Whether a business may deduct litigation settlement payments can have a substantial real dollar impact on the business. In the midst of combating potential litigation, companies rarely first focus on the potential tax impact of settlement payments. Some businesses mistakenly assume that the Internal Revenue Service (IRS) will not challenge a deduction of settlement payments, and later find themselves in a dispute with the IRS over the characterization. The recent case of Fresenius Medical Care Holdings Inc. v. United States, involving payments under the False Claims Act (FCA), underlines that tax planning can reduce surprises in the tax treatment of such payments.1
Ordinary and necessary business expenses are deductible under Section 162 of the Internal Revenue Code of 1986, as amended (the Code). Although settlement payments made by a business are generally deductible expenses, a business must look to the origin and character of the claim with respect to which the expense is incurred to make the determination.2 Amounts paid to settle a legal action may be deductible as ordinary and necessary expenses if the acts that gave rise to the litigation were performed in the ordinary course of the taxpayer’s business, provided that the amounts were not fines or similar penalties paid to a government for the violation of any law. Settlement payments to the government may be compensatory or punitive. When a business pays the government to compensate the government for losses as a result of violations of the law, a business is allowed to deduct such payments as ordinary and necessary business expenses. Conversely, settlement payments that are not directly related to the losses sustained by the government are usually for the purpose of punishing the lawbreaker and deterring similar violations. These payments are nondeductible. Allocating settlement payments between deductible compensatory payments and nondeductible fines and penalties can be a difficult exercise without an express agreement between the parties regarding the intent of the settlement payments. A hurdle for taxpayers is that the taxpayer bears the burden of proving that it is entitled to any deduction claimed.
The government normally does not agree to an allocation for tax purposes of settlement payments under the FCA. Although allocations agreed to in a settlement agreement are generally respected, the IRS is not bound by allocations set forth by a taxpayer or in a settlement agreement to which it is not a party.3 Without an express agreement, the tax allocation of the payments boils down to the intent of the parties, which can be difficult for the taxpayer to establish.
Damages under the FCA may be single, double, or treble, and are assessed on a case-by-case basis. Single damages are awarded for actual losses sustained by the government. An award of multiple damages typically adds layers of complexity, since determining the purpose for such damages may not be clear. For instance, the court in U.S. v. Bornstein characterized double damages as compensatory since they were necessary to compensate the government completely for the "costs, delays, and inconveniences occasioned by fraudulent claims."4 Subsequent to Bornstein, the FCA was amended to allow treble damages, and courts expressed different views on the purpose of multiple damages. The court in Cook County v. U.S. observed that FCA damage multipliers can have both compensatory and punitive traits.5 Double and treble damages may be necessary to make the government whole by providing compensation for the secondary costs of detecting and deterring fraud and also may serve the purpose of penalizing a violator of the law.
In Fresenius, the court considered whether payments made by Fresenius Medical Care Holdings, Inc., a provider of kidney dialysis services, pursuant to a civil settlement with the government under the FCA, were deductible by the company. To resolve the claims of civil and criminal fraud, Fresenius agreed to pay fines of $101 million to settle the criminal aspect and to make a payment of $385 million to settle the civil case. Fresenius deducted the entire civil settlement payment on its 2000 and 2001 returns. The IRS disallowed $127 million of the civil payment as a nondeductible penalty. Fresenius challenged the disallowance by filing for a refund.
The company asserted that the payments were compensatory in nature and therefore, deductible as ordinary and necessary business expenses. The government, on the other hand, claimed that the payments were nondeductible because the amounts were intended as punitive damages.
The agreement between Fresenius and the government failed to specify the allocation of the payments between compensatory damages and penalties. The language in the civil agreements did not provide insight as to the intent of the parties. Each agreement contained a provision that stated "nothing in this Agreement constitutes an agreement by the United States concerning the characterization of the amounts paid hereunder for purposes of any proceeding under Title 26 of the Internal Revenue Code." This is consistent with the government’s policy of declining to include an allocation in agreements involving FCA settlements. Further, each agreement contained a provision in which the company agreed that nothing in the agreement was punitive in purpose or effect. Notably, the government did not agree to the statement.
