By: Douglas E. Roberts
October 01, 2018
More Than Just Taxes: Considering the Effects of the New Government Reporting Requirements
The sprawling new federal tax law, enacted early this year, has engendered great controversy about systemic issues like wealth distribution, deficit expansion, and job creation. Hidden in the maelstrom is a rather uncontroversial provision that attempts to bring predictability and efficiency to the process of seeking tax deductions for payments made to the government in satisfaction of a settlement agreement or judgment. The U.S. Department of Justice (DOJ) and other agencies already have begun to apply this provision to civil defendants. As this article explains, practitioners must not only understand the tax consequences of the new law, but also its potential effect on the availability of insurance coverage for their clients.
Breaking Down the Text
Payments to a private party in settlement of a claim or to satisfy a judgment are typically deductible as business expenses under Section 162 of the Internal Revenue Code. When the payment is made to a government entity, however, the picture changes: Any part of a settlement or judgment considered a “fine or similar penalty” historically was not a deductible business expense for public policy reasons.1 In other words, a deduction would not be permitted if it “would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.”2 Treasury regulations (circularly) define a “fine or similar penalty” to include amounts “[p]aid as a civil penalty imposed by Federal, State, or local law … or in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).”3 However, the regulations exclude “compensatory damages … paid to a government” from the definition.4
The new tax law, which sports the snappy title, “An act to provide for reconciliation pursuant to Titles II and V of the concurrent resolution on the budget for fiscal year 2018,” maintains that distinction. But it shifts the burden of proof from the IRS to the claimant. Previously, after a taxpayer deducted a civil settlement with, or judgment in favor of, the government, the IRS had to establish that a payment — or portion of a payment — constituted a fine or penalty to foreclose deductibility. Now, the IRS must only show the payment was made to a government unit in response to an allegation that the taxpayer violated some law. The taxpayer must then demonstrate that the payment is for “restitution” or to “come into compliance with any law that was violated or otherwise involved in the investigation or inquiry.”5
How does a taxpayer make that showing? The new law provides a mechanism. In each “suit or agreement,” the government must report (1) the amount of the “suit or agreement” that constitutes restitution, remediation of property, or a payment to “come into compliance” with the law that was violated or involved in the investigation; and (2) the portion that constitutes a “fine, penalty, or other amount.”6 While the IRS will be able to contest any categorization, the new reporting requirement was designed to bring tax predictability to the settlement process.
A few definitional notes: First, while there is some ambiguity in the definition of “suit or agreement,” it certainly encompasses settlement agreements, dispositive court orders in the government’s favor, and sanctions in which the aggregate amount exceeds $600. Second, “fine, penalty, and other amount” is defined only as anything other than restitution, remediation, and the costs of “com[ing] into compliance” with whatever law was violated. Such costs would include, for example, money expended to implement a compliance program that satisfies the terms of a corporate integrity agreement.
Third, “fines and penalties” reflects the traditional language describing the punitive, as opposed to compensatory (i.e., restitutory or remedial), nature of a payment. Though it is not entirely clear, “other amounts” appears to refer to “any amount paid or incurred as reimbursement to the government or entity for the costs of any investigation or litigation.”
Implementation and Defense Strategy
As the reporting requirements apply to all government units, and even some nongovernmental regulatory entities, questions abound regarding implementation. Will the various players report consistently with one another? Will each entity report in the same manner in each settlement agreement?
Anecdotal evidence suggests that the DOJ — the agency that will most frequently apply the new law — will expressly designate within the body of the settlement agreement what portion of the settlement amount constitutes restitution, but not what constitutes “fines, penalties, and other amounts.” The DOJ’s strategy for identifying restitution only is unclear; perhaps the agency is leery of foreclosing the IRS from later arguing that the undefined portion of a settlement is something other than a fine or penalty. However, such an argument likely would not travel far. Except, perhaps, for reimbursement for the cost of the investigation, the noncompensatory portion of a settlement amount must represent fines and penalties.
In any event, the DOJ’s tactic represents a dramatic change from past practice, where agreements were silent as to the composition of the settlement amount. Under statutes like the False Claims Act, where treble damages are available and the government typically requires double damages for settlement, the fines and penalties can be substantial.
In essence, the new law removes the option to settle the underlying dispute with the government and litigate the tax consequences later. Agencies will be compelled to consider tax issues concerning enforcement actions during the investigation and litigation stages. Thus, defense counsel must consider the tax implications of potential settlements early in the representation, when he or she has the greatest opportunity to shape the government’s damage theory. If the objective is to maximize the client’s tax deduction, counsel might press a theory in which compensatory damages are larger, in exchange for a discount on the punitive portion of the settlement.
Don’t Forget Insurance
Perhaps less intuitively, defense counsel also should evaluate the insurance consequences of the new tax law. Business entities and professionals, such as physicians, may well have policies that permit recovery for restitution or compensatory damages that flow from a regulatory action. Such policies, which often foreclose recoupment for fines and penalties, provide an even stronger incentive for counsel to advocate for the maximum apportionment of the settlement amount as restitution.
The calculus changes, however, when the policy in question expressly insures for civil or regulatory fines and penalties. These policies, while less common than those that exclude fines and penalties, exist in many insurance markets, including the environmental and medical spaces. Where this kind of policy excludes restitution, counsel may be put in the unusual position of arguing for damages theories that weigh heavy on the punitive side of the balance. That kind of pitch may appeal to government attorneys, given the presumed general deterrent value of stiff fines and penalties.
As is true with the tax consequences of a potential settlement, it is imperative that defense counsel assess the relevant insurance coverage issues early in the representation.7 Knowing what policies are applicable will help counsel shape the most favorable resolution for the client.
1. 26 U.S.C. § 162(f).
2. Tank Truck Rentals v. Comm’r, 356 U.S. 30, 33-34 (1957) (citations omitted).
3. 26 C.F.R. § 1.162-2(b)(1).
4. 26 C.F.R. § 1.162-2(b)(2).
5. 26 U.S.C. § 162(f)(2)(A)(i)(II).
6. 26 U.S.C. § 6050X(a)(1).
7. If the client is fortunate enough to have a policy that provides insurance for fines and penalties, counsel should ensure that the applicable law does not prohibit the enforcement of the provision as contrary to public policy.
Reprinted with permission from the September/October 2018 edition of "The Champion" © 2018, National Association of Criminal Defense Lawyers. All rights reserved. Further duplication without permission is prohibited.