Companies deduct settlement payments from taxes, GAO finds.

Corporations that negotiate high-dollar settlements of civil suits with the government often turn around and deduct the settlement payments from their income taxes, according to a recent Government Accountability Office (GAO) report.

"A civil settlement is supposed to sting like a bee, not annoy like a gnat," Sen. Charles Grassley (R-Iowa) said in a press statement. "Letting companies deduct settlement payments from their income taxes takes away the sting. It minimizes the deterrent effect, and it makes chumps out of the taxpayers who subsidize these deductions."

Grassley and Sen. Max Baucus (D-Mont.), chair and ranking minority member of the Senate Finance Committee, asked the GAO to investigate companies' practice of deducting settlement payments. They have sponsored legislation to clarify what part of a settlement can be deducted and to require government agencies to report settlements to the IRS for tracking and auditing.

The GAO examined 34 unnamed companies that settled high-dollar civil suits with government agencies, including the Environmental Protection Agency, the Securities and Exchange Commission, the Department of Justice, and the Department of Health and Human Services.

"In general, payments that are intended to punish (punitive payments) a violator are not deductible and payments made to compensate (compensatory payments) those who were harmed by a violation are deductible under federal law," the GAO said.

But the IRS doesn't address the deductibility of all types of payments, and statutes that govern them maybe unclear on whether the payments are punitive, compensatory, or both. For example, the study reported, a payment labeled as a "civil penalty" could have been imposed as a remedial measure to compensate the government, and the IRS allows those payments to be deducted.

However, 20 of the 34 companies deducted all or parts of settlements from their taxes. Company officials reasoned that if a settlement agreement doesn't specifically state that the settlement is not tax deductible, then the law allows the deduction. Three companies took deductions totaling about $15.5 million, their officers said, because the companies did not admit any wrongdoing in the settlement agreements. After being questioned by the GAO, two companies said they erred in taking deductions for settlements and would file amended tax returns.

"It is galling that artfully crafted settlement agreements create loopholes that allow wrongdoers to escape the full impact of fines and water down any deterrent effect," said Bancus in a statement. "The GAO report confirms what many have suspected for some time--that companies were shifting the cost of their fines and penalties onto the backs of honest taxpayers."

Because the IRS has no system for gathering information on civil settlements from the government agencies involved, it relies on public sources such as Web sites and press releases to find out about agreements. The government agencies involved with the study told the GAO that it is not their role to negotiate with companies over whether their payments are tax deductible; instead, it is the IRS's job to determine that. Justice Department officials said that since the law is clear that penalties paid to a government agency for a civil settlement are not deductible, it is unnecessary to restate the law in its agreements.

The GAO recommended that the IRS work with other government agencies that enter into civil settlements with companies to develop a cost-effective way to share information so the IRS can ensure the proper tax treatment of the payments.

The IRS responded that it will form a team to implement the GAO's recommendation. It has already begun to collect more information on settlements: Starting this month, corporations with consolidated assets of $10 million or more must file with their corporate income tax returns a schedule listing any fines, penalties, and punitive damages they paid.

The report, Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments (No. GAO-05-747), is available online at www.gao.gov/new. items/d05747.pdf.