Vol. 76, No. 3, March
Tax Deductions for Settlements
with Government Agencies
Depending on the circumstance, companies that
pay settlements to government agencies may be eligible for a tax
deduction. Learn what circumstances may lead to a deduction and the
attorney's role in drafting settlements with the tax issues in mind.
by Douglas H. Frazer & Karen M. Schapiro
The Wall Street Journal recently reported that the slew of
companies caught in chicanery might soften the resultant financial
impact by getting huge tax breaks from Uncle Sam. "Corporations that pay
large sums to atone for their sins," said the paper, "usually can write
off the money on their tax returns, substantially softening the
financial blow.... Even settlements with government regulators can be
deducted in many circumstances."1
But what are those circumstances? This article explores the issue of
the deductibility of settlements with government agencies and the
attorney's role in drafting settlements with the tax issues in mind. The
article also addresses the related questions of timing: whether it
matters that a proceeding is pending or whether a court has ordered or
confirmed a settlement.2
The Legal Authority for the Deduction
The principal federal code provision authorizing the deductibility of
settlement payments to government agencies is 26 U.S.C. § 162
(1986). Section 162(a) allows a deduction of "all the ordinary and
necessary expenses paid or incurred during the taxable year in carrying
on any trade or business...." Settlement payments most often are
characterized in this way. The principle, however, contains an important
limitation. Under section 162(f), a deduction is disallowed for a "fine
or similar penalty paid to a government for the violation of any
Alternatively, deductions for settlement payments to government
agencies could fall under 26 U.S.C. § 165 (losses on transactions
entered into for profit). Unlike section 162, however, section 165 does
not have a parallel limitation that disallows a deduction for a fine or
similar penalty paid to a government for the violation of any law.
Allowance of the Deduction: The IRS Position
The Internal Revenue Service most recently addressed the issue of the
deductibility of settlement payments to the government in Field Service
Advice (FSA) 2002-10011. The FSA involved a taxpayer that had pleaded
guilty to a Sherman Antitrust Act violation in connection with a Defense
Department contract for producing image converter tubes. Section 162(f)
clearly barred the deduction of the criminal fine. The government,
however, also believed it could recover civil damages under the Lanham
Trademark Act from the company for filing a false claim, breach of
contract or warranty, fraudulent or negligent misrepresentation, unjust
enrichment, or payment by mistake. The taxpayer and the government
entered into a financial settlement of the claims. The FSA concerned the
deductibility of a payment under that settlement.
A civil penalty, explained the FSA, "even if it is labeled a penalty,
may be deductible if it is imposed to encourage compliance with the law
or as a remedial measure to compensate the party." There is no deduction
for penalties, however, "imposed for the purpose of enforcing the law or
as punishment for violation of the law."
Therefore, the determination of the character of a given payment
involves an interpretation of the statute giving rise to the potential
or actual litigation (the "origin of the claim") and the specific facts
of the settlement itself. This is particularly true when a statute
serves both punitive and compensatory purposes. In such a situation,
said the FSA, it may be helpful to compare "the payment amount with the
actual damages caused by the conduct at issue. If a payment exceeds the
amount needed to compensate the victim, or if it is in addition to a
separate compensatory payment, it can often be inferred that the payment
had a punitive purpose."
The potential claims discharged by the settlement included claims
under the Lanham Trademark Act, which recognizes both compensatory and
punitive remedies. Section 35(a) of the Act provides that any recovery
under that part of the Act "shall constitute compensation and not a
penalty."3 Section 35(b) of the act, on the
other hand, provides for monetary recovery in the amount of three times
the defendant's profits or damages, whichever is greater.
The FSA noted that "it is possible for payments pursuant to section
35(b) of the Lanham Trademark Act to be covered by section 162(f)."
Thus, the FSA suggested that an attempt be made to ascertain "the intent
of the parties as to what purpose the payment was designed to serve."
The FSA observed that "the fact [that] the settlement amount is
significantly larger than the total contract amount suggests that some
portion of the settlement payment is likely punitive and subject to
The Deduction in Practice: Case Studies
Government Contract Settlements. The deductibility
issue frequently arises in government contract litigation settlements. A
good illustration of this is Talley Industries Inc. v.
A Talley subsidiary, Stencel Aerow Engineering Co., had charged
certain costs to the wrong government contracts. Talley and the federal
government settled the case for $2.5 million.
