15 May 2020 IRS issues long-awaited proposed regulations on the non-deductibility of certain fines, penalties and other amounts, and related reporting requirements The IRS has issued proposed regulations (REG-104591-18) limiting the deductibility of fines, penalties and other amounts paid to, or at the direction of, governmental entities (and other identified entities), for violating or potentially violating a law, under IRC Section 162(f) and on the related reporting requirements under IRC Section 6050X. The proposed regulations also address the requirements that taxpayers must satisfy to deduct payments characterized as restitution, remediation or an amount paid to come into compliance with a law. The proposed regulations also explain that the IRS may challenge the characterization of an amount identified as an exception to the non-deductibility rule by a taxpayer. As discussed herein, taxpayers may choose to rely on the proposed regulations if they apply the regulations consistently and in their entirety. Prop. Reg. Section 1.162-21 is generally proposed to apply to tax years beginning on or after the date of publication of the final regulations in the Federal Register. Previously, IRC Section 162(f) disallowed an ordinary and necessary deduction under IRC Section 162(a) for any fine or penalty paid to a government for violating the law. Amendments made to IRC Section 162(f) by the Tax Cuts and Jobs Act (TCJA) broadened the scope of IRC Section 162(f)(1) to include "any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government, governmental entity, or nongovernmental entity in relation to the violation of a law or the investigation or inquiry by such government or governmental entity into the potential violation of a law." IRC Section 162(f)(2), (f)(3) and (f)(4) provide exceptions to the general rule in IRC Section 162(f)(1) for:
IRC Section 162(f)(2)(B), however, prohibits deductions for payments reimbursing the government for its legal or investigations costs. The TCJA also added new IRC Section 6050X, which requires a government or entity that is described in IRC Section 162(f)(5) and involved in a suit, agreement, or other action to which IRC Section 162(f) applies to file an information return if the aggregate amount involved in the orders or agreements is $600 or more. Under IRC Section 6050X(a)(3), the government or governmental entity must file the information return at the same time it enters into the agreement. The amendments to IRC Section 162(f) and new IRC Section 6050X apply to amounts paid on incurred on or after December 22, 2017. In Notice 2018-23 (issued on April 9, 2018), the IRS provided transition guidance on the requirement under IRC Section 162(f)(2)(A)(ii) to identify an amount paid or incurred as restitution, remediation or an amount paid to come into compliance with a law (identification requirement), as well as the information reporting requirement under IRC Section 6050X. The Notice delayed the information reporting requirement until the date specified in the proposed regulations. The Notice also indicated that the identification requirement is satisfied if the order or agreement expressly states that an amount is paid or incurred as restitution, remediation or to come into compliance with a law. The proposed regulations would generally disallow deductions for amounts paid or incurred by suit, agreement or otherwise to, or at the direction of, a government or governmental entity for the violation, investigation or inquiry into the potential violation of any civil or criminal law. This provision would apply "regardless of whether the taxpayer admits guilt or liability or pays the amount imposed for any other reason, including to avoid the expense or uncertain outcome of an investigation or litigation." The proposed regulations, however, would allow deductions for amounts identified as restitution or remediation, or amounts paid or incurred to come into compliance with a law, if the taxpayer establishes that the amount was paid or incurred for the purpose identified. The proposed regulations define "government or governmental entity" as (i) the government of the United States, a State, or the District of Columbia, (ii) the government of a territory of the United States, and (iii) the government of a foreign country. The definition also includes (1) a federally recognized Indian tribal government or subdivision; (2) a political subdivision of, corporation or other entity serving as, an agency or instrumentality of, any government; or (3) a nongovernmental entity treated as a governmental entity. Additionally, the proposed regulations would adopt the definition of "nongovernmental entity" in IRC