In our former life as lawyers defending False Claims Act cases, our defendant clients had to consider whether the payments made to settle qui tam cases under the False Claims Act were deductible for tax purposes, and to what extent.
The IRS recently issued a paper on the subject: whether a defendant’s payment to the Department of Justice to resolve False Claims Act allegations is “deductible in its entirety as a section 162(a) ordinary and necessary business expense, or includes non-deductible penalty amounts under section 162(f).”
This paper, LMSB-4-0908-045, is reproduced below:
Coordinated Issue – All Industries – False Claims Act Settlements With Department Of Justice (DOJ)
LMSB-4-0908-045 Effective Date: September 5, 2008
COORDINATED ISSUE ALL INDUSTRIES FALSE CLAIMS ACT SETTLEMENTS WITH DEPARTMENT OF JUSTICE (DOJ)
UILs:
162.21-17 (Health Care Fraud)
162.21-18 (Environmental Fraud)
162.21-19 (Aerospace Defense Contractors)
162.21-20 (DOJ – Fraud Settlements not under False Claims Act)
162.21-01 (Cases not covered by the above UILs)
Note: This issue paper is not an official pronouncement of the law or the position of the Service and can not be used, cited or relied upon as such.
ISSUE
Whether a payment made by a taxpayer to the Department of Justice (DOJ) pursuant to a settlement of a lawsuit brought under the False Claims Act (FCA) is deductible in its entirety as a section 162(a) ordinary and necessary business expense, or includes non-deductible penalty amounts under section 162(f).
CONCLUSION
In many cases, a portion of the civil fraud settlement may represent a penalty that is not deductible for tax purposes. In a FCA settlement, if the government’s intent in assessing multiple damages was punitive and not compensatory, the portion of the payment that represents multiple damages, less certain relator fees (see Generic Legal Advice Memorandum below), will be a penalty that is not deductible.
The tax law is clear. The taxpayer bears the burden of proving that it is entitled to a full or partial deduction with regard to any settlement amount paid.
(This issue deals with, but is not limited to, FCA settlements with DOJ. In any case in which a taxpayer has entered into a settlement with any other government entity under any authority other than the FCA, the facts and law must be analyzed to determine the application of this position.)
BACKGROUND AND FACT PATTERN
Investigations of alleged fraud against the federal government are directed by the Justice Department, either through a DOJ trial attorney or a local Assistant US Attorney (AUSA). The investigations are conducted under Title 31, US Code, Section 3729, referred to as the False Claims Act (FCA), and various other statutory and common law provisions. The FCA allows the government to recoup funds it paid out as a result of fraudulent acts and/or the filing of false claims. It also calls for multiple damages. The total amount of damages may be up to three times the amount of the actual losses suffered by the government, referred to as treble damages. In most cases that it investigates, DOJ reaches a settlement with the accused rather than litigating in the courts.
The FCA also contains a whistleblower provision, called a qui tam, which allows citizens to sue on behalf of the government in order to recover funds paid due to fraud. A whistleblower is referred to as a relator. In most cases, after the relator files a lawsuit under the FCA, the government intervenes and takes over prosecution of the lawsuit. Most FCA investigations result from a qui tam action, and in most settled cases the relator is paid a reward for taking this action, a statutory provision of the FCA.
There are two primary questions which must be answered when FCA litigation results in a settlement. First, is a portion of the settlement payment a penalty, and therefore not deductible for tax purposes? Second, what amount of the settlement is penalty?
A settlement is a practical way of resolving allegations of misconduct. The FCA is not strictly compensatory in nature since it is not designed merely to recoup the government’s losses. The purpose of the FCA is to discourage fraudulent billing practices from occurring, to punish illegal behavior in order to deter similar behavior in the future, and to recover monies fraudulently obtained from the government. The FCA mandates that defendants who litigate their case and are found to have violated the Act will be assessed treble damages by the court. The fact that a defendant elects to settle a case rather than litigate does not relieve it of exposure to penalties. In cases seen to date, settlements typically include less than treble damages, but almost never concede penalties altogether.
Any settlement between the parties is memorialized in a formal document called a Settlement Agreement. It is the policy of DOJ to remain neutral regarding the character of the settlement amount and any tax consequences that may result. Standard settlement agreements reflect no admission of guilt by the defendant and contain no allocation of compensatory vs. punitive amounts. Settlement Agreements are also silent on the tax treatment. In fact, many such settlement agreements specifically include a paragraph reflecting neutrality under Title 26[1].