Talley tried to deduct the full settlement amount. The IRS denied the
deduction in part. The IRS argued that $940,000 of the total was a
payment of double damages under the Federal Contracts Act and therefore
was a nondeductible payment of a "fine or similar penalty" under section
162(f). Talley, on the other hand, contended that the $940,000 was
intended to compensate the government for any unknown losses. The tax
court found for the government. Talley appealed.5
The Ninth Circuit Court of Appeals observed that "[i]f the $940,000
represents compensation to the government for its losses, the sum is
deductible. If, however, the $940,000 represents a payment of double
damages, it may not be deductible. If the $940,000 represents a payment
of double damages, a further genuine issue of fact exists as to whether
the parties intended the payment to compensate the government for its
losses (deductible) or to punish or deter Talley and Stencel
(nondeductible)." Having framed the issue, the court remanded the case
for a determination of the purpose of the $940,000 payment - and thus
On remand, the tax court noted that because the settlement agreement
did not evidence an intention by the parties that the $940,000 be
compensatory, the burden of proof was on Talley to establish that it
was. The company failed to carry that burden. Consequently, the tax
court disallowed the deduction for the $940,000 portion of the
Environmental Contamination Settlements. Cases
involving government contracts are not the only situations in which
deductions may be denied for amounts paid as the result of actual or
potential litigation. Environmental contamination actions also raise
In Allied-Signal Inc. v. Commissioner,6 a divided court affirmed the tax court's denial of
any deduction for the $8 million that Allied-Signal paid to an endowment
set up to eradicate Kepone, a highly toxic chemical pesticide. The
court, echoing the trial judge's opinion, concluded that the $8 million
was paid "with the virtual guaranty that the district court would reduce
the criminal fine by at least that amount."7
Thus, "the payment was for punishment and deterrence of environmental
The court found that the parties carefully crafted the transaction so
that part of the payments would remain in Virginia, where the endowment
was expected to carry out its activity. "This transaction," concluded
the court, "did indeed take Allied out of the literal language of
section 162(f) and provided Allied an arguable basis for claiming an
ordinary and necessary business expense deduction."9 That, however, was not enough. The court held that
the payment was in the nature of a criminal fine diverted from the U.S.
Treasury to the endowment and was thus nondeductible.10
The dissent conceded that the $8 million payment to the endowment
"was not made from the goodness of Allied-Signal's heart, nor out of an
overwhelming humanitarian concern, nor from some ecological passion for
the environment." The payment was made in lieu of a fine and with the
expectation that it would not be allowed as a deduction if the $8
million were a fine paid to the government. "Allied's argument to the
contrary is ridiculous." Nevertheless, concluded the dissent, section
162(f) applies only if the payment is made to a government. "I cannot
contort the plain language of section 162(f) that the payment must be
'to a government,' to arrive at a result that, were I a legislator, I
would intend. I am not impressed with the arguments about what Congress
intended to say, because what they did say is clear and
In light of the dissent, Allied-Signal's settlement technique likely
will be attempted in other circuits.
Colt Industries Inc. v. United States12 also involved the environment, but with civil
rather than criminal penalties at issue and with the payments going to
government-operated clean-up funds. Through a subsidiary, Crucible, Colt
Industries received EPA notices of violations of the Clean Air Act.
Ultimately, the EPA sought both an injunction and the imposition of
civil penalties for violations of both the Clean Air Act and the Clean
Water Act. To settle this, Crucible and the EPA entered into a consent
agreement. Part of the consent agreement required Crucible to pay $1.6
million to the Pennsylvania Clean Air and Clean Water funds administered
by the Pennsylvania Department of Environmental Resources. In turn, Colt
deducted the payments on its consolidated corporate tax return.
The IRS disallowed the $1.6 million deduction. On appeal, Colt argued
that section 162(f) "only bars deduction of those civil penalties that
serve a punitive or criminal purpose." According to Colt, the EPA
penalties did neither.
The court declined to address the merits of this position. Rather,
the court found against Colt on the basis that its position was
administratively impractical. Accepting Colt's interpretation, stated
the court, would require an analysis of the purpose of each penalty at
issue "to ascertain whether the payment is barred from deduction." The
court decided it did not want to get involved with such an inquiry. "The
role of the judiciary in cases of this sort begins and ends with
assurance that the Commissioner's regulations fall within his authority
to implement the congressional mandate in some reasonable manner."
