Deepwater Horizon and Sec. 162.

• Author: Pratt, Jenifer

On April 20, 2010, the explosion and subsequent sinking of the Deepwater Horizon drilling rig in the Gulf of Mexico commenced the largest U.S. oceanic oil spill in history. The immense amount of cleanup and related expenses incurred by the oil company BP are expected to total in the billions.

The Congressional Research Service (CRS) recently published a report titled "Tax Deductible Expenses: The BP Case" (August 11, 2010), which concluded that BP will be able to reduce its tax liability by $10 billion, the "result of standard business expense deductions and the general ability of taxpayers to claim refunds for previously paid taxes when realizing a net operating loss (NOL) or carrying the loss forward to offset future tax liabilities." Under current law, this amount is the estimated tax benefit from oil-spill-related expenses of approximately $32 billion.

Fines and penalties paid to governmental entities have long been nondeductible (Sec. 162(f)). "Involuntary" payments, including putative donations, to restore a region to pre-catastrophe levels and rehabilitating image are also nondeductible (Allied-Signal Inc., 54 F. 3d 767 (3d Cir. 1995), aff'g T.C. Memo. 1992-204). In Allied-Signal, the Third Circuit, affirming the Tax Court, reasoned that a voluntary payment must be one that is made without the expectation of a quid pro quo from the government entity. Furthermore, amounts paid because of conviction or a plea of guilty or nolo contendere for a crime, whether felony or misdemeanor, in a criminal proceeding are nondeductible, as arc civil penalties and settlements of actual or potential liabilities for a civil or criminal fine or penalty (Regs. Sec. 1.162-21(b)(1)).

Legal fees, court costs, and related expenses incurred in the defense of a prosecution or civil action are deductible if they are business related, ordinary, and necessary (Sec. 162(a); Regs. Sec. 1.162-21(b)(2)). This applies even in the event of an unsuccessful defense against criminal prosecution (Tellier, 383 U.S. 687 (1966)). In addition, compensatory damages (including remedial damages and damages under Section 4A of the Clayton Act (15 U.S.C. [section]15a), as amended) paid to a government do not constitute a nondeductible fine or a penalty (Regs. Sec. 1.162-21(b)(2)).

Less clear is the deductibility of expenses incurred in an industry fraught with inherent risk. Are these risks reasonable, ordinary, and necessary? According to BP's second-quarter 2010 report, released...