IRS Identifies Factors for Determining Deductibility of Settlement Payments

Background

Payments made pursuant to a settlement agreement or court judgment ordinarily will be characterized, from the payor's perspective, as a deductible expense, a capital expenditure, or a nondeductible, noncapital payment.

The origin and character of the claim with respect to which an expense was incurred determines its tax treatment. Generally, if a claim arises from acts performed by a taxpayer in the ordinary course of its business operations, settlement payments and payments made pursuant to court judgments related to the claim are deductible under section 162. For example, payments made to compensate a plaintiff for actual damages or harm caused by the defendant's action generally are deductible. However, some settlement payments or legal fees may be characterized as capital expenses if they are incurred in connection with the acquisition of a capital asset. For example, if a settlement agreement in patent litigation provides for payments both to compensate a plaintiff for past royalties and to acquire rights to the plaintiff's intellectual property, the portion of the payment allocable to the acquisition of intellectual property represents a capital expenditure.

Another notable exception to the notion that business payments ordinarily are deductible under section 162(a) is section 162(f), which prohibits the deduction of any "fine or other similar penalty paid to the government for the violation of any law."

Application to Relator Fees under the False Claims Act

The False Claims Act (FCA) provides that either the Attorney General or a private citizen (the relator orqui tam plaintiff) may bring an action in the name of the government for a violation of the FCA. The FCA entitles the relator to a share of any amounts recovered.

Under the facts considered in the memorandum, the government intervened in a suit brought by a relator and eventually settled with the defendant. The settlement agreement provided that the defendant will pay a lump-sum amount to the government in settlement of all potential FCA claims. The settlement agreement also provided that a specified portion of the amount will be paid by the government to the relator in satisfaction of the statutory relator fees.

The memorandum concludes that the amount paid to the relator is deductible in full by the defendant-payor because reimbursement of relator fees has a compensatory -- not punitive -- purpose. The memorandum cites the Supreme Court's 2003 opinion in United States ex rel. Chandler for the proposition that damages paid in the context of an FCA settlement serve remedial as well as punitive purposes and that the portion of a settlement payment that is intended as recompense to the government for its obligation to pay the relator is not a nondeductible fine or penalty under section 162(f).

The memorandum notes that other courts, including the U.S. Tax Court, have concluded that relator fees are not penalties. For example, the Tax Court said in Rocco v. Commissioner , "The payment to a relator in a qui tam action is not a penalty imposed on the wrongdoer; instead, it is a financial incentive for a private person to provide information and prosecute claims relating to fraudulent activity."