A similarly situated party may want to try again. Simply labeling
something a penalty does not necessarily make it so. The IRS's recent
FSA makes this point explicitly.
Colt also argued that the penalty should be deductible
because it fit within the "compensatory damages" exception set forth in
Treas. Reg. § 1.162-21(b)(2). In Colt's view, the $1.6 million it
paid was intended to reflect the economic benefit Crucible had derived
from noncompliance with the pollution control law.
Douglas H. Frazer, Northwestern 1985, and
Karen M. Schapiro, Northwestern 1985, are shareholders
with Frazer & Schapiro S.C., Milwaukee.
The court, however, had a different understanding of compensatory
damages. It viewed the compensatory damages as being limited to an
amount paid to a victim to make the victim whole. "Colt," said the
court, "does not explain how penalties designed to return Crucible to
the status quo ante compensate the government.... Colt's own argument
confirms that this was not the purpose of the penalty it paid."
In addition, stated the court, neither the Clean Air Act nor the
Clean Water Act authorizes the EPA to seek compensatory damages.13
Settlements of Section 165 Losses on For-profit
Transactions. While section 162(f) controls deductions claimed
under section 162, a somewhat different set of rules exists as to
deductions claimed under other sections, such as section 165 (losses on
transactions entered into for profit). The question is whether public
policy considerations come into play as to deductions under other
Before 1969, the courts had created a "public policy" doctrine
disallowing a deduction if it frustrated defined national or state
policies. Section 162(f) codified that area of the law. "It was designed
to narrow and make more specific the situations in which fines and
penalties would be nondeductible by implicitly acknowledging that some
fines and penalties are really more user fees than they are law
enforcement tools. While that eliminated the public policy doctrine, as
such, being applicable for section 162 deductions, the codification had
no direct impact on deductions falling within other sections."14
In Stephens v. Commissioner,15
the taxpayer was convicted of defrauding the Raytheon Company by
conspiring with Raytheon personnel and others to overcharge on shipments
of prefabricated housing to Saudi Arabia. The trial court sentenced the
taxpayer to either probation or prison, depending on whether the
taxpayer made restitution to Raytheon.
Stephens had placed part of the proceeds from the crime in an annuity
account in a Bermuda bank. Stephens allowed $530,000 of the funds in the
Bermuda account to be applied as partial restitution of the amounts owed
The tax question before the court was the deductibility of that
$530,000 in the year of repayment. The tax court held that the deduction
was not properly claimed as a section 162 deduction. It was not an
ordinary and necessary business expense. Rather, if there were to be a
deduction, it would be for a loss incurred in a transaction entered into
for profit under section 165(c)(2).
Because the deduction was not under section 162, then section 162(f)
would not, by its terms, be applicable. "However," stated the tax court,
"it does not follow that the standards, which have been established for
the application of section 162(f) to payments which would otherwise be
allowable under section 162(a), should not be utilized to determine
whether a taxpayer should be denied a deduction for a payment which
might otherwise be allowable under section 165(c)(2)."
The court concluded that at a minimum, "the considerations involved
in applying section 162(f) extend to the determination of deductibility
under section 165(c)(2)." Stephens' $530,000 payment as the result of
the criminal conviction was a probation condition and was in lieu of an
additional prison term. "That the payment had the effect of reimbursing
Raytheon for all or part of its loss and, therefore, had a civil aspect,
does not detract from this overriding fact." The court saw the
restitution payments as a "similar penalty." The court thus incorporated
the animating principles of section 162(f) into section 165 and denied
any deduction. The Second Circuit disagreed with the tax court's
conclusion. Where the tax court saw the restitution as a trade-off for a
lighter punishment, the appeals court saw the heavier punishment that
would be incurred if restitution were not made as a way of assuring that
Stephens made the restitution. Compensatory payments, which are
deductible, return the parties to the position they were in; the
payments that are nondeductible are those imposed to serve a law
enforcement purpose. Stephens' payments to Raytheon looked compensatory
to the appeals court, and thus deductible.
The Second Circuit also did not think that allowing the deduction
would frustrate public policy. Interestingly, the reviewing court agreed
with the tax court as to the relevance of section 162(f) to deductions
under other sections, such as section 165. "Congress can hardly be
considered to have intended to create a scheme where a payment would not
pass muster under section 162(f), but would still qualify for deduction
under section 165." The court, however, declined to comment on whether
the converse was true: whether a payment that would be deductible under
the narrow constraints of section 162(f) would always be deemed to pass
the public policy test that might still apply to section 165. This
leaves open the question of the applicability of pre-1969 public policy
law to deductions not under section 162.
