Effective January 14, 2021, the Internal Revenue Service (“IRS”) implemented a final rule (the “Final Rule”) concerning the tax deductibility of settlement payments made to the government. This rulemaking followed a legislative update to the Internal Revenue Code of 1986 (“IRC”), which was implemented as part of the 2017 federal tax overhaul and specifically included a prohibition against deducting certain settlement payments. Relative to the IRS proposed regulations released in May 2020 (the “Proposed Rule”), and as further detailed below, aspects of the Final Rule favor taxpayers, relaxing certain restrictions contemplated under the Proposed Rule. Those making payments in connection with litigation or governmental investigations, including False Claims Act (“FCA”) investigations by the Department of Justice (“DOJ”), should consider the Final Rule’s impact on their approach to documenting a settlement or related payment.
The Tax Cuts and Jobs Act of 2017 (“TCJA”) modified the rules governing the deductibility of certain government settlement-related expenses under IRC Section 162(f). As amended, Section 162(f) prohibits deductibility for “any amount paid . . . to, or at the direction of, a government or governmental entity in relation to: (1) the violation of any law or (2) the investigation or inquiry by such government or entity into the potential violation of any law.”
The TCJA-amended Section 162(f) includes a related exception, however, allowing tax deductions for “amounts constituting restitution or paid to come into compliance with law.” To qualify for this exception, an order or settlement agreement must identify as restitution, remediation, or amounts paid or incurred to come into compliance with a law (see “identification requirement” described below), and the taxpayer must establish that the amounts were paid or incurred as restitution or to come into compliance with a law (see “establishment requirement” described below). If the applicable governmental entity agrees to include exception language associated with this exception under an order or settlement agreement, that governmental entity must also contemporaneously file an IRS form required under the TCJA-created IRC Section 6050X.
On May 13, 2020, the IRS published a notice of proposed rulemaking detailing guidance under the Section 162(f) deduction disallowance rules and associated Section 6050X reporting requirements. The Final Rule followed on January 14, 2021, lending additional regulatory clarity and loosening certain restrictive provisions that were proposed in May 2020, as further described below. The Final Rule confirms that the TCJA amended Section 162(f) does not apply to any order or settlement agreement issued or entered into before December 22, 2017.
The Final Rule’s deduction prohibition remains largely unchanged from the Proposed Rule, confirming that a taxpayer may not take a deduction for amounts: (1) paid or incurred by suit, agreement, or otherwise; (2) to, or at the direction of, a government or governmental entity; and (3) in relation to the violation, or investigation or inquiry by such government or governmental entity into the potential violation, of any civil or criminal law. The Final Regulations rejected commenter requests to exclude certain administrative proceedings from the definition of “suit, agreement, or otherwise,” confirming that this language is intended to apply both to formal legal proceedings and other, less formal proceedings. Specifically, the final regulations confirm that the Section 162(f) deduction disallowance rule applies to the following, without limitation:
- settlement agreements;
- non-prosecution agreements;
- deferred prosecution agreements;
- judicial proceedings;
- administrative adjudications;
- decisions issued by officials, committees, commissions, or boards of a government or governmental entity; and
- any legal actions or hearings in which a liability for the taxpayer is determined or pursuant to which the taxpayer assumes liability.
Exception Clarification and Guidance
As confirmed under the Final Rule, the Section 162(f) exception to the disallowance prohibition requires applicable amounts to be identified in the order or agreement as paid or incurred for restitution or remediation, or to come into compliance with a law. Key components of this exception, particularly to the extent they deviate from the Proposed Rule, are detailed below:
The Final Rule clarified Section 162(f)’s “identification requirement,” which mandates that a qualifying, tax deductible payment must be specifically identified in its applicable order or agreement as restitution, remediation, or amount paid to come into compliance with law. The IRS clarified that it is the order or agreement, and not the taxpayer, that must meet this identification requirement.
According to the Final Rule, this identification requirement will be met even if the order or agreement uses a different form of the key terminology mentioned above (i.e., “restitution, remediation, or amount paid to come into compliance with law”), including alternative language such as ‘‘remediate’’ or ‘‘comply with a law.’’ Similarly, even if those key terms are not used in any form, an order or agreement will meet the identification requirement if “the nature and purpose of the payment, as described in the order or agreement, are clearly and unambiguously to restore the injured party or property or to correct the non-compliance.”
