On May 12, the Department of the Treasury (Treasury) and the Internal Revenue Service (the Service) issued proposed regulations (REG-104591-18) that address the disallowance of deductions for amounts paid or incurred for fines, penalties and other amounts. The proposed regulations provide helpful guidance with respect to the disallowance of such deductions under Section 162(f) of the Internal Revenue Code, and generally conform with the Congressional desire to limit taxpayers' ability to deduct settlement amounts paid in connection with a violation of law. That, however, may frustrate efforts to make settlements with governments going forward. 

The Statute

Prior to the enactment of the Tax Cuts and Jobs Act of 2017 (TCJA), Section 162(f) provided that fines and penalties paid in connection with a violation of law were nondeductible for federal income tax purposes. Large and often high-profile corporate settlements were often deductible in whole or substantial part under this standard because such settlements did not fall within the definition of either a fine or a penalty. In response to public criticism of this result, Congress expanded the disallowance of deductions under Section 162(f).  

As amended by the TCJA, Section 162(f)(1) disallows a deduction for amounts paid or incurred (whether by suit, agreement or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or for the investigation or inquiry by such government or entity into the potential violation of any law. However, Section 162(f)(2) permits such a deduction (provided the payment is otherwise deductible under the Code) if the amount paid or incurred both

  1. either (1) constitutes restitution (including 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, or (2) is paid to come into compliance with any law that was violated or otherwise involved in the investigation or inquiry into the potential violation of any law (the establishment requirement), and

  2. is identified as such in the applicable court order or settlement agreement (the identification requirement).

Proposed Regulations

1. Establishment Requirement

The proposed regulations provide that a taxpayer satisfies the establishment requirement by providing documentary evidence (i) that the taxpayer was legally obligated to pay the amount the order or agreement identified as restitution; (ii) of the amount paid or incurred; and (iii) of the date on which the amount was paid or incurred. The proposed regulations provide a nonexhaustive list of documents that taxpayers may use to satisfy the establishment requirement, including receipts; the legal or regulatory provision related to the violation or potential violation of a law; documents issued by the government or governmental entity relating to the investigation or inquiry; documents describing how the amount to be paid was determined; and correspondence exchanged between the taxpayer and the government or governmental entity before the order or agreement became binding under applicable law.

As a general matter, an amount is considered restitution or remediation if it restores, in whole or part, the person, government or governmental entity, or property harmed by the violation or potential violation of law. However, the proposed regulations exclude forfeiture and disgorgement from the definition of restitution. Treasury's rationale for this exclusion is that forfeiture and disgorgement are not restitution because they focus on "unjust enrichment of the wrongdoer, not the harm to the victim."    

Under the proposed regulations, a payment for a specific corrective action, or to provide specific property, is treated as an amount paid to come into compliance with a law. However, amounts paid to come into compliance with a law do not include (i) payments to reimburse the government or government entity for investigation or litigation costs; (ii) payments made in lieu of a fine or penalty at the payer's election; and (iii) payments constituting disgorgement or forfeiture.

Some practitioners believe that the regulatory exclusion of forfeiture or disgorgement payments from the scope of the restitution and compliance with law exceptions could frustrate efforts to reach settlements with governments because taxpayers would have reduced opportunities to reach a tax-efficient (deductible) settlement. Consequently, Treasury is likely to receive comments requesting that the final regulations remove this exclusion. However, excluding forfeiture and disgorgement payments appears consistent with Section 162(f), as amended by the TCJA. 

2. Identification Requirement

As stated above, an order or agreement must identify an amount paid or incurred as restitution or remediation for such amount to be deductible. Under the proposed regulations, a court order or an agreement identifies a payment by stating the nature of, or the purpose for, each payment a taxpayer is obligated to pay and the amount of each payment identified.

The identification requirement is presumed to be met if an order or agreement specifically states that the payment and the amount of the payment constitute restitution, remediation or an amount paid to come into compliance with a law. Further, the identification requirement may be satisfied if the order or agreement uses a different form of the required words, such as "remediate" or "comply with a law."

If the order or agreement identifies a payment as restitution, remediation or coming into compliance with a law, but does not identify some or all of the aggregate amount the taxpayer must pay, the identification requirement may be met, with respect to any payment amount not identified, if the order or agreement describes the damage done, harm suffered or manner of noncompliance with a law, and describes the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property.

The Service may challenge the characterization of an amount identified in the order or agreement. To rebut the presumption described above, the Service must develop sufficient contrary evidence that the amount paid or incurred was not for the purpose identified in the order or agreement. While a challenge is possible, taxpayers should benefit from the foregoing presumption because such presumption should shift the burden of proof to the Service.

Taxpayers can rely on the proposed regulations pending the issuance of final regulations.

Originally published 21 May 2020

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.