Background

Sections 162(f) and 6050X changed the requirements for taxpayers to deduct amounts paid to the government or at its direction under court-ordered judgments, settlement agreements, non-prosecution agreements, deferred prosecution agreements, and decisions by certain boards/commissions. At a high level, under Section 162(f), to be deductible, such payments must be restitution, remediation, or an amount paid to come into compliance with the laws, and payments must be identified as such in either the order or agreement (Identification Requirement). In addition, taxpayers must maintain records substantiating the nature of their payments (Establishment Requirement).

Section 6050X requires governments to file information returns (Form 1098-F) with the IRS to report payments received from taxpayers under an order or agreement and to report the amount of the payment that constitutes restitution, remediation, or payments to comply with a law. The same information must be furnished to the taxpayer. Section162(f) was amended, and Section 6050X added, by the 2017 Tax Cuts and Jobs Act. Final regulations were released on January 12, 2021, effective for orders and agreements entered into on or after January 19, 2021. The reporting rules are effective for orders and agreements that become binding on or after January 1, 2022.

General

Section 162(f) and the final regulations generally disallow a deduction for amounts that are:

• paid or incurred by suit or agreement or otherwise;

• paid to, or at the direction of, a government or governmental entity, such as the Securities and Exchange Commission, state regulators, and foreign governmental entities (Governmental Entity); and

• paid in relation to the violation, or investigation or inquiry by such Governmental Entity into the potential violation, of any civil or criminal law.

Section 162(f) does not disallow deductions for such amounts if a taxpayer satisfies an applicable exception. The major exception is for amounts paid or incurred (i) for restitution or remediation for damage or harm connected with an actual or potential violation of a law or (ii) to come into compliance with a law that was the subject of the government investigation, provided that specified identification and documentation requirements are met.

Restitution and Remediation

An amount constitutes restitution or remediation if the amount is "paid or incurred to restore, in whole or in part," the person, entity, or property (including the environment, wildlife, or natural resources) "harmed, injured or damaged by the violation or potential violation of any law … to the same or substantially similar position or condition as existed prior to such harm, injury or damage." In Example 3 of the final regulations, Corp. B is being investigated for a potential violation of State X's emissions standards law. Corp. B enters into an agreement with State X in which it agrees, among other things, to construct a nature center in a local park for the benefit of the community. The example states that Corp. B may not deduct the amounts paid to construct the nature center because no facts exist to establish that the amount was paid either to come into compliance with a law or as restitution or remediation.

Amounts that are paid or incurred to a segregated fund or account, and that meet the Identification and Establishment Requirements, may satisfy the exception for restitution, remediation, or an amount paid to come into compliance with a law. However, no amount will satisfy the exception if it is paid to a general account of a Governmental Entity for general enforcement efforts or other discretionary purposes.

If amounts paid under an order or agreement to an entity, fund, group, or government or Governmental Entity are returned to the taxpayer, the taxpayer must include those amounts in its income under the tax benefit rule.

Coming into Compliance with a Law

The final regulations treat an amount paid or incurred for "performing services; taking action, such as modifying equipment; providing property" or any combination of these actions as an amount paid to come into compliance with a law, provided that such actions are taken to come into compliance with the law that has been violated or potentially violated. Reimbursements to a Governmental Entity for its litigation or investigation costs related to the violation or potential violation of a law, as well as amounts paid at the taxpayer's election in lieu of a fine or penalty, will not constitute an amount paid or incurred to come into compliance with a law.

The final regulations clarify that the excess of amounts paid or incurred to upgrade equipment or property to a higher standard than that required to come into compliance with a law is not subject to the disallowance rules. For example, if it cost $12 to come into compliance with the law, and the taxpayer chooses to spend $15 to upgrade to a higher standard than what is required, the $3 difference would not be subject to the new rule and is tested for deductibility under existing law.

The Identification Requirement

In order for the exception to apply, an amount must be “identified” by the relevant order or settlement agreement as restitution, remediation, or an amount paid to come into compliance with law. The Identification Requirement may be satisfied by specifically stating in an order or agreement the amount of the payment and that the payment constitutes restitution, remediation, or an amount paid to come into compliance with the law. It also is satisfied so long as the order or agreement specifically describes (i) the damage done, harm suffered, or manner of noncompliance with a law and (ii) the action required of the taxpayer to provide restitution or remediation or to come into compliance with the law. Similarly, if the amount to be paid as restitution or remediation or to come into compliance with the law is not identified (for example, because it is unknown) or does not allocate a lump-sum amount among taxpayers or types of payments, the Identification Requirement may still be met by describing the items specified in (i) and (ii) of the preceding sentence.

The Establishment Requirement

The exception applies only if the taxpayer “establishes” that the relevant amount constitutes restitution or remediation or is paid to come into compliance with the law. Under the final regulations, this requirement is met if the taxpayer, using documentary evidence, proves:

• the taxpayer’s legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution or remediation or to come into compliance with law;

• the amount paid or incurred;

• the date the amount was paid or incurred; and

• that based on the origin of the liability and the nature and purpose of the amount paid or incurred, the amount the taxpayer paid or incurred was for restitution or remediation or to come into compliance with a law.

Documentary evidence that may be used to show that the Establishment Requirement is met includes, but is not limited to, receipts and documents issued by the Governmental Entity relating to the investigation, including court pleadings, documents describing how the payment amount was determined, and correspondence between the taxpayer and the Governmental Entity.

Disgorgement and Forfeiture

Provided the Identification and Establishment Requirements are met, restitution may include amounts paid or incurred as disgorgement or forfeiture if such amounts are:

• paid directly to the person harmed by the violation or potential violation of a law or to a segregated fund or account for the benefit of such person; and

• not in excess of the taxpayer’s net profits.

Disgorgement or forfeiture amounts will not be treated as restitution if, under the order or agreement, the amounts are disbursed to the general account of the Governmental Entity for general enforcement purposes or other discretionary purposes.

Other Significant Provisions in the Final Regulations and Preamble

Section 162(f), as amended by the TCJA, does not apply to any pre-December 22, 2017 binding orders or agreements, even if they are modified after that date.

Section 162(f) does not apply in the following circumstances, meaning that payments may be deductible if other requirements are met:

• Amounts paid for routine investigations required to ensure compliance with rules or regulations, where there is no evidence of suspected wrongdoing.

• Payments made under any order or agreement in a suit in which a Governmental Entity enforces its rights as a private party.

• Amounts paid in connection with the cleanup requirements and reimbursement provisions of the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA), where there is no violation of the law.

Key Takeaways for Investigations and Litigation Involving Governmental Entities

• Orders and settlement agreements should state explicitly that amounts are paid as restitution, remediation, or to come into compliance with law and should describe the alleged harm and actions required to provide restitution.

• Orders and settlement agreements should state the specific amount paid as restitution or other deductible payments, and documentation should be preserved to determine such amount.

• Payments under a settlement or order should not be made for fines and penalties or to the general account of the Governmental Entity to be used for general enforcement purposes.

• Contemporaneous files and records that substantiate the amount and purpose for the payments should be maintained in the event they are necessary to defend deductions upon IRS audit.