On May 12, 2020, the IRS and Treasury Department released proposed regulations (the Proposed Regulations) to provide guidance to taxpayers in determining which payments are disallowed by section 162(f) of the Internal Revenue Code. Although the interpretative rules announced in the Proposed Regulations are not effective until promulgated as final regulations, a taxpayer may rely on the provisions of the Proposed Regulations as long as the taxpayer applies the Proposed Regulations in their entirety. Alternatively, until final regulations are issued, a taxpayer may rely on the transitional guidance set forth in Notice 2018-23. Whichever set of guidance a taxpayer follows, it is important to make sure that a payment that is intended as restitution, remediation, or to come into compliance with a law is documented accordingly so that the deduction is not lost.
Section 162(f) generally prohibits a taxpayer from deducting an amount paid or incurred to (or at the direction of) a governmental entity if that amount is related to a legal violation or the investigation or inquiry into a potential violation of law. On the other hand, section 162(f) does not prohibit taxpayers from deducting restitution, remediation, or payments made to come into compliance with a law.
General rule disallowing deductions
Under the Proposed Regulations, a deduction generally is denied for any amount that is paid or incurred on or after December 22, 2017
- 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 denial of the deduction does not apply, however, to amounts paid or incurred for otherwise deductible taxes or related interest, other than interest attributable to a penalty.
For purposes of this general rule, a "suit, agreement, or otherwise" includes, but is not limited to
- Settlement agreements,
- Non-prosecution agreements,
- Deferred prosecution agreements,
- Judicial proceedings,
- Administrative adjudications,
- Decisions issued by officials, committees, commissions, boards of a government or governmental entity, and
- Any legal actions or hearings which impose a liability on the taxpayer or pursuant to which the taxpayer assumes liability.
For purposes of this general rule, "government or governmental entity" means
- The federal government,
- A state government,
- The government of the District of Columbia or a US territory,
- An Indian tribal government,
- A foreign government, and
- A political subdivision, or a corporation or other entity serving as an agency or instrumentality, of any of the above.
Solely for purposes of this rule, a nongovernmental entity is treated as a governmental entity if it (a) exercises self-regulatory powers (including imposing sanctions) in connection with a regulated securities exchange, board of trade, or other identified exchange or (b) exercises self-regulatory powers, including adopting; administering; or enforcing laws and imposing sanctions, as part of performing an essential governmental function.
It is important to keep in mind that, for this general prohibition to apply, a government or governmental entity must be a party, and not just the adjudicator, to the dispute. In other words, the disallowance of section 162(f) does not apply to any amount paid or incurred by reason of any order or agreement in a suit in which no government or governmental entity is a party.
Exception for restitution, remediation, or payments to come into compliance with a law
Section 162(f) does not deny a deduction for amounts paid or incurred for restitution, remediation, or to come into compliance with a law, as long as the taxpayer meets the applicable identification and establishment requirements.
Restitution or remediation
An amount is paid or incurred for restitution or remediation if it restores, in whole or in part, the person, government; governmental entity, or property harmed by the violation or potential violation of a law.
Amounts paid to come into compliance with a law
Amounts paid to come into compliance with a law includes more than just cash payments. Performing services, taking action (such as modifying equipment), providing property; or doing some combination of those acts may also constitute amounts paid or incurred to come into compliance with a law that the taxpayer has violated, or is alleged to have violated.
Amounts not treated as restitution, remediation, and amounts paid to come into compliance with a law
Even if the order or agreement identifies certain payments as restitution, remediation, or amounts paid to come into compliance with a law, if the payments are, in substance, for any of the flowing purposes, they will not be deductible:
- Amounts paid or incurred to reimburse the government or governmental entity for investigation costs or litigation costs,
- Amounts paid or incurred at the payor's election, in lieu of a fine or penalty, or
- Amounts paid or incurred as forfeiture or disgorgement.
Note that the payment must meet the definition of "restitution, remediation, or amounts paid to come into compliance with a law" to be deductible. Simply making a payment to an entity, fund (including a restitution, remediation, or other fund), group, government; or governmental entity does not necessarily cause the payment to qualify as restitution, remediation, or amounts paid to come into compliance with a law.
The court order or agreement must identify the payments at issue by stating the nature of, or purpose for, each payment each taxpayer is obligated to pay and the amount of each payment identified. Under the Proposed Regulations, the identification requirement is presumed to be met if an order or agreement uses specific phrasing noting that the payment, and the amount of the payment, constitutes restitution, remediation, or an amount paid to come into compliance with a law. The wording permitted by the Proposed Regulations is a relaxation of the strict wording required by Notice 2018-23. Still, it is unclear how a taxpayer can meet this specific identification requirement when the order or agreement at issue involves lump-sum judgments or settlements, multiple damage awards, or multiple taxpayers. The Treasury Department and IRS have requested comments on how taxpayers may meet the identification requirement with respect to lump-sum payments, multiple damage awards, and multiple taxpayers, and so guidance regarding those situations may be included in the final regulations.
If the order or agreement identifies a payment as restitution or remediation or to come into compliance with a law but does not fully identify the amount the taxpayer must pay, the Proposed Regulations state that the identification requirement is considered met if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law and describes the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property.
Complying with the identification is a necessary but not sufficient condition for deductibility. The IRS may challenge the characterization of an amount if the IRS can show sufficient contrary evidence that the amount paid or incurred was not for the purpose identified in the order or agreement.
To meet the establishment requirement, the Proposed Regulations require the taxpayer to substantiate, with documentary evidence,
- The taxpayer's legal obligation, pursuant to the order or agreement, to pay the amount identified as restitution, remediation, or to come into compliance with a law,
- The amount paid, and
- The date the amount was paid or incurred.
The Proposed Regulations provide a non-exhaustive list of documents that taxpayers may use to satisfy the establishment requirement:
- The legal or regulatory provision related to the violation or potential violation of a law,
- Documents issued by the government or governmental entity relating to the investigation or inquiry,
- Documents describing how the amount to be paid was determined, and
- Correspondence exchanged between the taxpayer and the government or governmental entity before the order or agreement became binding under applicable law.
Section 162(f) generally applies to amounts paid or incurred on or after December 22, 2017. This effective date generally does not apply, however, to amounts paid or incurred under any binding order or agreement entered into before December 22, 2017. On the other hand, if such a grandfathered binding order or agreement is materially changed after December 22, 2017, any amounts paid or incurred, or any obligation to provide property or services, after the date of the material change is subject to disallowance under section 162(f).
Whether a business may deduct payments or other costs it incurs pursuant to an order, settlement, or agreement depends on several factors, including section 162(f). To determine the economic cost to the business of the order, settlement, or agreement, an affected business must undertake an analysis of the restrictions (if any) on deduction of the costs incurred to fulfil its obligations under the order, settlement, or agreement. Further, to the extent the business has the opportunity to shape the order, settlement, or agreement, designing it so that it complies with section 162(f) can help ensure that the aggrieved parties receive the remediation, restitution, or other relief to which they are entitled at the lowest cost to the business.