Industry Director Directive on Government Settlements
On June 14th, the IRS's Large and Mid-size Business Division (LMSB) issued a directive (LMSB-04-0507-042) regarding the practice of deducting for tax purposes the portion of settlements entered into with governmental agencies that the IRS determines to be a fine or penalty. The directive focuses on settlements involving the False Claims Act (FCA) and the Environmental Protection Agency (EPA) and elevates the issue of whether payments under these settlements constitute payments of fines or penalties to "Tier I Issue" status.
IRC Sec. 162(f) prohibits business deductions for fines or similar penalties paid to a government for the violation of any law. Fines and penalties are amounts paid:
· As a result of conviction or a plea of guilty or no contest for a felony or misdemeanor in a criminal proceeding;
· As a civil penalty imposed by federal, state, or local law;
· As a settlement of the taxpayer's actual or potential liability for a civil or criminal fine or penalty. (Reg. § 1.162-21(b)(1) )
The directive cites existing guidance that bears on the issue, including:
· PLR 200502041 - this technical advice memo states that a portion of a lump-sum payment in settlement of claims arising under the FCA is nondeductible under IRC Sec. 162(f).
· Case law concluding that civil penalties imposed to enforce the law and as punishment for violation of the law are not deductible. By contrast, civil penalties imposed to encourage prompt compliance with a law, or as a remedial measure to compensate another party for expenses incurred as a result of the violation, are deductible because they do not serve the same purpose as a criminal fine and are not similar to a fine within the meaning of IRC Sec. 162(f).
· PLR 200629030 - this ruling concludes that part of the costs incurred when executing a beneficial environmental project is comparable to a nondeductible fine or similar penalty under IRC Sec. 162(f) and therefore cannot be included in the basis of assets produced under IRC Sec. 263A or of property under IRC Sec. 1012.
False Claims Act issues
The directive says that 75% of settled FCA cases involve health care fraud (primarily Medicare-related). The remaining cases involve various matters such as defense contractors, environmental issues, securities law violations, and governmental contracts. In the Directive, IRS auditors are told that they must examine FCA settlements of $10 million or more using a risk analysis process to identify settlements and projects below that threshold that may require examination.
The directive says that almost every taxpayer deducts the entire amount of a FCA settlement as a business expense even though a portion of the settlement payment represents a nondeductible penalty. Taxpayers have claimed that the goal of the total settlement was to compensate the government for its losses, pointing to the Department of Justice's (DOJ) usual statement at the beginning of an investigation of the amount by which it believes the government was over-billed. Ultimately, the settlement is less than this initially publicized amount, and the taxpayer argues that since it is less than the losses DOJ reported, all of the settlement has to represent losses actually suffered by the government, which are compensatory and, therefore, deductible. The directive says this argument is not representative of the final settlement agreement.
Before June of 2005, most DOJ settlement agreements included the following phrase, “The Parties agree that this agreement is not punitive in purpose or effect.” Taxpayers have argued that this phrase makes it clear that the entire settlement is compensatory. The directive clarifies* that this phrase relates only to double jeopardy under the Constitution and has no meaning for US income tax purposes.
EPA issues
Environmental enforcement settlements generally include a written summary of the settlement's components. The breakdown may include:
· The agreed-upon penalty amount.
· Mandatory compliance projects required so that the taxpayer meets minimum environmental laws and regulations.
· Supplemental environmental projects - These are voluntary projects incorporated into a consent decree that provide the taxpayer with a significant reduction to the proposed penalty amount. The EPA does not allow supplemental projects to be used to reduce compensatory or remediation liability.
Although in most cases a portion of the proposed civil penalty was reduced for agreeing to perform such a project, the directive says that most defendants/taxpayers either deduct the entire amount of the supplemental project as an IRC Sec. 162 business expense or capitalize the cost of the project and claim related depreciation deductions. To remedy this, the Directive concludes that the portion of the cost of a supplemental project that is analogous to a nondeductible fine or similar penalty under IRC Sec. 162(f) is both nondeductible and cannot be included in the basis of assets it produces under IRC Sec. 263A or the basis of property under IRC Sec. 1012.
The Directive tells Auditors that examination of supplemental projects of $1 million or more is mandatory, and that they should use a risk analysis process to see if settlements and projects below this threshold should be examined. Going forward, when dealing with supplemental projects (the costs of which are generally nondeductible) taxpayers must determine the amount of the penalty that was mitigated (i.e., forgiven) in exchange for the taxpayer's agreement to perform a supplemental project. This amount may be stated as part of the consent decree; however, in other cases extensive factual development of the negotiation history may be necessary.
Conclusion
Although taxpayers have known for a while that the IRS was challenging these payments, this Directive draws unwelcome scrutiny to an already sensitive area. Taxpayers may have to become more aggressive with governments in defining, in writing, the composition of the settlement payments or have better documentation supporting that the payment was compensatory, and not punitive. Either way, it is clear that the IRS has these payments in their cross hairs and taxpayers will need to be more prepared to support their deductible amount.
Publications Search Page
