In Fresenius Medical Care Holdings, the US Court of Appeals for the First Circuit held that taxpayers can meet their burden of proving that a government settlement was compensatory—and thus deductible—with evidence beyond the settlement's terms. Thus, if the settlement agreement does not address tax treatment, the trial court is to look to the "economic realities of the transaction." Fresenius provides several important lessons for taxpayers settling disputes with the government. 

Whether a government settlement is deductible depends on whether it is compensatory or punitive. Section 162(a) of the Internal Revenue Code allows deductions for ordinary and necessary business expenses. But section 162(f) disallows deductions for "fine[s] or similar penalt[ies] paid to a government." The regulations provide that payments to settle "actual or potential liability for a fine or penalty (civil or criminal)" are fines or similar penalties. But payments of compensatory damages are not. Because deductions are a "matter of legislative grace," taxpayers bear the burden of proving that settlements are compensatory and thus deductible.

Fresenius had paid to settle—among other things—allegations under the False Claims Act (the FCA, described further here), which provides for treble damages and compensation to qui tam relators, i.e., whistleblowers, who bring actions on the government's behalf. Here, the government refused to address tax issues in the settlement agreement. (Notably, the Department of Justice has a policy of not characterizing settlements for tax purposes.)

Before trial in the tax case, the parties agreed that the "single" damages and the amounts paid to the relators were deductible. The parties further agreed that an amount paid for a criminal fine was not deductible. As a result, the remaining issue was whether the balance was compensatory. The district court gave that issue to the jury, which concluded that two thirds of it was, in fact, deductible. After the district court denied the government's motions for judgment as a matter of law, the government appealed to the First Circuit.

On appeal, the government argued that, because there was no tax characterization agreement for the settlement, the remaining balance could not be deductible. In doing so, it relied on Talley Industries, Inc. v. Commissioner, in which the Ninth Circuit held that the taxpayer bore the burden of proving the compensatory nature of the payment. In Fresenius, the government reasoned that whether the payment was compensatory depended solely on the parties' intent and that the taxpayer could therefore never prove compensatory intent unless the agreement itself provided that the payment was compensatory.

The First Circuit disagreed, instead following the general rule that the "economic reality" governs the tax consequences of a transaction. As a result, the jury instruction, which measured the compensatory amount by the amount it would take to make the government whole, was proper. Although the court acknowledged that it was arguably creating a circuit split, it noted that Talley was distinguishable because, in that case, neither side had offered evidence to quantify the government's actual losses (Op. at 14). Fresenius, on the other hand, had "meticulously developed just such a record."

Lessons Learned and Best Practices

Fresenius offers several lessons for taxpayers. First, taxpayers should develop contemporaneous evidence to support the compensatory nature of the payment, including evidence of the government's actual losses and of the parties' intent. For example, many government contracts include provisions for liquidated damages and interest on overpayments. Taxpayers should attempt to quantify such compensatory elements of their settlements. Second, although the IRS will likely continue to assert its Talley-based argument (claiming the Fresenius case has little value because it merely upheld a jury's verdict), taxpayers can cite Fresenius as authority that they can meet their burden with extrinsic evidence of the parties' intent or with evidence of the "economic reality" of the settlement.

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