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Donna Hartl, Partner at Golan Christie Taglia LLP
The Federal Tax Cuts and Jobs Act of 2018 (“TCJA”) changed dozens of Federal tax laws that directly affect businesses. One of these changes the ability of businesses to deduct certain fines, penalties, and settlements owed to the government as a result of regulatory violations. Previously, Internal Revenue Code (the “Code”) Section 162(f) disallowed the deduction of punitive fines or penalties paid to the government, both criminal and civil, for the violation of any law. However, businesses could usually deduct amounts paid to the government as compensatory damages, including single damages under the False Claims Act and for remediation of property under the environmental laws.
The new law replaces the original language regarding business tax deductions in TCJA Section 13306 amended Section 162(f). As described in IRS Notice 2018-23, starting in 2018, businesses that are the subject of government enforcement may not deduct payments made to or at the direction of the government “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.” This change has significant implications for businesses named in a lawsuit as well as those being investigated by a government entity, and not just those businesses ultimately found to be in violation of federal law. Any payments owed to the government as a result of enforcement action, including the costs of the investigation or any resulting litigation, are now non-deductible for tax purposes.
The new law applies to court orders and settlements finalized on or after December 22, 2017. Under this new rule payments are non-deductible if paid to or at the direction of (i) a government, (ii) a governmental entity, or (iii) certain self-regulating organizations, for the violation or investigation by such above reference entities for a potential violation of any law.
Other than restitution, Code Section 162(f) provides for two other exceptions. Section 162(f)(3) provides amounts paid pursuant to a court order in a private lawsuit are not subject to the general rule barring deductions because “no government of government entity is a party.” Second, Code Section 162(f)(4) applies to an exception for amounts paid as taxes due. Thus, this is a clear carve-out of otherwise payments made to a government or governmental entity.
However, one important narrow exception to this rule remains. Under the exception, an amount that would otherwise not be deductible under the Code may be deducted if the taxpayer satisfies three requirements. First, the payment amount must be owed as restitution or remediation of property “for damage or harm that was or may be caused by violation of any law or the potential violation of any law” (Notice 2018-23). Second, the amount paid must bring the business into compliance with the law in question, but only if the exact amount to be paid is identified in a settlement agreement or court order that it is restitution, or an amount paid to come into compliance with the law. Finally, Section 162(f)(2)(A)(iii) allows businesses to treat a restitution payment owed due to failure to pay any tax imposed under the Code as if it were that tax payment, as long as the tax payment would have been deductible if it were paid on time (Notice 2018-23).
In practice, the amended Code makes it more difficult for businesses to prove that payments made as a result of government enforcement are deductible. For example, a business will no longer be able to claim that payments to resolve a violation are compensatory (and thus deductible) without a court order or settlement agreement. Under the new tax law, the payments being claimed as restitution or to bring the business into compliance with the law must be specifically identified as compensatory in the court or settlement papers. In addition, the enforcing government entity must also file an information return describing the amounts required to be paid that fall within the scope of Code Section 162(f) and any amounts eligible for restitution per Code Section 162(f)(2). See new Code Section 6050X. Even so, Code Section 162(f)(a)(2)(A) indicates that the IRS may not consider a court order or settlement agreement definitive proof of the compensatory nature of government payments. This suggests that the IRS is not bound by legal documentation of compensatory business payments and may choose to disqualify a deduction based on the premise that the actual nature or origin of the payment does not match the manner in which it has been identified by the documentation. Depending on the circumstances, the IRS may also attempt to argue that the payments do not qualify as restitution to the victims of the violation of the law, or that payments identified as deductible were paid instead of other nondeductible amounts and so are not deductible, either.
In effect, the business must convince the entity responsible for penalizing them in the first place to allow them to deduct their fines, penalties, or settlement payments on their tax return. Such discussions may become contentious, with negotiations now accounting for actual values after taxes paid. On top of that, the IRS may still disagree. Experts predict that the current tax code may ultimately lead to fewer settlement agreements with enforcement agencies.
Tax law, guidance, and precedence can change frequently and quickly. Businesses involved in enforcement actions with a government entity should involve tax counsel early in any settlement negotiations.
The information in this blog post is provided for informational purposes only and is not intended to be legal advice. You should not make a decision whether or not to contact an attorney based upon the information in this blog post. No attorney-client relationship is formed nor should any such relationship be implied. If you require legal advice, please consult with an attorney licensed to practice in your jurisdiction.
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