New IRS Rules on the Deductibility of Settlement Payments Related to Government Investigations

On January 19, 2021, the Internal Revenue Service (IRS) issued final rules on the deductibility of fines, penalties, and settlement payments made to a government or governmental entity in relation to the violation of a law. The new guidance addresses the deductibility of payments made to regulators such as the Securities and Exchange Commission, the Environmental Protection Agency, and the Commodity Futures Trading Commission, as well as payments made in connection with Department of Justice False Claims Act cases and investigations.

For taxpayers involved in legal proceedings with the government or a governmental entity, it is important that identification and establishment language be included in their settlement agreements and draft orders as detailed in the new guidance and as explained in this Tax Alert. The new rules include several taxpayer-friendly changes from the 2020 proposed regulations and provide important guidance for taxpayers in negotiating and drafting settlement agreements. Meeting these rules will likely increase the time and costs related to entering into such settlement agreements, but doing so is key to ensuring deductibility of payments.

The Tax Cuts and Jobs Act (“TCJA”) modified the Internal Revenue Code (“IRC”) rules governing the deductibility of certain government settlement-related expenses under IRC Section 162(f). Under that section, a taxpayer may not take a deduction for amounts:

• Paid or incurred by suit, settlement agreement, or otherwise;
• To, or at the direction of, a government or governmental entity; and
• In relation to the violation, or investigation or inquiry into the potential violation, of any civil or criminal law.

The rule applies regardless of whether the taxpayer admits guilt or liability or pays the amount simply to avoid the expense or uncertainty. The new regulations confirm that IRC Section 162(f) now applies to a broader universe of settlements and payments than before the TCJA changes, covering not just fines and penalties paid to the government, but anypayments paid to, or at the direction of, the government or governmental entities. It also applies not just to the resolution of actual violations, but also of potential violations.

An exception was allowed, however, that states that the disallowance does not apply to amounts that taxpayers establish, and court orders or settlement agreements identify, are paid as “restitution, remediation, or to come into compliance with a law.” The new guidance includes definitions of “restitution,” “remediation,” and “paid to come into compliance with a law.”

In order to qualify for the exception, an order or settlement agreement must specifically identify a qualifying, tax deductible payment as restitution, remediation or paid to come into compliance with law (“Identification Requirement”). The taxpayer must also establish, with appropriate records and documentation, that a tax deductible amount was actually paid or incurred for the nature and purpose identified (“Establishment Requirement”). 

The new guidance includes detailed rules about what type of language must be used and how the Identification Requirement can be met. It also includes specific rules about how to meet the Establishment Requirement, including in the case of multiple taxpayers.

Taxpayers should be particularly careful about meeting the Identification Requirement and seek to structure settlement agreements so as to maximize the amounts that are paid as “restitution,” “remediation,” or “coming into compliance with the law.” It is likely that doing so could complicate and slow settlement negotiations, but it will be important with respect to the tax implications of the settlement agreement.

If the applicable government entity agrees to include exception language under an order or settlement agreement, that government entity must also contemporaneously file an IRS form required under IRC Section 6050X. The new guidance includes information reporting requirements under IRC 6050X.

The IRS made an important change in the final rules related to “disgorgement and forfeiture” payments. Under the proposed regulations, these payments were not covered by the exception language, but in the final rules, the IRS provides for a circumstantial, fact-based test to determine deductibility for disgorgement and forfeiture payments.

Taxpayers who are in the position of making government-related settlement payments are well advised to review the new IRS guidance in order to determine the appropriate approach needed to document potentially deductible payments with the maintenance of substantiating records. As explained above, a taxpayer must ensure that its settlement agreement specifically identifies amounts that are paid as “restitution or remediation, or to come into compliance with law,” and thereafter, must maintain adequate records and documentation to establish that the amounts were paid for that identified purpose.