Foreshadowing the dissent in Allied-Signal, the Second
Circuit also emphasized that Stephens' payment was made to Raytheon and
not to a government. It disagreed with the tax court's conclusion that
Stephens' distinction was irrelevant. "To the extent that ... a
restitution payment, ordered in addition to punishment and paid directly
to a victim, would not be a deductible loss, we respectfully disagree.
In codifying the public policy exception to deductibility of expenses
under section 162, Congress was clear and specific, limiting the
exception to bribes, kickbacks and other illegal payments; a portion of
treble damage payments; and fines and similar penalties paid to a
government. That codification was intended to be
Other Issues and Strategies
Payments to a Government. The IRS in recent years
has generally accepted the significance of the requirement that punitive
payments, to be nondeductible, must be made to a government. Thus, the
IRS in FSA 1999-1054 indicated that an insurance company was not barred
by section 162(f) from taking a deduction for punitive damages it paid
to an insured employer to settle a civil lawsuit. The IRS, however, has
taken an expansive view of what constitutes "a government."
In FSA 1999-1006, the Federal Reserve Bank (FRB) assessed a
deficiency penalty on a member bank. The FSA found the penalty not
deductible under section 162(f). The bank had deducted the penalty on
the theory that it was a compensatory or remedial penalty. In
disagreeing, the IRS relied on the facts that 1) the reserves were not
interest-bearing and thus there was no loss necessitating compensation
to the FRB; and 2) the FRB could waive the penalty, which is a feature
of punitive fines. Was the payment to the FRB a payment to a government
agency? Implicitly, the IRS answered "yes" - given that the FRB is an
independent watchdog of federal government fiscal policy.
FSA 1997-26, in contrast, dealt with fines imposed on a member of a
regulated trading exchange for violating exchange rules and faced
squarely the question of the limitations of the requirement under
section 162(f) that payments be made to a government. To "insure fair
trading practices and honest dealing and provide a measure of control
over speculative activity," explained the FSA, regulation is
accomplished through a federally mandated duty of self-policing by
The FSA then observed that "[a]ccordingly, for purposes of section
162(f), we could argue that pursuant to this statutory scheme, exchanges
in the performance of their mandatory self-regulatory duties are acting
as delegatees of the CFTC [and SEC].... Under this congressional design,
exchanges are imbued with quasi-governmental power that transforms them
from private trade associations into organizations sharing
responsibility for the maintenance of an orderly and fair
market."17 "Accordingly, when an exchange
conducts disciplinary proceedings under self-regulatory power conferred
upon it, it may be considered, under certain circumstances, to be
engaged in governmental action, federal in character.... [A] strong
argument exists that when engaged in the enforcement of federally
mandated rules and regulations the actions of these hybrid organizations
are sufficiently governmental in nature to trigger application of
In other words, the IRS position is that penalties imposed by what it
deems self-regulating organizations are imposed by a government for
section 162(f) purposes.
Settlements Ahead of Government (or other Claimant)
Action. Codification of another part of the public policy
doctrine is contained in section 162(g). This section addresses
settlements made under the federal antitrust laws. Two-thirds of any
amounts paid for damages are rendered nondeductible by this provision,
which, like section 162(f), was enacted in 1969. The question in FSA
2001-43006 was what happens when the taxpayer beats a claimant to the
FSA 2001-43006 involved a taxpayer that pleaded guilty to Sherman Act
violations. The taxpayer entered into a settlement with a claimant who
had not yet filed a civil suit against it but who presumably could have
sued for triple damages. If the suit had been filed, and then settled,
the payments made would have been allowed only to the extent of
one-third of the damages, explained the FSA. However, because no suit
was ever filed, section 162(g) did not apply.
The government previously lost on that point in Fisher Cos. v.
Commissioner.18 In Fisher,
the tax court read the plain language of the statute as requiring that
an action be brought under the triple damages provision to trigger the
two-thirds disallowance rule. Without the filing of a complaint,
therefore, the mere fact that the antitrust violation was the basis for
settlement makes no tax difference. This clearly is a situation in which
settlement before the claimant gets
to the courthouse can be good tax planning.