Section 162(f)(5). Under the proposed regulations, a nongovernmental entity would be treated as a governmental entity if it exercises self-regulatory powers in connection with a qualified board or exchange. A nongovernmental entity also would be treated as a governmental entity if it exercises self-regulatory powers, such as adopting or enforcing laws and imposing sanctions, to perform an essential governmental function. The term "governmental entities" would include nongovernmental entities treated as governmental entities. The proposed regulations would consider an amount paid or incurred to be restitution or remediation if the amount restores, in whole or in part, the person, government, governmental entity or property harmed by the violation or potential violation of the law. In response to comments on Notice 2018-23, the proposed regulations would clarify the Government's position that restitution does not include forfeiture and disgorgement. Similarly, restitution and remediation do not include "any amounts paid or incurred as reimbursement to the government or governmental entity for investigation costs or litigation costs from restitution or remediation." Thus, as discussed later, it is important that taxpayers determine and establish whether the restitution amount is paid (i) to compensate (which may be deductible), or (ii) to punish or deter (which is not deductible). The proposed regulations would treat a payment for a specific corrective action or to provide specific property as an amount paid to come into compliance with a law. Taxpayers must still determine whether to capitalize the amount paid to come into compliance. Commenters on Notice 2018-23 asked for clarification on whether amounts paid in the ordinary course of business, as required by law, would be included in amounts paid or incurred for an investigation or inquiry into the potential violation of a law. The IRS requests comments on situations in which audits, inspections or reviews conducted in the ordinary course of business would not be investigations or inquiries into potential violations of a law that would fall under IRC Section 162(f). The proposed regulations would require an order or agreement to specifically identify a payment or amount as restitution, remediation, or an amount paid to come into compliance with the law. The proposed regulations would allow the identification requirement to be met using a different form of the requisite words, such as "remediate" or "comply with the law." The IRS, however, may challenge the characterization of the amount identified. To rebut the presumption, the IRS would have to develop sufficient contrary evidence that the amount was not for the purpose identified in the order or agreement. The proposed regulations also would require taxpayers to provide documentary evidence that they were legally obligated to pay the amount identified in the order or agreement as restitution, remediation or an amount paid to come into compliance with a law (establishment requirement). The evidence should document the amount paid or incurred and the date on which the taxpayer paid or incurred the amount. The proposed regulations would include a non-exhaustive list of documents that may satisfy the establishment requirement. Those documents would include the legal or regulatory provision related to the violation or potential violation of the law, and correspondence between the taxpayer and the government. The proposed regulations would indicate that meeting the identification requirement alone is not sufficient to meet the establishment requirement. IRC Section 162(f)(4) prohibits IRC Section 162(f)(1) from applying to amounts paid or incurred as taxes due. "Taxes due" includes interest on taxes, but not interest on penalties. The proposed regulations would not apply to amounts paid or incurred as deductible taxes or related interest. If penalties are imposed, the proposed regulations would disallow a deduction for the interest paid on the penalties. If an amount is paid or incurred as restitution for failure to pay taxes imposed, the proposed regulations would permit a deduction under IRC Section 162(f)(1) that is otherwise allowed under Chapter 1. Deductions allowed under the proposed regulations would be taken into account under the IRC Section 461 rules and regulations or the rules applicable to the allowed deduction. If the deduction results in a tax benefit to the taxpayer, the proposed regulations would require the taxpayer to include in income the recovery of any amount deducted in a prior tax year to the extent the prior year's deduction reduced the taxpayer's tax liability in accordance with IRC Sections 61 and 111.
