Internal Revenue Code s. 162(f) and Its Implication on Settlement Agreements Occurring After the Tax Cuts and Jobs Act.

• Author: Bousquet, Brittany

"While the new law may appear to be a sword, taxpayers may be able to use it as a shield and push the government to engage meaningfully on the character of any payments being made." (1)

1. INTRODUCTION

   Investigations into potential violations of domestic and foreign laws are often resolved by settlement agreements, which require businesses to make payments to governmental entities such as the U.S. Department of Justice (DOJ), the U.S. Securities and Exchange Commission (SEC), and the U.S. Environmental Protection Agency. (2) One important issue that arises during settlement negotiations is whether the business's settlement payment will be tax deductible. (3) A taxpayer is allowed to deduct "ordinary and necessary" trade or business expenses when calculating taxable income under Internal Revenue Code (IRC) [section] 162(a). (4) Since 1969, however, the Internal Revenue Service (IRS) has prohibited deductions for "any fine or similar penalty paid to a government for the violation of any law" under [section] 162(f). (5)

   Yet despite the language prohibiting deduction of fines or penalties, businesses frequently negotiate settlement agreements with government entities that explicitly state the amount paid is tax deductible. (6) For example, out of the $42 billion that British Petroleum Company PLC (BP) paid due to the 2010 Deepwater Horizon rig explosion, at least 80% qualified for a tax deduction, saving BP an estimated $10 billion to $14 billion. (7) Similarly, many of the banks that contributed to the 2008 financial crisis were able to deduct portions of their multibillion-dollar settlements. (8)

   The reason behind this lies in what was formerly a tax code "gray area." (9) While [section] 162(f) prior to the Tax Cuts and Jobs Act (TCJA) prohibited the deduction of fines or penalties, Treasury Regulation [section] 1.162-21 has always stated compensatory damages are not considered a fine or penalty, and are thus deductible business expenditures under [section] 162(a). (10) Treasury Regulation [section] 1.162-21(b)(2) also states legal fees are deductible. (11) Because Treasury Regulation [section] 1.162-21 is clear that the nondeductible fines or penalties category does not include compensatory damages paid to a government or governmental entity, settling parties often categorize settlement payments as "compensatory" rather than as fines or penalties. (12) As a result, businesses are often able to deduct large portions of a settlement agreement as ordinary and necessary business expenses under [section] 162(a). (13)

   Section 162(f) underwent substantial revisions as part of the U.S. tax reform law, the TCJA, which was enacted in December 2017. (14) The revised law applies to settlement agreements and court orders finalized on or after December 22, 2017. (15) Under the revised law, no deduction is allowed for "any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law." (16) The revised law shifts the relevant test away from whether a settlement payment constitutes a fine or penalty. (17) Instead, any payment to the government relating to a violation or an investigation into a potential violation is strictly not deductible unless one of three exceptions applies. (18) The first exception is for amounts paid pursuant to a court order in a private lawsuit. (19) The second exception covers amounts paid as taxes due. (20) The third exception relates to amounts the taxpayer establishes as restitution or an amount paid to come into compliance with the law. (21)

   This Recent Development focuses on the third exception, which allows the taxpayer to deduct payments that constitute either restitution or an amount paid to come into compliance with the law. (22) This Recent Development examines [section] 162(f) and its implication on settlement agreements occurring after the TCJA. (23) Part II discusses the history of [section] 162(f) and the impact of enacting the TCJA on the law. (24) Then, Part III examines the impact of the revised law on the deductibility of government settlement payments. (25) Specifically, this Recent Development discusses how the law expands the scope of the prohibition on deductions by explicitly outlining what businesses can and cannot deduct, while still leaving room for companies to write off restitution payments. (26) Finally, Part IV reiterates the argument that the revised law serves a valid purpose because it will mitigate postsettlement conflict between taxpayers and the IRS, eliminate vagueness, facilitate more efficient tax administration, and potentially promote greater transparency. (27) Additionally, the revised law will likely incentivize corporations to agree to a larger overall settlement as long as a substantial portion of the settlement is classified as restitution or a payment made to come into compliance with the law. (28) This Recent Development ultimately concludes the revised law is a win-win situation for all parties because the injured party will receive a higher settlement payment, while the business will be permitted to deduct the portion allocated to restitution. (29)

