agreement language that supports the tax deduction.
ABOUT THE AUTHOR: David Nolte
Mr. Nolte has 30 years experience in financial and economic consulting. He has served as an expert witness in over 100 trials. He has also regularly served as an arbitrator. Mr. Nolte has achieved the following credentials, CPA, MBA, CMA and ASA.
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The IRS recently issued two pronouncements that specify limited conditions under which settlement payments made to any government will be deductible. Lawyers negotiating settlement agreements will need to be more specific before their taxpayer clients can get a deduction.
While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer. For specific technical or legal advice on the information provided and related topics, please contact the author.