Under the proposed regulations, a material change to the terms of an order or agreement would include "changing the nature or purpose of a payment obligation; or changing, adding to, or removing a payment obligation, an obligation to provide services, or an obligation to provide property." A material change would not include "changing a payment date or changing the address of a party to the order or agreement." The proposed regulations also address the tax benefit rule. Under this rule, if an allowed deduction results in a tax benefit to the taxpayer, the taxpayer must include in income the recovery of any amount deducted in a prior tax year to the extent the prior year's deduction reduced the taxpayer's liability. A taxpayer's recovery of any amount deducted in a prior tax year includes, but is not limited to: (A) receiving a refund, recoupment, rebate, reimbursement or otherwise recovering some or all of the amount the taxpayer paid or incurred, or (B) being relieved of some or all of the payment liability under the order or agreement. An example in this context could involve an insurance recovery or other reimbursement received by the taxpayer. Generally, if the aggregate amount a payor must pay under an agreement or order exceeds a threshold amount (i.e., $50,000), the proposed regulations would require the appropriate official of a government or governmental entity that is a party to the order or agreement to file an information return with the IRS for the amounts paid or incurred and any additional information, including the payor's taxpayer identification number. The appropriate official also would have to provide a written statement with the same information to the payor. The definition for "government or governmental entity" under the IRC Section 6050X proposed regulations is narrower than the definition provided in the IRC Section 162(f) proposed regulations. Specifically, government or governmental entity under the proposed IRC Section 6050X regulations would include only the US government, state government, government of the District of Columbia, or a political subdivision, corporation or other entity serving as an agency or instrumentality of those governments. Under the proposed regulations, those entities would have to comply with the reporting requirement. Nongovernmental entities that exercise self-regulatory powers also would have to comply with the information reporting requirements. Unlike the proposed regulations under IRC Section 162(f), Indian tribal governments would not be included in the definition of "government or governmental entity." The definition also would exclude foreign governments, governments of US territories, or any political subdivision, corporation or entity serving as an agency or instrumentality of those governments. The proposed regulations would adopt the definition of "appropriate official" set out in IRC Section 6050X. The proposed regulations, however, would extend the definition to the officer or employee of the government or governmental entity assigned to comply with the information reporting requirement. If more than one government or governmental entity is a party to an order or agreement, the proposed regulations would require only the appropriate official of the government or governmental entity listed first on the order or agreement to comply with the information reporting requirement. Currently, the threshold amount for the information reporting requirement is $600 or more. Because of comments received from governments and governmental entities, the proposed regulations would increase the threshold amount to $50,000 or more. If the payment amount is not identified, but the government or governmental entity expects the amount the payor must pay to equal or exceed the threshold amount, the proposed regulations would require the appropriate official of the government or governmental entity to file an information return on Form 1098-F, Fines, Penalties, and Other Amounts, and provide a written statement to the payor. The proposed regulations would require the information return to include: (1) the aggregate amount a payor is required to pay; (2) the separate amounts required to be paid as restitution, remediation or to come into compliance with a law; and (3) any additional information required by the information return and related instructions. Currently, IRC Section 6050X(a)(3) requires the government or governmental entity to file the information return at the time it enters into an agreement. The proposed regulations would modify the filing requirement by requiring the government or governmental entity to file Form 1098-F with Form 1096, Annual Summary and Transmittal of US Information Returns, on or before the annual due date as provided in Prop. Reg. Section 1.6050X-1(b)(2). The proposed regulations would allow the appropriate official to satisfy the written statement requirement by providing the payor with a copy of Form 1098-F. The written statement would have to be provided on or before the date the appropriate official files the Form 1098-F. If more than one payor is individually liable for an amount in the agreement or order, the proposed regulations would require the appropriate official to file an information return for the separate amount that each payor must pay, even if the payor's liability is less than the threshold amount, and to provide a written statement containing the information to each payor. If more than one person is a party to an order or agreement, the appropriate official would not have to file an information return or provide a written statement to each person who does not have a payment obligation or obligation to provide service or property. If multiple payors are jointly and severally liable, the proposed regulations would require the appropriate official to file an information return for each payor with the aggregate amount to be paid by all jointly and severally liable payors. The appropriate official also would have to provide a written statement to each payor, regardless of which payor makes the payment. The proposed regulations would require the appropriate official to file the information return on or before January 31 of the year following the calendar year in which the order or agreement becomes binding under law, even if all appeals have not been exhausted. The Preamble to the proposed regulations notes that this due date differs from the March 31 due date for electronically filed information returns under