IRS cracking down on government settlements: taxpayers who are charged with violating federal law routinely pay millions of dollars in settlement payments to the government. This article discusses the controversy surrounding the tax treatment of settlement payments, relevant case low on the subject, and the latest IRS directive to its employees on how to deal with settlement payments.

• Author: Wood, Robert W.

EXECUTIVE SUMMARY

* The IRS's Large and Mid-Sized Business Division has issued an Industry Director Directive to its employees on the deductibility of settlement payments made under a settlement with the Department of Justice for violations of the Fair Claims Act and the Environmental Protection Agency for supplemental or beneficial environmental projects.

* If a settlement payment is a fine or penalty paid to a government, it is not deductible; flit is compensation paid to the government for the damage done by the payor, it may be a deductible business expense.

* In cases where a settlement agreement is not clear about whether a payment is a nondeductible fine or penalty or a deductible compensatory payment, a court will look to the intent of the parties as expressed outside of the agreement to determine the purpose of the payment.

* A payment that is not made to a government (and thus not a fine or penalty under the express wording of Sec. 162(f)) may still be treated as such by a court flit is in substance a fine or penalty.

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The IRS issues a wide array of guidance. There are various types of regulations (final, proposed, and temporary), revenue rulings, private letter rulings, field service advice, notices, actions on decision, technical advice memoranda, audit guidelines, and so on. All of these pieces of guidance are not of equal weight, of course, and some are, technically speaking, not even treated as authority

In a world of growing information accessibility, practitioners may become overwhelmed and may not carefully review every regulation release, piece of proposed legislation, and unofficial guidance. The sheer volume of material to read has a chilling effect on what many do read. Becoming a selective reader may be a modern survival skill, but with the increasing size and number of settlement payments made to the government, it would be wise to read all the information on the high-stakes topic of government settlement deductibility.

Industry Director Directive Release

On May 30, 2007, the IRS released an Industry Director Directive (IDD) on the tax deductibility of government settlements. The directive comes from the Service's Large and Mid-Sized Business Division (LMSB) and is labeled "Directive Number One" presumably indicating that there may be others. (1) It is formatted as a memorandum from "John Risacher, Industry Director, Retailers, Food, Pharmaceuticals and Healthcare" to "Industry Directors, Director, Field Specialists, Pre-filing and Technical Guidance, Director, International Compliance Strategy and Policy, and Director of Examination, SBSE."

The IDD provides field direction on the deductibility of settlements with a government agency. There is a dichotomy between a deductible business expense on the one hand and a nondeductible fine or penalty on the other (Sec. 162(f)). The memo's background notes that settlements are enforcement tools used by government agencies to resolve violations of law and to punish companies, short of going to court. According to the IRS, a settlement payment can include compensatory amounts, punitive payments, or a combination of the two. (2)

The specific types of settlements addressed include settlements with the Department of Justice (DoJ) under the False Claims Act (FCA) and with the Environmental Protection Agency (EPA) for supplemental or beneficial environmental projects. (3) But the IDD's preamble states that outside the context of DoJ and EPA settlements, its principles can apply to any settlement between a government entity and a defendant under any law in which a penalty can be assessed. The statement that this penalty can be assessed, not that it actually will be assessed or that it has been assessed, is significant.

Boeing Case

The IDD also reveals that the government settles cases without regard to the tax consequences of a payment. That hardly seems a revelation, given, for example, the furor that developed over a 2006 Boeing settlement and its tax benefits. In mid-2006, Boeing settled the largest "penalty" ever imposed on a military contractor for weapons program improprieties. (4) As final details of the $615 million settlement were hammered out, tax issues took center stage. In July 2006, Senators Chuck Grassley (R.-IA), John McCain (R-AZ), and John Warner (R-VA) sent a letter to Attorney General Alberto Gonzales expressing outrage at the possibility that Boeing could deduct the $615 million. Allowing the Boeing settlement to be tax deductible, the senators said, would result in "leaving the American taxpayer to effectively subsidize its misconduct." (5)

The three senators made it clear that they were shocked that Boeing could legitimately whittle down the net after-tax "penalty" with a deduction that is effectively at taxpayers' expense. McCain and Grassley had raised similar concerns in 2003 about a $1.4 billion settlement with several Wall Street firms involved in allegedly biased reports by their research departments. Some of that settlement was deductible. Indeed, $432.5 million of it went to finance independent research, and $80 million was to finance investor education programs. (6)

A GAO study released in 2005 found that four large federal agencies (including the DoJ) do not negotiate with companies over whether settlement payments are tax deductible. Instead, the GAO says the agencies believed that was the IRS's job. (7)

On July 18, 2006, Senator Grassley questioned Gonzales:

I am very troubled that ... DoJ was completely blind as to the real amount of the penalty, that is, the after-tax amount. To have a situation where the federal government is negotiating a settlement without understanding what the real settlement amount will be, the after-tax amount, is embarrassing.... I can assure you that the lawyers on the other side of the table ... are very aware of the after-tax amount.... It means millions of dollars to their client.... It is actually worse that DoJ doesn't even know what the tax treatment is of the Boeing settlement. It tells me that DoJ lawyers gave away 35 percent of the store without even knowing it. (8)

The DoJ formally responded to Grassley, saying that the Boeing settlement had been fully signed on June 30, 2006, before Grassley's complaint was made. It also noted that as a matter of policy, its agreements are "tax neutral," leaving the difficult...