The IRS has issued final regulations (T.D. 9946) providing guidance on the disallowance of a deduction for certain 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), as amended by the Tax Cuts and Jobs Act (TCJA), and the related reporting requirements under IRC Section 6050X. The final regulations adopt, with significant modifications, the proposed regulations (REG-104591-18) published in the Federal Register on May 13, 2020.

Background

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 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:

• Amounts paid or incurred that a taxpayer identifies and establishes as:
• Restitution or remediation (i.e., compensatory amounts) or
• Paid to come into compliance with a law
• Amounts paid or incurred with respect to private party suits
• Certain taxes due

IRC Section 162(f)(2)(A), regarding the exception for restitution, remediation and amounts paid to come into compliance with a law, introduces an identification requirement and an establishment requirement, both of which must be satisfied in order to meet these exceptions to the disallowance of a deduction.

IRC Section 162(f)(2)(B), however, prohibits deductions for payments reimbursing the government for its legal or investigation 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 or 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.

On May 13, 2020, the IRS issued proposed regulations under IRC Sections 162(f) and 6050X. The preamble to the proposed regulations indicated that 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 were allowed to rely on the proposed regulation until it was adopted as final, but only if they applied 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.

Final IRC Section 162(f) regulations

The final regulations 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 by the government or governmental entity into the potential violation of any civil or criminal law. This provision applies 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." In the preamble to the final regulations, the IRS indicates that an admission of guilt or liability is not required because IRC Section 162(f)(1) is broad in its disallowance of the deductions.

The final regulations, however, allow exceptions to the disallowance for amounts identified as restitution or remediation (i.e., compensatory amounts), or amounts paid or incurred to come into compliance with a law, if the order or agreement identifies the amount as such and the taxpayer establishes that the amount was paid or incurred for the purpose identified.

Restitution and remediation

An amount constitutes restitution or remediation if the amount is "paid or incurred to restore, in whole or in part," the person, entity or property (including the environment, wildlife or natural resources) "harmed, injured or damaged by the violation or potential violation of any law described in [Treas. Reg. Section 1.162-21(a)(3)] to the same or substantially similar position or condition as existed prior to such harm, injury or damage." Example 3 in the final regulations provides a situation in which Corp. B is under investigation for a potential violation of State X's emissions standards law. Corp. B enters into an agreement with State X where it agrees, among other things, to construct a nature center in a local park for the benefit of the community. The example explains that "Corp. B may not deduct the amounts paid to construct the nature center because no facts exist to establish that the amount was paid either to come into compliance with a law or as restitution or remediation."

This exception applies to both criminal and civil restitution. However, as the preamble notes, it would be more difficult for a taxpayer to establish that an amount paid is restitution in the criminal context due to the punitive purpose underlying most criminal liability.

In a significant change from the proposed regulations, the final regulations provide that neither disgorgement nor forfeiture will be subject to a per se disallowance under the final regulations. Rather, amounts paid or incurred as disgorgement or forfeiture may qualify as restitution and therefore be permitted a deduction if (1) the amount is otherwise deductible; (2) the order or agreement identifies the amount, not in excess of net profits, as restitution, remediation, or paid to come into compliance; (3) the taxpayer establishes the amount was paid as restitution, remediation, or to come into compliance; and (4) the origin of the taxpayer's liability is restitution, remediation, or to come into compliance.

Amounts that are paid or incurred to a segregated fund or account and that meet the identification and establishment requirements may satisfy the restitution or remediation exception to a deduction disallowance. However, no amount will constitute restitution, remediation, or paid to come into compliance if it is disbursed to a general account of a government or governmental entity for general enforcement efforts or other discretionary purposes. Example 4 in the regulations describes the following situation:

Corp. D enters into an agreement with governmental entity, Trade Agency, for engaging in unfair trade practices in violation of Trade Agency laws. The agreement requires Corp. D to pay $80X to a Trade Agency fund, through disgorgement of net profits, to be used exclusively to pay restitution to the consumers harmed by Corp. D's violation of Trade Agency law. Corp. D pays $80X to Trade Agency fund and Trade Agency disburses all amounts in the restitution fund to the harmed consumers.

Because the agreement identifies the $80X payment as restitution and Trade Agency uses the funds to provide restitution, and does not use it for general enforcement or discretionary purposes, the $80X will not be disallowed as long as Corp. D establishes the $80X constitutes restitution.

