On Dec. 22, 2017, President Donald Trump signed into law Pub. L. No. 115-97, commonly known as the Tax Cuts and Jobs Act of 2017 (the Act). While the Act makes numerous revisions to the Internal Revenue Code (Code), one notable change is to restrict taxpayers' ability to deduct, as business expenses, payments made in connection with violations of law, including in settlement of government investigations of violations of law. This change potentially affects businesses that are targets in a wide range of government enforcement matters.
Below are five key highlights related to these changes, found in Section 13306 of the Act:
- What were the previous requirements governing the deductibility of payments to resolve a violation or alleged violation of law? Previously, Code Section 162(f) prohibited the deduction of fines or similar penalties paid to a government for the violation of any law as trade or business expenses. Under regulations, this precluded the deduction of criminal fines and penalties and civil penalties, as well as amounts paid in settlement of a taxpayer’s actual or potential liability for such fines and penalties. Treasury Reg. § 1.162-21(b). However, deductions were generally allowed for amounts paid to a government as compensatory damages, including single damages under the False Claims Act and for remediation of property under the environmental laws. Courts typically looked at whether the governing statute’s purpose was punitive or compensatory to determine whether a payment was deductible under Code Section 162(f).
- What changes does Section 13306 of the Act make to the prior requirements governing the deductibility of payments to resolve a violation or alleged violation of law? Section 13306 of the Act completely repeals the prior language of Code Section 162(f) and replaces it with a general prohibition of business expense deductions for any payments made to or at the direction of a government, a governmental entity or certain nongovernmental self-regulatory entities in connection with a violation of law or an investigation involving a potential violation of law. Code Section §162(f)(1). However, taxpayers continue to be allowed deductions for payments that they can establish “constitute restitution (including remediation of property) for damage or harm” related to the violation or potential violation of law or that were made “to come into compliance with any law which was violated or otherwise involved” in an investigation. Code Section 162(f)(2)(A)(i). Nevertheless, amounts paid to reimburse the costs of investigation or litigation are not deductible as restitution or otherwise. Code Section 162(f)(2)(B). Furthermore, as a prerequisite to establishing the right to the remaining allowable deductions, the court order or settlement agreement involved must identify the amounts paid as restitution or payments made to come into compliance with applicable law. Otherwise, no deductions are allowed regardless of the nature of the payments. Code Section 162(f)(2)(A)(ii). Additionally, the governmental or self-regulatory entity involved must file an information return with the Internal Revenue Service (IRS) (with a copy to the taxpayer) specifying the amounts regarded as being deductible under these new standards. Code Section 6050X. Payments involving matters where a federal, state or local governmental entity or an applicable nongovernmental entity is involved as an enforcement agency are covered by these new provisions, but not payments arising from actions involving only other private parties, including NGOs, as plaintiffs.
- Is it harder than before to demonstrate that payments to resolve a violation or alleged violation of law are deductible? Quite possibly yes, in many cases. It will no longer be possible for a taxpayer, on its own, to justify that payments qualify for deduction on the basis that they were not made to a government, or on the basis that they were paid as compensatory, remedial or otherwise non-punitive amounts. Instead, the relevant court order or settlement agreement must specifically identify the payments as being restitution or as amounts paid to come into compliance with law in order for them to be deductible. Then, the enforcing entity is also required to file an information return setting forth the deductible amounts. This means that, unlike in the past, a taxpayer seeking to deduct settlement payments to resolve violations or alleged violations of law is forced to directly confront the enforcing authority with the issue of the extent to which the settlement will be structured to allow deductions. Discussion of these matters is likely to prove contentious and may lead to fewer settlements. Under prior policy, the U.S. Department of Justice (DOJ) often avoided taking any position regarding the tax treatment of settlement payments. However, DOJ has now formed a working group, which includes IRS representatives, to determine the extent to which its approach should be modified in the wake of these changes to the Code.
- What are some issues that could arise with respect to deduction of payments identified as being “restitution” or “amounts paid to come into compliance”? Although specification in a court order or settlement agreement of amounts as fitting into the relevant categories is a prerequisite to establishing the right to deductions, it is not conclusive or binding on the IRS. Code Section 162(f)(a)(2)(A). As a result, the IRS is apparently free to argue that amounts identified as restitution or as paid to come into compliance have a different nature or origin than identified and, therefore, should not qualify for deduction as business expenses. Strictly speaking, restitution involves repayment to the victim of the underlying violation of law. While this should not be an issue in False Claims Act or environmental remediation cases, the IRS may not agree, in other contexts, that a payment to the government qualifies as restitution to the victims of a violation of law. Depending on the circumstances, the IRS may also take the position that amounts identified as being in the categories permitted to be deducted were paid in lieu of other nondeductible amounts involved in the matters and, therefore, despite the identification, are not deductible. However, the new rules should make it less likely that the IRS will be able to sustain, as it sometimes has in the past, the argument that amounts paid as restitution should be nondeductible simply because they were paid in connection with a criminal matter.
- When do these changes go into effect? Section 13306 provides that the new standards generally apply to amounts paid or incurred on or after the date of enactment of the Act, which was Dec. 22. However, the new provisions do not apply to amounts paid or incurred under any binding order or agreement entered into before Dec. 22. The Act specifically provides that the new rules do apply to payments to be made under orders or agreements requiring court approval that were pending as of Dec. 22 but did not receive such approval before that date.
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