The Final Rule also acknowledges that the precise payment amount relating to “restitution, remediation, or coming into compliance with the law” may be unknown on the date of the settlement agreement or order, particularly in instances where only a lump sum payment is specified or if a payment is divided among multiple taxpayers. The Final Rule clarifies how a taxpayer may meet the identification requirement in these circumstances and also confirms that the identification requirement may be met even if the order or agreement does not provide an estimated payment amount. Particularly in the latter circumstance, the agreement or order must contain language specifically stating that the forthcoming amount, once established, will be paid or incurred in accordance with the Section 162(f) exception requirements.
The TCJA-amended IRC Section 162(f) also requires that a taxpayer establish, with appropriate records and documentation, that a tax deductible amount was actually paid or incurred for the nature and purpose identified above. The final regulations clarify that this “establishment requirement” is met if the documentary evidence submitted by the taxpayer proves: (1) that the taxpayer was legally obligated to pay the amount identified in the order or agreement as restitution, remediation, or to come into compliance with a law, (2) the amount actually paid, and (3) the date on which the amount was paid. The Final Rule expanded upon the Proposed Rule’s non-exhaustive list of documents that can be used to fulfill this establishment requirement, including the following:
- the violated or potentially violated legal or regulatory provision;
- government documents relating to the investigation or inquiry;
- documents describing how the payable amount was determined; and
- correspondence between the taxpayer and government.
According to the Final Rule, in the case of a lump sum payment or multiple damage award that includes a combination of restitution, remediation, and coming into compliance with the law, the taxpayer must establish the exact amount paid or incurred for each purpose to meet the establishment requirement. Similarly, if an order or agreement involves multiple taxpayers, each taxpayer must establish the amount it paid or incurred as restitution, remediation, or to come into compliance with the law, each as required under Section 162(f).
Disgorgement and Forfeiture
Under the Proposed Rule, the Section 162(f) deduction exception did not apply to payments for “forfeiture or disgorgement” (the latter being an equitable remedy involving the return of ill-gotten gains), meaning that any amount paid or incurred as forfeiture or disgorgement would have been unequivocally disallowed. The IRS changed its course in the Final Rule, however, implementing a circumstantial, fact-based test to determine deductibility for forfeiture and disgorgement payments, looking to whether each of the following is true: (1) the amount is otherwise deductible under IRC, (2) the identification rule is met, (3) the establishment rule is met, and (4) the amount is not disbursed to the general account of the governmental entity for general enforcement purposes.
Qui Tam Cases
The Final Rule clarifies that the deduction disallowance rule does not apply to any amount paid in connection with an order or agreement for a suit in which no governmental entity is a party. Citing a commenter concern regarding qui tam cases brought by private citizens on behalf of a governmental entity, the Final Rule confirms the absence of any “single rule” that determines the treatment of such cases. The final regulations do note, however, that the governmental entity is the real party in interest in qui tam cases, and Section 162(f) likely applies to any amount paid, including any share ultimately paid by the governmental entity to the relator, whether or not the governmental entity intervenes in the suit. Therefore, any amount paid or incurred to a governmental entity as a result of the suit will likely be disallowed unless a Section 162(f) exception applies.
Government Reporting under Section 6050X.
The Final Rule also interprets IRC Section 6050X, which provides appropriate officials of government entities the operational, administrative, and definitional rules for complying with the statutory information reporting requirements for suits or agreements to which that section applies. In general, under the final regulations, if the aggregate amount a payor is required to pay pursuant to an order or agreement for a violation, investigation, or inquiry to which Section 6050X applies equals or exceeds the $50,000 regulatory threshold amount, the appropriate official of a governmental entity that is a party to the order or agreement must file an information return with the IRS regarding certain amounts paid or incurred pursuant to the order or agreement, the payor’s taxpayer identification number, and other IRS required information.
Taxpayers making governmental related settlement payments, including those in connection DOJ FCA investigations, should consult the Final Rule and determine how it might impact their approach to documenting potentially deductible payments and maintaining associated records. Specifically, a taxpayer should ensure that its settlement agreement specifically identifies amounts that are paid as “restitution or remediation, or to come into compliance with law,” and thereafter, taxpayers should maintain sufficient records and documentation to be able to establish that the amounts were paid for that identified, qualifying purpose.