Example 13 provides that:

Accounting Firm was convicted of embezzling $500X from Bank in violation of State X law. The court issued an order requiring Accounting Firm to pay $100X in restitution to Bank. The court also issued an order of forfeiture and restitution for $400X, which was seized by the State X officials. Accounting Firm paid $100X to Bank. The $400X seized was deposited with Fund within the State X treasury and, at the discretion of the State X Attorney General, was used to support law enforcement programs.

In this example, the $400X identified as forfeiture and restitution will be subject to the disallowance under IRC Section 162(f) because the amounts are used by the government for discretionary purposes and therefore do not constitute restitution.

In response to comments requesting a special restitution and remediation rule for amounts paid or incurred for irreparable harm to the environment, natural resources or wildlife, the final regulations modify the proposed regulations' definition of "restitution, remediation of property, and amounts paid to come into compliance with a law" to include amounts paid or incurred for restitution or remediation of the environment, natural resources or wildlife. To constitute restitution or remediation, the taxpayer must pay or incur the amounts "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." Importantly, the amounts paid or incurred also must have a strong "nexus with the harm that the taxpayer has caused or is alleged to have caused."

If amounts paid or incurred, under an order or agreement, to an entity, fund, group, or government or governmental entity are returned to the taxpayer, the taxpayer will have to include those amounts in its income under the tax benefit rule.

Coming into compliance with a law

The final regulations adopt the proposed regulations' rules on coming into compliance with a law. The final regulations treat an amount paid or incurred for "performing services; taking action, such as modifying equipment; providing property" or any combination thereof as an amount paid to come into compliance with a law, provided that such actions are taken to come into compliance with the law that has been violated or potentially violated. Reimbursements to a government or governmental entity for its litigation or investigation costs related to the violation or potential violation of a law, as well as amounts paid at the taxpayer's election in lieu of a fine or penalty, will not constitute an amount paid or incurred to come into compliance with a law.

Additionally, the final regulations modify an example to clarify that if an order or agreement requires a taxpayer to come into compliance with a law and the taxpayer decides to upgrade equipment or property to a higher standard than what is required, amounts paid or incurred in excess of the amount paid or incurred to come into compliance will not be disallowed under IRC Section 162(f)(1). In the preamble, the IRS notes that the excess amounts are not paid or incurred to, or at the direction of, a government or governmental entity for the violation of a law or the investigation or inquiry into the potential violation of a law.

Identification and establishment requirements

The final regulations adopt, with certain modifications, the proposed regulations' identification requirement provisions, which 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 final regulations also clarify that the order or agreement must meet the identification requirement, not the taxpayer.

The final regulations allow the identification requirement to be met if the order or agreement uses a different form of the requisite words, such as "remediate" or "comply with the law," and describes the purpose for which the amount will be paid or the law with which the taxpayer must comply. Significantly, the order or agreement may describe the damage done, harm suffered or manner of noncompliance with a law, and the action required of the taxpayer for restitution, remediation or compliance purposes to satisfy the identification requirement.

The rule pertaining to when a payment amount is not identified provides that where an estimated payment amount is not included in the order or agreement, the identification requirement may be met if "the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property." The final regulations modify this rule to apply also "to orders or agreements that impose lump-sum payment judgments for 'restitution, remediation, and coming into compliance,' or that involve multiple taxpayers or multiple damage awards." Therefore, the identification requirement may be met "even if the order or agreement does not allocate the total lump-sum payment amount or multiple damage award among restitution, remediation, or to come into compliance or allocate the total payment among multiple taxpayers."

The final regulations eliminate the rebuttable presumption rule, which allowed the IRS to challenge the characterization of the amount identified.

The final regulations adopt the establishment requirement in the proposed regulations, with certain modifications. To meet the establishment requirement, the taxpayer must use documentary evidence to prove (1) its legal obligation to pay the amount identified in the order or agreement as restitution, remediation or an amount paid to come into compliance with a law; (2) the amount paid or incurred; (3) the date the amount was paid or incurred; and (4) "that, based on the origin of the liability and the nature and purpose of the amount paid or incurred," the amount was for restitution or remediation or to come into compliance with a law. This fourth requirement was added by the final regulations.

The final regulations also expand the non-exhaustive list of documents that may satisfy the establishment requirement.

Both the identification and the establishment requirements must be met for an amount to meet the exception for amounts that are restitution, remediation, or paid to come into compliance. Example 8 in the final regulations underscores this point. In that example, Corp. C is required to pay the harmed party $50X in restitution and $150X in treble damages pursuant to a court order related to a violation of the False Claims Act. The example explains that because "[t]he order identifies the $50X Corp. C is required to pay as restitution," the amount will not be disallowed under IRC Section 162(f) as long as "Corp. C establishes … that the amount paid was for restitution." The $150X in treble damages, however, will be disallowed under IRC Section 162(f).

