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(Non)Deductibility of Fines and Penalties under New § 162(f) Regulations

Introduction

As you sat down one fine Tuesday morning in January 2021, and you cycled through the emails that rolled into your inbox in the 12 minutes since you last checked them, you notice an update announcing that the IRS is issued final regulations on IRC § 162(f) – deductibility of fines and penalties. You have had prior experience with the Code section, due to Uncle Bill’s penchant for minor violations of laws, regulations, and social mores…and his ill-fated ostrich farm.

As you remember it, IRC § 162(f) was fairly straightforward. Generally, a fine or similar penalty paid to the government for a violation of the law is not deductible unless an exception applies. Somewhere in the deep recesses of your memory, you seem to recall that IRC § 162(f) was amended by the Tax Cuts and Job Act of 2017.  You’ve been so busy lately that you can’t remember what you ate for lunch yesterday, much less the birthday of your middle child, and so you consult the Google to verify this fact.  Indeed, it was.

The IRS took its sweet damn time, you think to yourself. Why even bother clarifying a section that was fairly straightforward to begin with? Then you think about Uncle Bill. You realize that the very people to whom the statute would most often apply are the very people who would be most inclined and motivated to weasel out of it. One of Bill’s prized possessions was a wooden yardstick on which was written “Give the devil an inch, and he’ll be your ruler.” (Eventually, Aunt Ethel would break it over Bill’s head for something he muttered a bit too audibly, but that’s a story for another day.) The same standard stands true for people like Uncle Bill—if there is a loophole to be exploited, exploit it, they will.  As such, you pull up the shiny new regulations and brace yourself for a hootenanny.

Historic Context

IRC § 162(f) was enacted in 1969 to codify a generally held position enforced by the courts that criminal fines and penalties were not deductible from said criminal’s gross income.[1] The legislative history of IRC § 162(f) explains that it should apply when a taxpayer is required to pay a fine because he has been convicted of a crime by a court.[2] A few years later, Congress clarified the scope of the statute and observed that it intended the terms “fines and similar penalties” to encompass any monetary payments imposed under civil statutes, but which in general terms serve the same purpose as a fine exacted under a criminal statute.[3]

IRC § 162(f) was amended by the Tax Cuts and Jobs Act of 2017. In doing so, Congress disallowed deductions for any payment (not limited to fines and penalties) made to the government or governmental entity in relation to a violation of the law—or in relation to the investigation of a violation of the law—unless one of a number of exceptions applied. Moreover, IRC § 162(f) now prohibits the deduction for payments made to third parties at the direction of the government or a governmental entity.[4] However, payments that are not punitive in nature—specifically, restitution or payments to come into compliance with the law—may be deductible as a trade or business expense.[5]

Important Qualification

The fines and penalties provision arises under IRC § 162, which, for refresher purposes is entitled “Trade or Business Expenses.”  This means that Bill, personally, would never be subject to IRC § 162(f), but his damn ostrich farm would be (and in fact was).  To be clear, IRC § 162(f) applies to fines and penalties that a business pays to the government – not an individual.

The Language of the Code

Stated simply, the Code provides that, absent an enumerated exception, no deduction that would otherwise be allowable for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.[6]

This exception does not apply to any amount that

      1. the taxpayer establishes constitutes restitution/remediation or is paid to come into compliance with any law which was violated (the “establishment requirement”);
      2. is identified as restitution or as an amount paid to come into compliance with the law in a court order or settlement agreement (the “identification requirement”); and
      3. if restitution for failure to pay a tax, if the amount (if treated as a tax) would have been allowed as a deduction under the Code.[7]

Furthermore, the exception does not apply to any amount paid or incurred as a reimbursement to the government or entity for the costs of any investigation or litigation.[8]

The Definitions

What is a government?

A government means (i) the government of the United States, a State, or the District of Columbia;  (ii) the government of a territory of the United States, including American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the U.S. Virgin Islands;  (iii) the government of a foreign country;  (iv) an Indian tribal government, as defined in IRC § 7701(a)(40), or a subdivision of an Indian tribal government, as determined in accordance with IRC § 7871(d); or (v) a political subdivision (such as a local government unit) of a government.

What is a governmental entity?

A governmental entity means (i) a corporation or other entity serving as an agency or instrumentality of a government, or (ii) a nongovernmental entity treated as a governmental entity as described immediately below.

What is restitution and remediation?

An amount is paid or incurred for restitution or remediation if it is paid or incurred to restore, in whole or in part, the person; government; governmental entity; property; 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.

Restitution or remediation of the environment, wildlife, or natural resources includes amounts paid or incurred for the purpose of conserving soil, air, or water resources, protecting or restoring the environment or an ecosystem, improving forests, or providing a habitat for fish, wildlife, or plants; however, environmental remediation will only be considered excludible if there is a strong nexus or connection between the purpose of the payment and the harm to the environment, natural resources, or wildlife that the taxpayer has caused or is alleged to have caused.

What are amounts to come into compliance with a law?

An amount is paid or incurred to come into compliance with a law that the taxpayer has violated, or is alleged to have violated, by performing services; taking action, such as modifying equipment; providing property; or doing any combination thereof to come into compliance with that law.

However, regardless of whether the order or agreement identifies them as such, restitution, remediation, and amounts paid to come into compliance with a law do not include any amount paid or incurred either (a) as reimbursement to a government or governmental entity for investigation costs or litigation costs incurred in such government or governmental entity’s investigation into, or litigation concerning, the violation or potential violation of any law; or (b) at the taxpayer’s election, in lieu of a fine or penalty.

What is a suit, agreement, or otherwise?

A suit, agreement, or otherwise includes, but is not limited to, suits; settlement agreements; orders; non-prosecution agreements; deferred prosecution agreements; judicial proceedings; administrative adjudications; decisions issued by officials, committees, commissions, or 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.

What isn’t an investigation or inquiry into a potential violation?

An investigation or inquiry into the potential violation of any law does not include routine investigations or inquiries, such as audits or inspections, of regulated businesses that are not related to any evidence of wrongdoing or suspected wrongdoing but are conducted to ensure compliance with the rules and regulations applicable to those businesses.

Footnotes:

[1] S. Rep. No. 552, 91st Cong., 1st Sess. (1969).

[2] Id.

[3] S. Rep. No. 437, 92d Cong., 1st Sess. (1971).

[4] IRC § 162(f)(1).

[5] IRC § 162(f)(2).

[6] IRC § 162(f)(1)(A).

[7] IRC § 162(f)(1)(A)(i)-(iii).

[8] IRC § 162(f)(1)(B).

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