Settlement agreement determines fine's or penalty's deductibility.

• Author: Hahn, Kristin

IRS Letter Ruling (TAM) 200502041 held that a portion of a lump-sum payment made to settle claims arising under the False Claims Act (FCA) was a nondeductible fine or similar penalty within the meaning of Sec. 162 (f). The Service's analysis in reaching this conclusion reaffirms the importance of (1) including language in a settlement agreement as to the tax characterization of the payment and (2) providing supporting documentation.

Facts

In the TAM, the taxpayer owned and operated numerous businesses that performed a wide range of tests for the U.S. government. Based on suspicions of unauthorized and inappropriate billing, the government began investigating the taxpayer under the FCA. The parties began settlement discussions to determine the government's estimated actual damages; they also discussed trebling actual damages under the FCA.

They eventually entered into a settlement agreement under which the taxpayer agreed to pay a lump sum in exchange for the government's release of all present and future liability for the conduct underlying the investigation. However, the agreement was silent as to (1) the purpose or tax characterization of the payment and (2) the portion (if any) that represented treble damages.

The taxpayer deducted the settlement payment under Sec. 162(a) as an ordinary and necessary business expense. The IRS took the position that a portion of the settlement payment represented punitive treble damages and, thus, was a nondeductible fine or similar penalty under Sec. 162(t:).

IRS's Analysis

Sec. 162(f) disallows a deduction for any "fine or similar penalty paid to a government for the violation of any law." Regs. Sec. 1.162-21(b) defines "a fine or other similar penalty" to include "any amount ... paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal)"; it also states that compensatory damages do not constitute a fine or similar penalty. It is well established that the purpose behind a fine or penalty must be analyzed to determine whether it is punitive or compensatory in nature. Punitive fines and similar penalties fall under Sec. 162(f); compensatory damages are deductible under Sec. 162(a).

Look to settlement agreement: TAM 200502041 cited Middle Atlantic Distributors, 72 TC 1136 (1979), in stating that a settlement agreement's language is the most important factor in determining a lump-sum payment's purpose. However, the settlement agreement at issue was silent on...