Vol. 76, No. 3, March 2003

Tax Deductions for Settlements
with Government Agencies

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 law."

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 section 162(f)."

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. Commissioner.⁴

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 its deductibility.

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 settlement.

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 this issue.

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 crimes."⁸

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 unambiguous."¹¹

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.

Frazer Schapiro 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 sections.

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 to Raytheon.

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 'all-inclusive.'"¹⁶

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 exchanges.

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 section 162(f)."

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 punch.

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

Conclusion

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.

Endnotes

¹McKinnon, 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. § 1125(c).

⁴68 T.C.M. (CCH) 1412 (1994).

⁵116 F.3d 382 (9th Cir. 1997).

⁶95-1 U.S.T.C. (CCH) ¶50,151 (3d Cir. 1995).

⁷Id. at p. 87,540.

⁸Id. at p. 87,541.

⁹Id. at p. 87,542.

¹⁰Id. at p. 87,543.

¹¹Id.

¹²880 F.2d 1311 (Fed. Cir. 1989).

¹³See 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.

¹⁴Raby, supra note 2, at 114.

¹⁵905 F.2d 667 (2d Cir. 1990).

¹⁶Id. 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).

¹⁷Sacks v. 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).

¹⁹26 U.S.C. § 6672 (1986).

²⁰Elliott v. Commissioner, 73 T.C.M. (CCH) 3197 (1997).

²¹Presumably, 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).

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