The global settlement and tax deductibility of fines and penalties.

On April 28, 2003, the Securities Exchange Commission (SEC), New York Stock Exchange (NYSE), National Association of Securities Dealers (NASD), North American Securities Administrators Association and New York State Attorney General announced the "Global Settlement of Conflicts of Interest Between Research and Investment Banking" (Global Settlement), finalizing an agreement reached in principle in December 2002. The Global Settlement followed joint investigations by regulators into alleged conflicts of interest between investment banking and securities research at brokerage firms. As a result of the investigation, 10 of the nation's top investment firms agreed to pay a total of approximately $1.4 billion; see www.nasd.com/global_settlement.asp.

The $1.4 billion settlement comprised $487.5 million in penalties, $387.5 million in disgorgement, $432.5 million to fund independent research and $80 million to fund and promote investor education. The Global Settlement, as well as recent agreements reached by MCI and others, have brought attention to uncertainties as to the tax treatment of settlement payments. The possibility of the firms obtaining sizable tax benefits from deducting the payments raised a political outcry and prompted proposed legislation to expand the definition of nondeductible fines or penalties.

Generally, no deduction is allowed if the payments are classified as a "fine or penalty payable to a government." However, it is not always clear when a payment is a penalty; payments called penalties may still be deductible if classified as compensation for damages. The tax treatment of fines and penalties is discussed below.

The Code

Sec. 162(f) disallows a deduction for "any fine or similar penalty paid to a government for the violation of any law." The history of Sec. 162(f)'s enactment in the Tax Reform Act of 1969 reveals that Congress intended to codify the general court position disallowing the deduction of fines and penalties.

The Supreme Court had addressed the issue in Tank Truck Rentals, Inc., 356 US 30 (1958), and Hoover Motor Express Co., Inc., 356 US 38 (1958), and declared in both cases that no deduction was allowable for a fine or penalty if the deduction would severely frustrate a sharply defined national or state policy. The goal was to prevent favorable tax treatment from "blunting the sting" of a validly imposed penalty. In H.A. True, Jr., 894 F2d 1197 (1990), the Tenth Circuit noted that committee comments and prior case law indicated that the Sec. 162(0 nondeductibility exception for "fines and similar penalties" includes criminal fines and any similar retributive civil penalty intended to sanction conduct the state specifically seeks to prohibit, but that compensatory or remedial payments are beyond Sec. 162(f)'s scope.

Regulations

Regs. Sec. 1.162-21(b)(1) defines a "fine or similar penalty" to include the following amounts:

1. Paid pursuant to a conviction or plea of guilty or nolo contendere in a criminal proceeding;

2. Paid as a civil penalty imposed by Federal, state or local law;

3. Paid in settlement of an actual or potential liability for a fine or penalty (civil or criminal); and

4. Forfeited as collateral posted for a proceeding that could result in a fine or penalty.

According to Regs. Sec. 1.162-21(b)(2), nondeductible fines or penalties do not include compensatory damages paid to a government.

Sec. 162(f) Cases

The courts have endeavored to interpret "fine or similar penalty"; in so doing, most have attempted to ascertain the purpose the statutory penalty serves. A civil penalty imposed to encourage prompt compliance with law, or as a remedial measure to compensate a third party for expenses resulting from the violation, does not serve the same purpose as a criminal fine and is outside of Sec. 162(f). The courts ruled in the following cases that penalties designated as liquidated damages were deductible if they were compensatory or remedial in nature, not primitive (Middle Atlantic Distributors, 72 TC 1136 (1979); The Mason and Dixon Lines, Inc., 708 F2d 1043 (1983); Larry. D. Huff, 80 TC 804 (1983); and H.A. True, Inc., 603 FSupp 1370 (1985)). The Service also ruled, in Rev. Ruls. 69-581, 80334 and 88-46, that penalties that are remedial, rather than punitive, are deductible.

