It is not surprising that disputes abounded between taxpayers and the IRS regarding what constituted a fine or penalty, or what constituted the payment of compensatory damages. Imprecise language and conflicting terms in criminal plea agreements and civil settlement agreements between private litigants and the government often fueled these disputes.
It is not surprising that disputes abounded between taxpayers and the IRS regarding what constituted a fine or penalty, or what constituted the payment of compensatory damages.
Taxpayers claimed business deductions for payments to the government that they maintained were compensatory or remedial in nature. When the IRS disallowed many of these deductions, litigation regarding the proper characterization of the payments frequently ensued.
The Tax Cuts and Jobs Act of 2017 (TCJA) amended IRC section 162(f) with the aim of ending the years of controversy between taxpayers and the IRS regarding when a fine or penalty paid to the government may be deducted. As amended, IRC section 162(f)(1) generally disallows a deduction for amounts paid or incurred to, or at the direction of, a government, a governmental entity, or a nongovernmental entity with respect to the violation of a law or the investigation into the potential violation of a law. Section 162(f)(2) provides exceptions to the general rule, and allows a taxpayer to deduct amounts that the taxpayer establishes constitute restitution, including remediation of property, for damage or harm caused by the violation of any law, or are paid to come into compliance with any law that was violated or otherwise involved in the investigation. For payments to be deductible, IRC section 162(f)(2)(A)(ii) requires that the amounts paid for restitution, remediation, or paid to come into compliance with the law must be identified in a court order or settlement agreement.
The amounts deductible under IRC section 162(f)(2) include amounts paid to the government as well as third parties at the direction of the government. The amended statute treats nongovernmental entities with self-regulatory powers (including the imposition of sanctions), such as a national securities exchange or domestic board of trade, as governmental entities. The TCJA included new IRC section 6050X, which imposes an information return reporting obligation on certain governmental officials entering into settlement agreements covered by IRC section 162(f).
The Proposed Regulations
On May 13, 2020, the Treasury Department and IRS issued proposed regulations under IRC section 162(f) and IRC section 6050X. The proposed regulations and the accompanying preamble provide guidance to taxpayers on the new provisions under amended IRC section 162(f) and new IRC section 6050X. They also respond to comments that Treasury and the IRS received with respect to Notice 2018-23, issued on April 9, 2018, which provided transitional guidance under IRC section 162(f).
The proposed regulations restate the general rule in IRC section 162(f), and provide that a taxpayer may not take a deduction in computing taxable income for amounts paid or incurred by suit, agreement, or otherwise; to, or at the direction of, a governmental entity; in relation to the violation, or investigation into the potential violation, of any civil or criminal law. The general rule applies whether the taxpayer admits guilt or liability, or pays the government’s claim for any other reason, including to avoid the expense or uncertainty in the outcome of the investigation or litigation.
The proposed regulations provide that an amount is paid or incurred for restitution, remediation, or paid to come into compliance with the law if it restores, in whole or in part, the person, governmental entity, or property harmed by the violation or potential violation of the law. Payments qualifying as restitution, remediation, or paid to come into compliance with the law may be made under settlement agreements, nonprosecution agreements, deferred prosecution agreements, judicial proceedings, administrative adjudications, and similar legal actions that impose liability on a taxpayer. Deductible payments do not include amounts paid to reimburse the government for investigation or litigation costs.
The proposed regulations contain a provision that is likely to cause continuing disputes between taxpayers and the government. The provision ensures that payments for restitution, remediation or paid to come into compliance with the law do not include forfeiture or disgorgement. Taxpayers have often argued that payments of forfeiture and disgorgement can be compensatory in nature, and are therefore deductible. In light of the limitation in the proposed regulations, particular care must be exercised in negotiating settlement agreements with the government to make certain that payments that have compensatory purposes are not misidentified as forfeiture or disgorgement.
