On January 12, 2021, the IRS released final regulations providing guidance on Section 162(f), as modified in 2017 by the legislation known as the Tax Cuts and Jobs Act (“TCJA”), which governs business tax deductions for costs commonly associated with a government investigation or enforcement action. The final regulations also address Section 6050X, which imposes related reporting obligations on certain governmental authorities. In May 2020, the IRS released proposed regulations on Sections 162(f) and 6050X, which we discussed here.

The final regulations include several taxpayer-friendly changes from the proposed regulations in addition to finalizing many welcome provisions for governmental authorities and needed guidance for taxpayers in negotiating and drafting settlement agreements. The final regulations also likely increase the time and costs in entering into such settlements and highlight the importance of tracking and substantiating restoration and compliance costs.

 

Background

Prior to the TCJA, Section 162(f) provided that fines and penalties paid in connection with a violation of law were non-deductible for federal income tax purposes. Taxpayers could thus still deduct payments made as compensatory damages, including single damages or remediation costs.

The TCJA’s modifications generally prohibit taxpayers from deducting any amounts paid or incurred to, or at the direction of, a government, governmental entity, or certain nongovernmental entities in response to a violation of law or potential violation of law. There are two exceptions:

1. Restitution or remediation payments for damage or harm that may have been caused by the violation of or potential violation of law (the “Restitution Exception”); or
   
   
2. Payments to come into compliance with any law that was violated (the “Compliance Exception”).

For either exception to apply, the relevant court order or settlement agreement must identify the amounts qualifying for the Restitution Exception or the Compliance Exception (the “Identification Requirement”).

Section 6050X requires governmental entities involved in the settlement to report such amounts to the IRS and provide written information statements to the payors (the “Reporting Requirement”).

The Reporting Requirement in effect binds the taxpayer and the governmental entity to a single position with respect to the nature and purpose of the various payments made pursuant to a settlement agreement or order.

 

Final Regulations Under Section 162(f)

The final regulations adopt most of the proposed regulations, retaining the same basic structure as the proposed regulations, but make a number of generally taxpayer-friendly revisions and additions in response to comments the IRS received.

• Restitution Exception and Compliance Exception
  
  
  • In contrast to the proposed regulations, the final regulations do not treat disgorgement of net profits or forfeiture as per se nondeductible but rather provide requirements that, if met, will allow a deduction for such amounts.
    
    
  • The final regulations remove the proposed regulations’ per se exclusion that amounts paid or incurred to a payee to the extent such payee was not harmed by the taxpayer’s violation or potential violation of a law are nondeductible. The final regulations clarify, however, that amounts paid to a general account or treasury of the government entity for general enforcement or other discretionary purposes are not deductible.
    
    
  • The final regulations, like the proposed regulations, retain the rule that amounts paid or incurred as reimbursement to the government or governmental entity for investigation costs or litigation costs related to the violation of any law are not deductible (excluding amounts for audits, inspections, or reviews conducted in the ordinary course of business if the payment is not related to the violation of a law or the investigation or inquiry into the potential violation of a law).
    
    
  • The final regulations also provide guidance on when amounts paid or incurred to restore or remediate the environment, wildlife, or natural resources will be deductible.
    
    
• Identification Requirement
  
  
  • The final regulations provide that an order or agreement will satisfy the Identification Requirement if it specifically states that the payment, and the amount of the payment, constitutes restitution, remediation, or an amount paid to come into compliance with a law. The proposed regulations had allowed the IRS to challenge this as a rebuttable presumption. The final regulations remove the rebuttable presumption in response to comments asserting that any such challenge is better brought under the Establishment Requirement (discussed below).
    
    
  • The final regulations also clarify how an order or agreement can satisfy the Identification Requirement when (i) the payment amount is not identified or is identified as a lump-sum, (ii) the order does not use the exact required words, or (iii) the order is in a different language. In general, the final regulations provide more flexibility to allow orders and agreements to satisfy the Identification Requirement.
    
    
• Establishment Requirement: Even if the Identification Requirement is met, a taxpayer must document that the claimed amount qualifies for the Restitution Exception or Compliance Exception (the “Establishment Requirement”). The final regulations clarify that the Establishment Requirement is met if the documentary evidence proves (i) the taxpayer’s legal obligation to pay the amount at issue, (ii) the amount paid or incurred and date the amount was paid or incurred, and (iii) that, based on the origin of the liability and nature and purpose of the amount incurred, the amount at issue was paid for restitution, remediation or to come into compliance with a law. The final regulations also (i) expand upon the proposed regulations’ non-exhaustive list of documents that taxpayers may use to satisfy this requirement and (ii) retain the proposed regulations’ rule that expressly excludes relying solely on the report made by the government or a governmental entity pursuant to Section 6050X, discussed below.
  