Regs. Sec. 1.162-21(b)(1)(iii) states that taxpayers may not deduct any amounts paid in settlement of actual of potential liability for a fine or penalty, whether civil or criminal. The courts have consistently ruled that settlement amounts paid in lieu of an actual penalty, of as an alternative to litigation, were nondeductible if not compensatory in nature; see, e.g., Adolf Meller Co., 600 F2d 1360 (1979); Henson Robinson Co., TC Memo 1984-358; and Allied-Signal, Inc., 54 F3d 767 (1995).

In John 77 Stephens, 905 F2d 667 (1990), the Second Circuit ruled that a taxpayer could claim a deductible loss for the return of embezzled funds to a corporation, because the restitution was to a private party and was a civil remedy ordered primarily to reimburse tire corporation's loss.

Finally, in Talley Industries, Inc., 18 Fed Appx 661 (9th Cir. 2001), the Ninth Circuit ruled that a government contractor who pled guilty to a charge of false and fraudulent statements could deduct the portion of the settlement payment that represented compensation of the government's actual loss. However, the balance of the payment could not be deducted, because the parties did not show they intended it to compensate for loss.

Sec. 165 Cases

Taxpayers have also attempted to deduct losses from seizures or forfeitures under Sec. 165(a), which allows a deduction for "any loss sustained during the taxable year and not compensated for by insurance or otherwise." However, the courts have consistently followed the Supreme Court in Tank Truck Rentals and held that a loss deduction will be denied when allowing it would frustrate a sharply defined Federal or state policy. For example, in Bill D. Holt, 69 TC 75 (1977), the taxpayer sought a loss deduction for property seized by authorities after his arrest for a drug trafficking violation. The Tax Court held "[t]he forfeitures, confiscation, fines, and imprisonment ... are all aimed at stopping illegal drug trafficking.... Clearly, it would be contrary to public policy to allow a deduction for the loss ... of his contraband."

In Francisco Murillo, 106 F3d 1201 (2nd Cir. 1998), the court ruled that a taxpayer could not take a deduction for money that he forfeited to the government under a consent decree springing from money-laundering charges. In the plea agreement, the U.S. Attorney's Office recommended that the imposition of a fine was not warranted because of the decree. The court ruled that to allow the taxpayer a deduction for losses arising out of illegal activities would undermine public policy, by permitting a portion of the forfeiture to be borne by the government, thus taking the "sting" out.

The Global Settlement and Proposed Legislation

Under the terms of the Global Settlement, the investment firms agreed not to seek a tax deduction as to any Federal, state or local tax for any penalty paid under the settlement. However, only the $487 million characterized as penalties would clearly be nondeductible under Sec. 162(f).The $510 million to fund independent research and investor education could be deductible as ordinary and necessary business expenses. The $387 million in disgorgement could be deducted under Regs. Sec. 1.162-21(b)(2), because this amount will be used to compensate victims for their damages. The IRS could challenge the deductibility of some of the payments, arguing that they should be treated as fines.

Uncertainty over which portion of the settlement payments would be tax deductible prompted legislation to expand the Sec. 102(f) definition of "fine or penalty." The proposed Government Settlement Transparency Act of 2003 provided that all amounts paid or incurred (whether by suit, agreement or otherwise) to, of at the direction of, a government in relation to the violation of any law or the investigation or inquiry into the potential violation of any law are nondeductible, except for payments that the taxpayer establishes are restitution. The Joint Committee on Taxation intended that a payment would be treated as restitution only if the payment were required to be paid to specific persons, or in relation to the specific property, actually harmed by the taxpayer's conduct that resulted in the payment. However, the Senate amendment was not included in the Jobs and Growth Tax Relief Reconciliation Act of 2003; to date, the proposed legislation has not become law.

Until legislation is passed, there will continue to be some uncertainty regarding the tax treatment of settlement payments. If, based on tire preceding discussion, a taxpayer is negotiating a settlement with a government that could result in a non-deductible penalty, the taxpayer should try to avoid having the payments characterized as a penalty in the agreement, but as compensation to the victimized parties instead.

FROM TIMOTHY S. OBERST; CPA, HENNETT THRASHER, PC, ATLANTA, GA

Allen M. Beck, CPA, MST 

Tax Manager

Ehrenkrantz Sterling & Co., L.L.C.

DFK International

Livingstone, NJ