A similar case can be made in connection with IRS trust fund recovery
penalties. Such penalties, equal to the unpaid trust fund portion of
employment-related taxes, can be assessed against the responsible
officers of an entity.19 The law is clear
that after such an assessment, the responsible officer cannot deduct
those payments because the payments are treated as a nondeductible
penalty under section 162(f).20
Although no reported cases on the issue appear to exist, a potential
responsible officer who is entitled to indemnification from the entity
and who pays the tax on behalf of the entity before the IRS assesses the
trust fund recovery penalty may be entitled to a business or nonbusiness
bad debt deduction under section 165(c).21
The outcome of government claims usually involves negotiation of some
sort of settlement, often without any court-level proceeding ever
commencing. For section 162(f) purposes, the fact that something is paid
under a settlement does not, standing alone, make it any more deductible
than if it is paid under a court order. When sections 162(g) or 6672 are
involved, however, deductibility may turn on whether a settlement or
payment was made before any litigation or payment was commenced.
The likelihood of a tax deduction is increased if language in the
settlement documents recites that the payments to be made are
compensatory and not punitive and that the government representatives
agree that a tax deduction should not be barred under section 162(f) or
on public policy grounds. If the amount being paid in a settlement
exceeds damages actually sustained, an explanation of the difference
ought to be made; for example, that it is intended to reimburse the
government for its investigative costs and for interest on the
underlying amount. The possibility should always be explored of crafting
a settlement so that compensatory payments are made - such as to victims
of an alleged securities fraud - rather than punitive payments being
made to government agencies.
The stakes are huge. Ask Merrill Lynch & Co., or Exxon, or
Salomon Brothers. Merrill Lynch's recent $100 million dollar settlement
with the New York attorney general's office is probably - by virtue of a
well-crafted agreement - deductible. So was almost all of Exxon's $1
billion Exxon Valdez oil spill settlement. So was $100 million of a
Salomon Brothers settlement in the early 1990s with the SEC over
manipulation of the U.S. Treasury bond market. A company confronting
this issue is almost always better served with early planning.
Firms Accused of Chicanery Could Get IRS Tax Break, Wall St.
J., Sept. 3, 2002, at A4. See also Zuckerman, Wall Street's
Settlement Will Be Less Taxing, Wall. St. J., Feb. 13, 2003, at C1
("Wall Street firms are getting ready to pay out billions of dollars to
resolve alleged stock research abuses. But the pain will be much easier
to take, thanks to U.S. taxpayers. The reason: Most of the payments
likely will be tax deductible for the companies.").
2This article was
inspired by an excellent discussion of the subject by Burgess J.W. Raby
and William L. Raby appearing in 34 Tax Practice 109 (May 3, 2002).
315 U.S.C. §
468 T.C.M. (CCH)
5116 F.3d 382 (9th
(CCH) ¶50,151 (3d Cir. 1995).
at p. 87,543.
12880 F.2d 1311
(Fed. Cir. 1989).
42 U.S.C. § 7413 (authorizing civil penalties and injunctive relief
for violations of the Clean Air Act) and 33 U.S.C. § 1319
(authorizing civil penalties and injunctive relief for violations of the
Clean Water Act). The standard form EPA consent decree contains explicit
language that the payment is nondeductible. In environmental cases in
which the EPA and a state environmental tax authority exercise
concurrent jurisdiction, a private party may wish to investigate whether
a better tax result might be gained by settling with the state
enforcement authority under a state statute.
supra note 2, at 114.
15905 F.2d 667
(2d Cir. 1990).
at 674. Note that the tax court in Stephens held that losses
under section 165(c)(2) were still subject to a broad public policy
test. While the Second Circuit reversed, it made clear that it agreed
with the tax court that the standard for a deduction under section 165
is no less demanding than under section 162(f). That, of course, leaves
open for future cases the possibility of the IRS disallowing deductions
claimed under sections other than 162 on public policy grounds even
broader than those set forth in section 162(f).
Reynolds Securities Inc., 593 F.2d 1234, 1244 (D.C. Cir. 1978).
1884 T.C. 1319
(1985), aff'd, 806 F.2d 263 (9th Cir. 1986).
§ 6672 (1986).
Commissioner, 73 T.C.M. (CCH) 3197 (1997).
the same theory would apply to the payment of Wisconsin trust fund taxes
ahead of a responsible officer assessment under, for example, Wis. Stat.
section 71.83(1)(b)2. or 77.60(9).