IRC Sections 6041 through 6050Y, but the provisions of IRC Section 6050X take precedence over the general March 31 due date. If there is a material change to the order or agreement for which the appropriate official has filed an information return, the proposed regulations would require the appropriate official to file a corrected information return on or before January 31 of the year following the calendar year in which the material change is made. The appropriate official also would have to provide an amended written statement to the payor on or before the date the corrected information return is filed. Prop. Reg. Section 1.162-21 would apply to tax years beginning on or after the date the final regulations are published in the Federal Register, except that such rules would not apply to amounts under any order or agreement that became binding before such date. Taxpayers may rely on the proposed regulation until it is adopted as final, but only if they apply the rules consistently and in their entirety. The proposed regulations under IRC Section 6050X would apply only to orders and agreements that are binding on or after January 1, 2022. The proposed regulations confirm that taxpayers must satisfy both the identification requirement and the substantiation (establishment) requirement. Simply identifying a payment as restitution, remediation, or made to come into compliance is not enough to support deductibility. Under the proposed regulations, failure to meet these identification and establishment requirements will result in the payments being non-deductible. Further, the proposed regulations specify that the IRS may nonetheless attempt to challenge a presumption created by the identification of an amount as restitution, remediation or an amount paid to come into compliance with a law. Accordingly, the nature and purpose of the payment must be appropriately substantiated and documented. This requires proof that the intent behind the payment is restorative and compensatory and not punitive or to deter. Proof of intent also will require consistent underlying facts (e.g., communications and other conduct between the taxpayer(s) and the government). Thus, taxpayers need to gather evidence (e.g., documents relevant to the purpose, nature, and the calculation of the amount, communications with the government, relevant underlying law to which the amount relates, etc.) showing the payment is intended to restore the payee to its position before any violation of the law and to compensate the payee for the harm suffered. Considering the nature of many investigations, lawsuits and settlements, taxpayers would benefit from collecting contemporaneous documentation from the legal process to support both the identification and substantiation requirements. Analysis of events related to the settlement or order from the inception of the violation or potential violation at issue through the resolution also would be appropriate for understanding the true nature of the payment. Determining whether an amount qualifies as "restitution" may require more analysis than taxpayers might expect. Simply labeling an amount as "restitution" does not necessarily mean the amount qualifies as restitution under IRC Section 162(f). Taxpayers will need to examine whether the payment is made for harm suffered and a return to the status quo before an injury, without also being a means of punishment, such as in the case of forfeiture or disgorgement. Additionally, they will also need to examine whether the circumstances suggest that a payment is voluntary or made in lieu of a fine or penalty, neither of which is deductible. Ambiguities in settlement agreements in this context may result in continued controversies between taxpayers and the IRS. As previously noted, the proposed regulations state that an amount may satisfy the identification requirement even if the agreement does not identify a specific amount. However, the order or agreement must describe the damage done, harm suffered, or manner of noncompliance with a law, and describe the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property. Accordingly, taxpayers should pay particular attention to the description in the order or agreement if an amount is not specifically identified. Additionally, the proposed regulations define what it means "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 or providing property), or a combination of both. Taxpayers may find this definition helpful if they are required to provide services or take action under an order or agreement. Even if an amount qualifies as restitution, remediation, or an amount paid to come into compliance, the amount may not be currently deductible. As with any expenditure, an analysis must be conducted to determine whether the amount should be capitalized. Furthermore, an obligation related to a violation of law may be a payment liability for economic performance purposes and only incurred under IRC Section 461 when paid. See Treas. Reg. Section 1.461-4(g)(2). The IRS has asked for comments on a variety of issues, including how taxpayers may meet the identification requirement with respect to lump-sum payments, multiple damage awards and multiple taxpayers. IRC Section 162(f) does not expressly address this type of fact pattern. The IRS also may receive comments on fact patterns involving so-called "whistle-blower" statutes and analogous relator fact patterns, whereby a party notifies the government of a violation or potential violation of a law and, as such, relates facts upon which an action is based. The whistle blower may serve as the party of interest in a fine or penalty related proceeding. Various fact patterns may exist depending in part on the underlying statute (e.g., Foreign Corrupt Practices Act; False Claims Act). The proposed regulations do not address the implications of whistle blower fees in the context of IRC Section 162(f). As information returns under IRC Section 6050X must describe the nature of a payment, taxpayers might be tempted to rely on them as proof that the payment qualifies as restitution, remediation or an amount paid to come into compliance. The proposed regulations make clear, however, that relying on these information returns alone is not an option. Rather, taxpayers must rely on the underlying agreement or settlement to support their claim that a payment satisfies identification and establishment requirements and is therefore deductible.
Document ID: 2020-1315 | |||||||||||||||