Since an allocation was not specified in the agreement, the court determined that the issue should be decided by a jury. The jury decided that $95 million of the disputed $127 million settlement payment was compensatory in nature, and therefore deductible as an ordinary business expense. The court in Fresenius acknowledged that an agreement with the government is not necessary to establish that all or a portion of a payment made in FCA litigation is non-punitive. The jury considered both the language in the settlement agreement and other evidence regarding the purpose of the settlement payment, including documents exchanged during settlement negotiations. Such other evidence included documents that indicated that making the government whole would require payment of a substantial amount of pre-judgment interest in order to compensate the government for the loss of the use of the money due as damages. The court concluded that from the evidence a jury could reasonably infer that the multiple damages pursuant to the FCA settlement included pre-judgment interest as compensation to the government. The Fresenius decision marked a turn from prior cases that discussed the allocation of FCA settlement payments, such as the decision in Talley Industries Inc. v. Commissioner.6 In these prior cases, a judge determined the proper treatment of the settlement payment, as opposed to Fresenius, in which a jury made the determination.
Talley Industries, Inc. did not fare as well as Fresenius in its dispute with the government over the tax treatment of its FCA settlement payments. Tally, through its subsidiary, manufactured ejection seats for military aircraft. The company obtained several government contracts for the production of ejection seats and for research and development projects. Talley faced potential civil liability under the FCA for making alleged false billing claims for payments on a number of government contracts. The government estimated its actual loss to be approximately $1.56 million. After several rounds of negotiation with the government, the parties agreed to a settlement amount of $2.5 million with respect to the government’s civil claims. Although the settlement agreement was silent on the subject of characterizing the settlement payment, the company reported the $2.5 million settlement payment as a deductible ordinary and necessary business expense. The IRS subsequently disallowed $940,000 of the deduction taken by the company. Initially, the Tax Court granted summary judgment for the taxpayer, reasoning that the $2.5 million settlement was less than double the $1.56 million loss that the government suffered, and the payment was intended be to compensatory.
On appeal by the government, the Ninth Circuit Court of Appeals noted that the double damage provision of the FCA has both compensatory and deterrence purposes. Characterizing double or multiple damages depends on the intent of the parties. The Ninth Circuit Court of Appeals overturned the decision of the Tax Court and remanded the case for further consideration, since there was a genuine issue of fact as to the nature and purpose of the disputed settlement payment. On remand, the Tax Court found for the IRS and determined that the company failed to establish it was entitled to the disputed deduction. In reaching its decision, the Tax Court considered the documents produced by the parties during the negotiation process, including an offer letter by the company that included a statement that the offer was intended to represent compensatory damages. The court noted that the government rejected that offer. In fact, in the government’s counteroffer, the government expressly adopted specific portions of the company’s offer but not the characterization of the settlement payment as compensation. The court found this counteroffer probative as to whether the parties agreed to any allocation of the FCA settlement payment. In addition, the court observed that the taxpayer suffers the consequence if the evidence to establish entitlement to the disputed deduction is lacking.
The government is unlikely to agree to any allocation in an FCA settlement agreement. Therefore, the case for deductibility must be made on the basis of the record. Prior to Fresenius, the task of establishing that the primary purpose of a settlement payment to the government was compensatory often seemed too steep of a hill to surmount. Fresenius, unlike other cases, allowed the jury to be the trier of fact in a situation in which no allocation was made in the settlement agreement. The jury then considered all of the correspondence that was exchanged during the settlement process. In order to prevail on the deduction issues, taxpayers should consider all of their settlement negotiations through the lens of the tax consequences. The record is made during the negotiation stage, and it is too late to alter the record once that process has been completed.
1 2013 U.S. Dist. LEXIS 66234 (D. Mass. 2013).
2 U.S. v. Gilmore, 372 U.S. 39 (1963).
3 See Robinson v. Commissioner, 102 T.C. 116 (1994), rev’d in part on other grounds, 70 F.3d 34 (5th Cir. 1995), cert. denied 519 U.S. 824 (1996).
4 423 U.S. 303 (1976).
5 538 U.S. 119 (2003).
6 T.C. Memo 1999-200, aff’d. 18 F.App’x 661 (9th Cir. 2001).
Lisa B. Petkun and Annika M. Chin