Identification and Establishment Requirements
The proposed regulations contain what are referred to as “identification” and “establishment” requirements. To satisfy the identification requirement, the proposed regulations require that the court order or settlement agreement specifically state that the payment, and the amount of the payment, constitutes restitution, remediation, or an amount paid to come into compliance with the law. If the order or agreement states that a payment constitutes restitution, remediation, or an amount paid to come into compliance with the law, a presumption arises in the taxpayer’s favor that the identification requirement has been met.
The proposed regulations leave unanswered several important questions regarding the identification requirement. For example, the provisions fail to address how to satisfy the identification requirement in the case of lump sum payments that may include both deductible and nondeductible components, or agreements that include multiple taxpayers, with multiple damage awards, that do not allocate the payments among the taxpayers.
The identification requirement in the proposed regulations has additional deficiencies. The provisions do not consider the fact that it may be beyond the expertise of the relevant government or governmental entity to place a value on the costs of restitution, remediation, or to come into compliance with the law. The proposed regulations also do not address the situation where the taxpayer ultimately pays more as restitution, remediation, or to come into compliance with the law than is stated in the court order or settlement agreement. Is the taxpayer entitled to a deduction for the greater amount without first obtaining a modification to the order or agreement? The proposed regulations are silent on this question.
The establishment requirement in the proposed regulations provides that the taxpayer must prove–or substantiate–the taxpayer’s legal obligation to pay the amount in the court order or settlement agreement identified as restitution, remediation, or to come into compliance with a law, the amount actually paid, and the date that the amount was paid. The proposed regulations state that a taxpayer can use a broad range of documents to establish the legal obligation to pay the amounts due, including receipts; the legal or regulatory provision related to the violation or potential violation of law; documents issued by the government or governmental entity related to the investigation; documents describing how the amount was determined; and correspondence exchanged between the taxpayer and the government or the governmental entity before the order or agreement became binding under applicable law.
Taxpayers’ representatives will need to use foresight and creativity in drafting court orders and settlement agreements to optimize the likelihood that deductions for these payments will pass muster in IRS audits and in tax litigation.
While the establishment requirement may appear on its face easy to satisfy, taxpayers and the IRS have long battled over the question of whether a taxpayer’s substantiation for a deduction is sufficient. An IRS audit of a deduction reported by a taxpayer under IRC section 162(f) may not occur until years after the court order was entered or the settlement agreement was executed. Taxpayers must be vigilant in obtaining and maintaining documentary evidence of settlements with the government to prove their entitlement to a deduction under IRC section 162(f).
The proposed regulations provide that if the parties to a court order or settlement agreement that became binding before the effective date of the TCJA make a material change to the terms of the order or agreement on or after the date that final regulations under IRC section 162(f) are issued, then the amended section applies to this change. A material change to the terms of the order or agreement may include changing the nature or purpose of the payment obligation, or removing or adding an obligation to make a payment or to provide services or property. A material change does not include changing the date that a payment is due.
Information Return Reporting
The TCJA enacted new IRC section 6050X, which requires that the officer or employee of the governmental unit who has control of the suit or investigation must file an information return (Form 1098-F) with the IRS. A copy must also be provided to the taxpayer that reports the amount paid under IRC section 162(f). The information return is due on January 31 following the calendar year in which the order or agreement becomes binding, even if all appeals have not been exhausted. Under the proposed regulations, information returns are only required for amounts of $50,000 or more.
The rules set forth in the proposed regulations under IRC section 162(f) are to apply to taxable years beginning on or after the date that the regulations are finalized and published in the Federal Register. The information reporting rules under IRC section 6050X apply to orders and agreements that become binding on or after January 1, 2022.
Planning for Deductibility
The TCJA amended IRC section 162(f) in a way that restricts the ability of taxpayers to claim business expense deductions for civil and criminal fines and penalties paid to the government for violations of the law. Taxpayers’ representatives will need to use foresight and creativity in drafting court orders and settlement agreements to optimize the likelihood that deductions for these payments will pass muster in IRS audits and in tax litigation. The new substantiation requirements under IRC section 162(f) will also place a burden on taxpayers and their representatives to thoroughly document deductible fines and penalties paid to the government.