2. HISTORY OF PRE-TAX REFORM [section] 162(F)

   The federal income tax laws are intended to tax only the taxpayer's earnings and profits, minus any expenses and losses, carrying out Congress's broad policy of taxing only net income. (30) Due to this intent, [section] 162(a) allows a taxpayer to deduct "ordinary and necessary" expenses paid or incurred during the taxable year in carrying on a trade or business. (31) This allows a taxpayer to take deductions for ordinary day-to-day costs of running a business, such as rent and salaries, ensuring only a business's net income is taxed. (32)

   There are limits, however, to what a business may deduct. (33) Deductions are a matter of legislative grace and not every business expense may be deducted. (34) Early on, the judiciary created exceptions to [section] 162(a), such as disallowing deductions for fines, bribes, penalties, kickbacks, and other immoral payments. (35) The courts disallowed these deductions to avoid frustrating public policy. (36) This exception became known as the public policy doctrine, and the lower courts frequently used this doctrine to deny deductions for claimed business expenses. (37)

   In a series of cases, the Supreme Court developed the public policy doctrine by disallowing deductions that frustrate state or federal public policy. (38) The landmark decision outlining the public policy doctrine is Tank Truck Rentals, Inc. v. Commissioner. (39) In Tank Trunk Rentals, a trucking company deducted numerous fines imposed on the corporation for violations of state maximum weight laws. (40) The Supreme Court affirmed the appeals court's decision, holding deducting fines and penalties frustrates state policy in a "severe and direct fashion by reducing the 'sting' of the penalty prescribed by the state legislature." (41)

   In Hoover Motor Express Co. v. United States, (42) the Court again used the public policy doctrine to disallow a deduction for fines and penalties. (43) The Court affirmed the appeals court's decision, which held allowing a violator to gain a tax advantage by deducting the penalty as a business expense weakens the punishment and undermines the public policy's purpose and effectiveness. (44) Additionally, the Court noted paying fines is not "necessary" to operating a business, and thus cannot be deducted as an "ordinary and necessary" business expense. (45)

   While the Supreme Court has held that certain business expenses, such as fines and penalties, cannot be deducted for public policy reasons, the Court has also held that the public policy doctrine is not limitless. (46) In Commissioner v. Tellier, (47) the taxpayer was a securities dealer charged with violating the Securities Act of 1933 and the mail fraud statute. (48) On his federal income tax return, the taxpayer deducted the $22,964.20 in legal expenses incurred during his criminal prosecution. (49) Although the Commissioner conceded that the taxpayer's legal expenses were "ordinary and necessary" expenses, the IRS disallowed the deduction on public policy grounds, and the Tax Court affirmed this decision. (50) The Second Circuit unanimously reversed the decision, and the Supreme Court affirmed. (51) In its opinion, the Court held that to establish a public policy disallowance, there must be a government declaration of a policy, and an immediate frustration of that policy would result if the tax deduction is allowed. (52) The Court articulated this case fell outside those sharply defined categories and stated that "[n]o public policy is offended when a man faced with serious criminal charges employs a lawyer to help in his defense. That is not 'proscribed conduct.' It is his constitutional right." (53) Thus, the Court held that legal fees paid in defense against criminal charges stemming from business dealings may be deducted under [section] 162(a) as ordinary and necessary business expenses. (54)

   In a series of cases, the Supreme Court continued to articulate the limits of the public policy doctrine. (55) In Lilly v. Commissioner, an optical business paid kickbacks to doctors in exchange for referrals. (56) The Court held that these payments were deductible because there were no governmental declarations that the payments violated public policy at the time the payments were made. (57) In Commissioner v. Sullivan, the Court held that the ordinary expenses of operating a business are deductible, even if the business is illegal or immoral. (58) Further, in Commissioner v. Heininger, the Court held that "the mere fact that an expenditure bears a remote relation to an illegal act" is insufficient to make it nondeductible. (59)

   Together, these cases stand for the...