DOJ attorneys intend singles damages to be compensatory and may intend multiples to be either compensatory or punitive, or both. DOJ’s intent in this context is evidenced by documentation and communication between the parties in each particular case as well as testimony of the government settlement attorneys. In almost every case there is documentation within the files of the AUSA or DOJ attorney that distinguishes the singles and multiples and demonstrates the intent of DOJ in including multiples in the settlement amount. It must be emphasized that every case is unique. Some contain a substantial amount of documentation while others have a limited amount. DOJ attorneys are given much flexibility to investigate and settle their cases. The large settlement amounts involved in most of the cases that are examined require settlement approval by DOJ at their executive level.
Once agreement on the settlement amount is reached, the defendant must pay the amount to DOJ, who then reimburses each government entity that is identified as having suffered damages related to the FCA issue. DOJ maintains a disbursements record which accounts for the entire settlement payment amount. The singles damages are paid directly to each government entity in the amount of its losses. The balance remaining after all damages are paid generally represents the multiples and is paid into a number of accounts, including the amount of the award to the relator and to the Treasury.
The policy and practice of DOJ to remain neutral regarding the tax deductibility of settlement payments, and to not characterize the payment as either singles or multiple damages in their settlement agreements requires examiners to look into these settlements and the facts behind them in order to determine if the settlement includes multiple damages, and if so, whether all or a portion of the multiples were intended to be compensation or a penalty.
LAW AND ANALYSIS
Section 162(a)
I.R.C. §162(a) allows a deduction of “all ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” Section 162(f) provides that “[n]o deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.” Treas. Reg. §1.162-21(b)(1) defines a nondeductible fine or penalty as, inter alia, an amount paid as a civil penalty imposed by Federal, State, or local law or an amount paid in settlement of a taxpayer’s actual or potential liability for a fine or penalty (civil or criminal). Section 1.162-21(b)(2) makes clear, however, that compensatory damages paid to the government do not constitute a fine or penalty for purposes of I.R.C. §162(f).
162(f) Fines and Penalties
I.R.C. §162(f) states, “No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.”
Treas. Reg. §1.162-21(b)(1) defines fines and penalties as an amount,
Paid pursuant to conviction or a plea of guilty or nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding;
Paid as a civil penalty imposed by Federal, State, or local law; or
Paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).
Treas. Reg. §1.162-21(b)(2) states,”The amount of a fine or penalty does not include legal fees and related expenses paid or incurred in the defense of a prosecution or civil action arising from a violation of the law imposing the fine or civil penalty, nor court costs assessed against the taxpayer…Compensatory damages paid to a government do not constitute a fine or penalty.”
Case Law
Ultimately, whether a payment constitutes a “fine” or a “penalty” (which is not deductible on a Federal income tax return) depends on the purpose the payment was meant to serve. Civil “penalties” imposed for purposes of enforcing the law and as punishment for violation of the law are not deductible for Federal income tax purposes. See Talley Industries, Inc. v. Commissioner, 116 F.3d 382, 385-386 (9th Cir. 1997), citing Southern Pacific Trans. Co. v. Commissioner, 75 T.C. 497 (1980). On the other hand, civil “penalties” imposed to encourage prompt compliance with a requirement of the law or as a remedial measure to compensate another party for expenses incurred as result of the violation, are deductible because they do not serve the same purpose as a criminal fine and are not “similar” to a fine within the meaning of section 162(f). Id. See also Colt Industries, Inc. v. United States, 880 F.2d 1311, 1313 (Fed. Cir. 1989). The taxpayer has the burden of establishing the deductibility of any payment or portion thereof
Talley Industries, Inc. v. Commissioner
Talley is the key group of cases on this issue. They hold that a portion of the settlement can represent a non-deductible fine or penalty, although it is not stated in the settlement agreement.
In 1986, Stencil Aero (Stencil), a subsidiary of Talley, was indicted and pled guilty to charges of fraudulent billing practices. Stencil entered into a settlement agreement with the government, agreeing to pay $2.5 Million. The IRS determined, from facts obtained from DOJ files, that the government’s actual losses were $1.56 Million. Stencil paid the $2.5 Million and deducted the entire amount on the Talley consolidated return. The Service contended that $940,000, the difference between the $2.5 Million payment and the $1.56 Million actual loss, was a nondeductible fine and disallowed it. Initially the Tax Court ruled that the entire payment was to compensate the government for its losses and allowed the deduction in full. The Service appealed. The Ninth Circuit found that because the multiple damages provision of the FCA can serve both compensatory and punitive purposes, there was a genuine issue of material fact regarding the $940,000 and remanded the case to the Tax Court with the instruction to determine which purpose this amount was intended to serve. The second time around, the Tax Court concluded that Talley was not entitled to deduct the $940,000, noting that the government accepted the settlement in the belief that the portion in excess of the $1.56 Million in government losses would amount to a penalty.