  
• Private Party Suits: Section 162(f) does not apply to any amount paid or incurred by reasons of any order or agreement in a suit in which no government or governmental entity is a party. The final regulations clarify that Section 162(f) also does not apply to any suit where a government or governmental entity enforces rights as a private party (e.g., a contract dispute).
  
  
• Taxes: Section 162(f) does not apply to amounts paid or incurred for otherwise deductible taxes (e.g., state and local tax payments or excise or employment taxes). The final regulations clarify that amounts paid as restitution for failure to pay any tax are similarly not subject to Section 162(f) up to the amount of the tax had it been timely paid if it were otherwise deductible. Further, neither interest nor penalties on such amounts are deductible.
  
  
• Tax Benefit: The final regulations retain the proposed regulations’ rule that, if an allowed deduction results in a tax benefit to the taxpayer, the taxpayer must include in income the recovery of any amount deducted in a prior taxable year to the extent the prior year’s deduction reduced the taxpayer’s tax liability.
  
  
• Material Change: The final regulations eliminate the proposed regulations’ “material change” rule. That rule would have provided that an agreement entered into before December 22, 2017, would be subject to the proposed regulations if there were a material change to the terms of such order or agreement after the proposed regulations were finalized.
  
  
• Applicability Date: The final regulations apply to taxable years beginning on or after the date of publication in the federal register.

 

Final Regulations Under Section 6050X

Consistent with the proposed regulations, the final regulations reduce the administrative burden on government or governmental entities that are subject to the Reporting Requirement by, among other things, (i) setting a reporting threshold of $50,000 (instead of the $600 in Section 6050X) for specified or expected payments and (ii) imposing the Reporting Requirement only beginning after 2021.

The final regulations also establish a reporting deadline of (i) January 31 of the year following the calendar year in which the order or agreement becomes binding under applicable law for the appropriate government official to furnish a written statement to the payor and (ii) either February 28 or March 31, depending on the method of filing, for the information return to be filed with the IRS. The proposed regulations had imposed a deadline of January 31 for both the written statement and the information return.

 

Impact of New Guidance on Settlement Negotiations

Section 162(f) increases the costs of settlement, a trend that the final regulations likely will not change. As the final regulations confirm, Section 162(f) now applies to a broader universe of settlements and payments than before the TCJA, covering not just fines and penalties paid to the government, but any payments paid to, or at the direction of, the government or governmental entities. Additionally, the modified Section 162(f) applies not just to resolution of actual violations, but resolution of potential violations as well. As a result, disclaiming liability in a settlement cannot be presumed to preserve the deductibility of the payment.

The final regulations require taxpayers to be extremely mindful of the Identification Requirement and to seek to structure the agreements so as to maximize, if possible, the amounts paid as “restitution,” “remediation,” or “coming into compliance with the law.” Despite these efforts, however, there will be varying degrees of flexibility to do so depending on the nature of the allegations being resolved and the actual facts at issue.

At the same time, the Identification Requirement could hamper or slow settlement negotiations by forcing the parties to consider the tax implications of the terms of the settlement. Not all settlement agreements or court orders clearly delineate fines, penalties, restitution, remediation, or forfeiture, and many are silent on the tax implications. This silence (along with the lack of a reporting requirement like that now contained in Section 6050X) had permitted taxpayers certain flexibility in how they reported the implications of the settlement, depending on the applicable facts.

The final regulations recognize that the Identification Requirement may be met if the nature and purpose of the payment is set out—even if the “magic words” of “restitution,” “remediation,” or “come into compliance” are not otherwise used. Additionally, the final regulations are more permissive of lump-sum payments or agreements that cover multiple taxpayers or damage awards. Taxpayers thus should have somewhat more flexibility in negotiating language in a settlement agreement than under the proposed regulations’ rules, but those seeking assurances of deductibility will want to nevertheless clearly negotiate and identify in the settlement agreement the specific amounts of restitution, remediation, or compliance costs.

The final regulations also recognize that specific costs may not be ascertainable at the time of settlement but that the Identification Requirement can still be satisfied. In these instances, the language of the settlement agreement will be of paramount importance as well as the evidentiary support once the remedial or compliance action is taken. In a change from the proposed regulations, the final regulations also recognize that disgorgement of net profits and forfeiture may still be deductible if certain conditions are met.

Where the final regulations granted more flexibility in the Identification Requirement, they continue to require clear documentary evidence to meet the Establishment Requirement. For example, the final regulations note that where an order or agreement identifies a lump sum payment or multiple damage award that covers some combination of restitution, remediation, and coming into compliance with the law, the taxpayer must establish the exact amount paid or incurred for each purpose. The Establishment Requirement highlights how critical it is for taxpayers to track and clearly document the efforts spent on restitution, remediation, and coming into compliance with the law, along with correspondence to the government agencies discussing the tax characteristics of the settlement amounts.

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