Prior to enactment of the new tax act (commonly known as the “Tax Cuts and Jobs Act” or “TCJA”), no deduction was permitted for fines or penalties paid to the government. Great care was taken to limit those amounts when entering into settlement agreements with government agencies regarding violation or potential violation of laws. Amounts paid to third parties or to reimburse for investigation costs were subject to the general business deduction rules. When engaging in negotiations, agencies generally avoid tax considerations and tend not to express much concern about, or have specific policies against, the characterization of agreed payments.
TCJA changes the rules in dramatic fashion (new IRC sec. 162(f). Deductions are now disallowed for any amounts paid or incurred (whether by suit, agreement or otherwise) to, or at the direction of, a governmental entity in relation to violation of any law, or the investigation or inquiry by such governmental entity into the potential violation of any law. Thus, even payments to third parties could be nondeductible despite previously qualifying as a business expense. Deductions are permitted, however, for amounts that (a) constitute “restitution (including remediation of property)” for damage or harm caused by the violation or potential violation of any law or (b) are paid to come into compliance with the law that was violated or involved in the investigation or inquiry. To qualify for deduction, the restitution, remediation or compliance amounts must be specifically identified as such in a court order or settlement agreement [note that identification alone does not establish qualification]. Amounts for reimbursement of costs of investigation are not included as restitution. Similarly punitive damages, treble damages, penalties and the like remain nondeductible, however characterized. In addition, certain non-governmental regulatory entities (those that exercise self-regulatory powers, including imposing sanctions, like boards, exchanges or others that perform essential government functions) are treated as governmental entities for purposes of applying this new tax provision. Finally (and importantly), to qualify for deduction, an appropriate official of any government involved in the suit or agreement must file an information return with the IRS (and the taxpayer) at the time the agreement is entered into, stating the total amount paid as a result of the suit or agreement and the amount that constitutes restitution or compliance costs (new IRC sec. 6050X).
The new provisions apply to amounts paid or incurred after December 22, 2017 (the date of enactment of TCJA), except for amounts paid or incurred under a binding order or agreement entered into prior to that date. Rules regarding how and who is responsible for filing the required information returns are on a list of IRS projects that are on a “fast track.” However, it is unlikely IRS will issue those rules before summer.
So, for any ongoing investigations or other governmental inquiries regarding violation or potential violation of any law, careful consideration to the tax consequences of judgment or settlement payments is required. The old rules no longer apply and greater care is needed to qualify for tax deductions. For example, unlike past practice when many governmental agencies would not agree or failed to agree on the characterization of settlement payments, the new provisions require the governmental agency entering into a settlement agreement to agree with the taxpayer on the characterization of amounts payable and report accordingly and timely to the IRS. Failure to do so will disallow any deduction to the taxpayer even if otherwise qualifying as restitution, remediation or compliance costs. It is likely that most government agencies are not yet familiar with (aware of?) the new rules and that could affect negotiations.
Please ask any of us in the Tax Group if you have questions about these new provisions and their potential effects. Like so many other provisions of TCJA, much remains to learn and determine about the changes effected by these new governmental payment rules. Of course, if you have questions about other aspects of TCJA, please let any of us know.