Similarities between Talley and Medicare Fraud Settlement Cases
Talley involved a lump-sum settlement of litigation brought under the FCA, as do most cases to which this Coordinated Issue Paper is addressed. During the negotiation of a settlement, offers and counteroffers are made. An estimate of damages and the total settlement amount are typically provided to the defendant. Throughout the settlement negotiations, the government typically adds a multiplier (of up to 2 times its actual damages) and intends for that additional amount to be a penalty. As noted above, the final settlement agreement with DOJ is usually silent as to the apportionment of the settlement amount between repayment of losses and penalties.
Three Significant Points of the Talley Cases:
Deductions are a matter of legislative grace. The taxpayer must show that it comes squarely within the terms of the law conferring the benefit sought. In other words, the taxpayer bears the burden of proving entitlement to the deduction sought. It must establish that both parties intended for the multiplier to be compensatory in order to claim a deduction. Otherwise, if there is evidence that the government intended for the multiplier amount to be a penalty, the taxpayer has failed on its burden of proof and the amount is a nondeductible fine or penalty.
The Court first looked at whether the parties intended the settlement to include multiple damages under the FCA. It concluded that they did intend for the settlement to include multiples. This is based on references to multiples in the offers and counteroffers. Since the multiple damages provision of the FCA can serve either a compensatory or punitive purpose, or both, the Court’s decision stated that in the case of an ambiguous settlement agreement, the Court may consider outside evidence in order to ascertain the parties’ intent. This evidence includes the parties’ negotiations and communications leading up to the settlement.
The Court considered whether the purpose of the $940,000 damage payment was to compensate the government for its losses or to punish Talley. The settlement agreement was silent on this point, as is typically the case in DOJ settlement agreements. In light of the ambiguity, the Court of Appeals instructed the Tax Court to resolve this question by determining the Parties’ intent by reference to contemporaneous objective evidence. The Court emphasized that petitioner, Talley, suffers the consequence if evidence to establish entitlement to the disputed deduction is lacking. It concluded that Talley failed to establish that both parties intended for the amount in dispute to constitute compensation and that Talley had thus failed to establish entitlement to the deduction claimed.
TAM 200502041
In Technical Advice Memorandum 200502041, issued January 14, 2005, the Service concluded that a portion of a lump-sum payment in settlement of claims arising under the FCA is nondeductible under section 162(f), and identified the portion of the settlement payment that constituted compensatory damages. This TAM includes a detailed discussion of the law and appropriate analysis relating to this issue.
Generic Legal Advice Memorandum
A Generic Legal Advice Memorandum released July 27, 2007, by the Office of Chief Counsel concluded that an amount paid by the taxpayer to compensate the government for its obligation to pay a relator from proceeds of a lump-sum settlement is deductible when the amount of the relator fee is specifically outlined in the settlement agreement. Where the relator fees are known to a defendant (as to both fact and amount), they may support a deduction as compensatory damages under the same rationale, even if not reflected in the Settlement Agreement, if the taxpayer can demonstrate that knowledge through contemporaneous objective evidence.
ANALYSIS AND DISCUSSION
One of the first steps taken on each case with DOJ is to document the settlement attorney’s assessment of his/her case relative to the position of whether multiple damages were included in the total settlement amount. Confirm the existence of multiples before additional time and effort is spent on the issue. Interviews and document requests are conducted directly with the responsible settlement attorney, as well as with the taxpayer. If multiples exist, critical documents that should always be requested include: all correspondence between DOJ and the defendant, and in particular those where multiples or penalties and the application of the FCA are mentioned, computations submitted to defendants, proposals made to defendants and counter-proposals made, and presentations made by DOJ or by the defendant.
No issue is ever proposed to a taxpayer unless DOJ fully supports the position that the settlement amount includes multiple damages that DOJ intended to serve as a penalty. The Service makes no attempt to interpret the application of the FCA. All interpretation of the FCA as it applies to each case is that of DOJ. In addition, no penalty amount is based on any computation made by IRS. All figures are those of DOJ. The entire issue is based on the facts, figures, documentary evidence and interpretation of DOJ.
CONTACTS AND ASSISTANCE WITH THIS ISSUE
An Industry Director Directive (IDD #1) on this issue was published on May 30, 2007, titled Tier I Issue: Government Settlements Directive #1. It included Attachment I., Audit Guidelines on Government Settlements. IDD #2 was subsequently issued which clarifies the roles and responsibilities for this Tier I issue.
For assistance with this issue, contact should be made with the Health Care Technical Advisor team.
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Prior to June 2005, most DOJ settlement agreements included the following phrase, “The Parties agree that this agreement is not punitive in purpose or effect.” Taxpayers argue that this phrase makes it clear that the entire settlement is compensatory. DOJ had included this phrase in its settlements to deal with a perceived problem under the Double Jeopardy clause of the Fifth Amendment to the Constitution. It has no meaning for tax purposes, and thus does not support the taxpayer’s argument in this respect. DOJ has since stopped using this language.