United States: Guide To The New Rules For The Deductibility Of ‘Misconduct' Payments: Government- And Quasi-Government-Imposed Penalties, Fines, And Other Amounts And Payments Related To Sexual Harassment

Recent US tax reform legislation P.L. 115-97, commonly known as the Tax Cuts and Jobs Act, made sweeping changes to when and how a taxpayer will be able to deduct payments made to settle claims of particular acts of misconduct, specifically government- and quasi-government-imposed fines and payments related to sexual harassment.

WHAT YOU NEED TO KNOW

Government- and Quasi-Government-Imposed Fines

  • Like under prior law, taxpayers may not deduct any portion of a payment to the government that is punitive in nature. Taxpayers may still be able to deduct payments for restitution or to come into compliance with the law, but only if a new requirement of disclosing such amounts in the court order or settlement agreement has been satisfied.
  • Amounts attributable to restitution and compliance must be expressly "identified as restitution or . . . an amount paid to come into compliance . . . in the court order or settlement agreement."1 Now, explicit identification in the settlement agreement is a threshold requirement for deductibility. Failure to expressly identify how much of the settlement the parties agree is attributable to restitution or compliance in the settlement agreement will per se prohibit a later deduction for any of the payment.
  • Now, the official representing the government in the dispute must also prepare and provide an information return to the taxpayer and to the US Internal Revenue Service (IRS).2 The information return must include (1) the name of the government entity involved in resolving the dispute, (2) the overall amount of the settlement, (3) the amount of the settlement attributable to restitution, and (4) the amount of the settlement attributable to coming into compliance.3
  • Under the new law, amounts paid to reimburse the government's investigation and prosecution costs are per se nondeductible.4
  • These changes do not apply to private claims. Instead, the new law applies to settlements with the government involving a wide range of actions, such as claims under the False Claims Act (FCA), Foreign Corrupt Practices Act (FCPA), Racketeer Influenced and Corrupt Organizations Act (RICO), Clean Water Act, Clean Air Act, Federal Trade Commission Act (FTCA), Sherman Antitrust Act, and Clayton Act.
  • The new law also changes the reach of the deduction disallowance rules to fines and penalties paid to "certain nongovernmental regulatory entities."5

Payments Related to Sexual Harassment

  • The new law prohibits a deduction for any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, as well as attorney's fees related to such settlement or payment.

A more detailed explanation of these provisions follows.

GOVERNMENT- AND QUASI-GOVERNMENT-IMPOSED FINES

Background

Standards for Deduction Under Prior Internal Revenue Code Section 162(f).

From 1969 until the enactment of the Tax Cuts and Jobs Act, Section 162(f) of the Internal Revenue Code of 1986, as amended (the Code), prohibited a deduction for "any fine or similar penalty paid to a government for the violation of any law." The corresponding Treasury Regulations defined a nondeductible "fine or similar penalty" 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, including additions to tax and additional amounts and assessable penalties imposed by Chapter 68 of the Internal Revenue Code of 1954; (3) paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal); or (4) forfeited as collateral posted in connection with a proceeding that could result in imposition of such a fine or penalty.6 The Treasury Regulations go on to provide that "compensatory damages . . . paid to a government do not constitute a fine or penalty" and therefore may be deductible.7

Therefore, whether settlements of civil claims with the government were deductible depended on whether the payment constituted a punitive fine or penalty, or some other type of damages. Payments that were punitive in nature were nondeductible, while payments that were compensatory in nature (rather than imposed to punish or deter) were generally deductible business expenses.

Whether a civil penalty is deductible depends upon "the purpose which the statutory penalty is to serve."8 Stated another way:

If a civil penalty is imposed for purposes of enforcing the law and as punishment for the violation thereof, [the payment is not deductible]. However, if the civil penalty is imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party for expenses incurred as a result of the violation, it [is deductible because it] does not serve the same purpose as a criminal fine and is not "similar" to a fine within the meaning of section 162(f).9

If the "payment ultimately serves each of these purposes, i.e., law enforcement (nondeductible) and compensation (deductible)," the courts were charged with "determin[ing] which purpose the payment was designed to serve."10 When determining the character of the settlement payments, the courts looked to all the facts and circumstances. First among these facts to be reviewed was the statute pursuant to which the action or claim was brought. The statute under which a claim is brought is essential to the origin of the claim doctrine, which assigns the same tax treatment and character to the amount received in a settlement as the treatment and character of the income at issue in the claim.11 And when the nature of the payment couldn't be determined from the statute, or in cases where the statute served dual purposes, the specific facts surrounding the payment at issue were to be considered, including a comparison of the payment amount to the actual damages caused by the taxpayer's conduct.

Footnotes

1 I.R.C. § 162(f)(2)(A)(ii).

2 I.R.C. § 6050X(a)-(b).

3 I.R.C. § 6050X(a)(1)-(b)(1).

4 I.R.C. § 162(f)(2)(B).

5 I.R.C. § 162(f)(5).

6 Treas. Reg. § 1.162-21(b)(1).

7 Treas. Reg. § 1.162-21(b)(2).

8 Talley Indus., Inc. v. Comm'r, 116 F.3d 382 (9th Cir. 1997) (quoting S. Pac. Trans. Co. v. Comm'r, 75 T.C. 497, 653 (1980)).

9 Id.

10 Id.

11 The origin of the claim doctrine looks to the claim to determine the character of the settlement. Hort v. Comm'r, 313 U.S. 28 (1941); United States v. Gilmore, 372 U.S. 39 (1963).

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