Last month, Senators Jack Reed (D-RI) and Chuck Grassley (R-IA) re-introduced bipartisan legislation intended to force government agencies to specify which payments made pursuant to out-of-court settlement agreements will be nondeductible under a newly expanded Section 162(f). Under the proposed new Section 162(f), amounts constituting restitution or paid to come into compliance with law (which generally are deductible under current law) would be deductible only if identified as such in the court order or settlement agreement. Amounts paid or incurred as reimbursement to the government for the costs of any investigation or litigation in relation to the violation or potential violation of law would not be deductible.

Current law Section 162(f) simply provides that no deduction is allowed for “any fine or similar penalty paid to a government for the violation of any law.” Regulations explicitly prohibit deductions for payments made in settlement of “actual or potential liability for” such a fine or penalty but allow deductions for compensatory damages, legal fees, court costs and related expenses borne by the taxpayer. Some agencies (e.g., EPA) consistently act to limit tax deductibility for settlements they negotiate, while others rarely do.

According to a 2015 report released by the U.S. Public Interest Research Group (“PIRG”) (available here), over a three-year period, corporations claimed deductions for at least $48 billion of $80 billion in corporate settlements with government agencies. The PIRG report noted that only 18.4% of DOJ settlement dollars and 15% of SEC settlement dollars were specifically marked as non-deductible.

Agency settlement agreements that do not label the required payments as a “fine or penalty,” or otherwise address the tax status of payments to be made, open the door for taxpayer claims that the settlement is an ordinary business expense and not within the purview of the current Section 162(f). An IRS challenge to such a position requires a factual inquiry to determine whether the payment is attributable to a fine or penalty (is it intended to compensate or penalize?) or whether the payment is in settlement of potential liability (what is the likelihood of a fine being imposed?). As expected, courts addressing these highly fact-intensive questions have not always arrived at consistent answers.

The Reed-Grassley bill would require government agencies entering into settlement agreements to report to the IRS what portion of a settlement constitutes a non-deductible fine or penalty, what portion constitutes restitution and what portion constitutes an amount required to be paid to come into compliance with law, and would permit a deduction only for amounts specifically identified in the settlement as restitution or as an amount paid to come into compliance with law. The bill (available here) was re-introduced on April 3, 2017, and has been referred to the Senate Committee on Finance.

The bill was previously estimated to raise $218 million over 10 years.