On May 12, 2020, the IRS released proposed regulations providing guidance on Section 162(f), as modified in 2017 by the legislation known as the Tax Cuts and Jobs Act (“TCJA”), which governs business tax deductions for costs commonly associated with a government investigation or enforcement action. The proposed regulations also address Section 6050X, which imposes related reporting obligations on certain governmental authorities. Taxpayers and governmental authorities have been awaiting this guidance.
If adopted as final regulations, these regulations would provide many welcome provisions for those governmental authorities and needed guidance for taxpayers in negotiating and drafting settlement agreements. These regulations would also likely increase the time and costs in entering into such settlements and highlight the importance of tracking and substantiating restoration and compliance costs.
Prior to the TCJA, Section 162(f) provided that fines and penalties paid in connection with a violation of law were non-deductible for federal income tax purposes. Taxpayers could thus still deduct payments made as compensatory damages, including single damages or remediation costs.
The TCJA’s modifications generally prohibit taxpayers from deducting any amounts paid or incurred to, or at the direction of, a government, governmental entity, or certain nongovernmental entities in response to a violation of law or potential violation of law. There are two exceptions:
Restitution or remediation payments for damage or harm that may have been caused by the violation of or potential violation of law (the “Restitution Exception”); or
Payments to come into compliance with any law that was violated (the “Compliance Exception”).
For either exception to apply, the relevant court order or settlement agreement must identify the amounts qualifying for the Restitution Exception or the Compliance Exception (the “Identification Requirement”).
Section 6050X requires governmental entities involved in the settlement to report such amounts to the IRS and provide written information statements to the payors (the “Reporting Requirement”).
The Reporting Requirement in effect binds the taxpayer and the governmental entity to a single position with respect to the nature and purpose of the various payments made pursuant to a settlement agreement or order.
Proposed Regulations Under Section 162(f)
The proposed regulations provide key clarifying guidance :
Amounts Not Included in the Restitution Exception or Compliance Exception:
Amounts paid in lieu of a fine or penalty or as forfeiture or disgorgement.
Amounts paid or incurred to a payee to the extent such payee was not harmed by the taxpayer’s violation or potential violation of a law.
Amounts paid or incurred as reimbursement to the government or governmental entity for investigation costs or litigation costs from restitution or remediation (but excluding amounts for audits, inspections, or reviews conducted in the ordinary course of business if the payment is not related to the violation of a law or the investigation or inquiry into the potential violation of a law).
Identification Requirement: An order or agreement will satisfy the Identification Requirement if it specifically states that the payment, and the amount of the payment, constitutes restitution, remediation, or an amount paid to come into compliance with a law. For orders or agreements that require a taxpayer to provide services or property or undertake a specific action, the Identification Requirement may be met by describing the damage done, harm suffered, or manner of noncompliance with a law, and describing the action required of the taxpayer (such as incurring costs to provide services or to provide property). The IRS is not bound by these characterizations.
Establishment Requirement: A taxpayer must provide documentary evidence, separate from the Identification Requirement, that such amount qualifies for the Restitution Exception or Compliance Exception (the “Establishment Requirement”) by showing, among other things, that the taxpayer was legally obligated to pay the amount at issue. The proposed regulations provide a non-exhaustive list of documents that taxpayers may use to satisfy this requirement, but expressly excludes relying solely on the report made by the government or a governmental entity pursuant to Section 6050X, discussed below.
Private Party Suits: Section 162(f) does not apply to any amount paid or incurred by reasons of any order or agreement in a suit in which no government or governmental entity is a party.
Taxes: Section 162(f) does not apply to amounts paid or incurred for otherwise deductible taxes (e.g., state and local tax payments or excise or employment taxes).
Tax Benefit: If an allowed deduction results in a tax benefit to the taxpayer, the taxpayer must include in income the recovery of any amount deducted in a prior taxable year to the extent the prior year’s deduction reduced the taxpayer’s tax liability.
Material Change: If there is a material change to the terms of an order or agreement after the proposed regulations are finalized, then the proposed regulations will apply to any amounts paid or obligations to provide property or services after the date of the material change.
Proposed Applicability Date: A taxpayer may rely on the proposed regulations prior to finalization only if the taxpayer applies the rules in their entirety and consistently.
Proposed Regulations Under Section 6050X
The proposed regulations under Section 6050X reduce the administrative burden on government or governmental entities that are subject to the Reporting Requirement by, among other things, setting a reporting threshold of $50,000 (instead of the $600 in Section 6050X) for specified or expected payments, establishing a reporting deadline of January 31 of the year following the year of payment, and imposing the Reporting Requirement only beginning after 2021.
Impact of New Guidance on Settlement Negotiations
Section 162(f) increases the costs of settlement, a trend that the proposed regulations likely do not change. Section 162(f) now applies to a broader universe of settlements and payments than before the TCJA, covering not just fines and penalties paid to the government, but any payments paid to, or at the direction of, the government or governmental entities. Additionally, the modified Section 162(f) applies not just to resolution of actual violations, but resolution of potential violations as well. As a result, disclaiming liability in a settlement cannot be presumed to preserve the deductibility of the payment.
The proposed regulations require taxpayers to be extremely mindful of the Identification Requirement and to seek to structure the agreements so as to maximize, if possible, the amounts paid as “restitution,” “remediation,” or “coming into compliance with the law.” Despite these efforts, however, there will be varying degrees of flexibility to do so depending on the nature of the allegations being resolved and the actual facts at issue.
At the same time, the Identification Requirement could hamper or slow settlement negotiations by forcing the parties to consider the tax implications of the terms of the settlement. Not all settlement agreements or court orders clearly delineate fines, penalties, restitution, remediation, or forfeiture, and many are silent on the tax implications. This silence has permitted taxpayers certain flexibility in how they report the implications of the settlement, depending on the applicable facts. Now, for the taxpayer to be able to deduct the permissible amounts, the parties must clearly negotiate and identify in the settlement agreement the specific amounts of restitution, remediation, or compliance costs.
The proposed regulations recognize that specific costs may not be ascertainable at the time of settlement but that the Identification Requirement can still be satisfied. In these instances, the language of the settlement agreement will be of paramount importance as well as the evidentiary support once the remedial or compliance action is taken.
The Establishment Requirement highlights how critical it is for taxpayers to track and clearly document the efforts spent on restitution, remediation, and coming into compliance with the law, along with correspondence to the government agencies discussing the tax characteristics of the settlement amounts.
ABOUT BAKER BOTTS L.L.P.
Baker Botts is an international law firm of approximately 750 lawyers practicing throughout a network of 14 offices around the globe. Based on our experience and knowledge of our clients' industries, we are recognized as a leading firm in the energy and technology sectors. Since 1840, we have provided creative and effective legal solutions for our clients while demonstrating an unrelenting commitment to excellence. For more information, please visit bakerbotts.com.