By suit, agreement or otherwise

An amount incurred "by suit, agreement, or otherwise" includes amounts incurred under "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."

Binding order

The proposed regulations under IRC Section 6050X would have treated an order or agreement as binding even if all appeals have not been exhausted. The final regulations adopt the same definition of "binding" for IRC Section 162(f).

Government and governmental entity

The proposed regulations would have defined "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 included (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.

The final regulations reorganized the regulations to define "government" in Treas. Reg. Section 1.162-21(e)(1) and "governmental entity" in Treas. Reg. Section 1.161-21(e)(2). While the definitions are based on those in the proposed regulations, the final regulations clarify that a political subdivision of a government includes a local government unit.

Nongovernmental entity

The proposed regulations would have treated a nongovernmental entity as a governmental entity if it exercises self-regulatory powers in connection with a qualified board or exchange. A nongovernmental entity also would have been 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 have included nongovernmental entities treated as governmental entities.

The final regulations clarify that a nongovernmental entity's self-regulatory powers include enforcing rules, not laws. They also adopt the proposed regulations' rule that a government entity "includes a nongovernmental entity treated as a governmental entity."

Investigation or inquiry

In response to comments requesting clarification on the investigation or inquiry by governments or governmental entities into the potential violation of any law, the final regulations clarify that amounts are not paid or incurred in relation to the potential violation of any law if the amounts paid or incurred are for routine investigations or inquiries, which are (1) required to ensure compliance with rules and regulations applicable to the business or industry, and (2) not related to any evidence of wrongdoing or suspected wrongdoing. Accordingly, IRC Section 162(f) will not "disallow an otherwise deductible ordinary and necessary business expense for amounts paid or incurred for … routine investigations and inquiries."

Taxes

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. If penalties are imposed for otherwise deductible taxes, the final regulations will not allow a taxpayer to deduct the penalties or the interest paid with respect to the penalties.

Other provisions

The final regulations eliminate the material change rule, which subjected some orders issued, or agreements entered into, before December 22, 2017, to IRC Section 162(f)(1) as amended by the TCJA. This change is a significant simplification.

The preamble mentions qui tam litigation, where a case is brought by a private citizen on behalf of the government, before stating that the final regulations "do not adopt a single rule concerning qui tam cases" and explaining that "certain principles apply to determine whether a deduction for the amounts paid or incurred will be allowed." Because the government is generally the real party in interest in such cases, and receives any funds paid pursuant to a resulting order or agreement, the preamble states that any amount paid or incurred as a result of the suit will likely be disallowed unless one of the exceptions under IRC Section 162(f)(1) applies.

Final IRC Section 6050X regulations

Generally, if the aggregate amount a payor must pay under an agreement or order exceeds a threshold amount (i.e., $50,000), the final regulations 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 must provide a written statement with the same information to the payor.

Government, governmental entity and nongovernmental entity

The final IRC Section 6050X regulations reorganize the regulations to define "government" in Treas. Reg. Section 1.6050X-(f)(2) and "governmental entity" in Treas. Reg. Section 1.162-21(f)(3). The final regulations also clarify that a political subdivision of a government includes a local government unit and that a governmental entity includes a nongovernmental entity treated as a governmental entity.

For information reporting purposes, the final regulations clarify that a nongovernmental entity treated as a governmental entity does not include a nongovernmental entity of a US territory, including American Samoa, Guam, the Northern Mariana Islands, Puerto Rico or the US Virgin Islands. It also does not include a foreign country or an Indian tribe.

Suit or agreement

The final regulations clarify that a government or governmental entity involved in a suit or agreement to which IRC Section 6050X(a)(2) applies must file an information return for amounts under IRC Section 6050X(a)(1). They also clarify that a suit or agreement is binding under applicable law even if all the appeals are not exhausted.

Payor

Under the final regulations, the payor is the person to which IRC Section 162(f) and Treas. Reg. Section 1.162-21 apply. The final regulations require the appropriate official to include the payor's taxpayer identification number (TIN) on the information return filed for the payor. If the appropriate official does not have the payor's TIN, the final regulations require the official to request the TIN from the payor.

Threshold amount

The final regulations increase the threshold amount for the information reporting requirement from $600 or more to $50,000 or more.

Return filing requirement

The final regulations require the appropriate official of a government or governmental entity to comply with the IRC Section 6050X information reporting requirements by filing Form 1098-F, Fines, Penalties, and Other Amounts, or any successor form, with Form 1096, Annual Summary and Transmittal of US Information Returns. The information return must be filed on or before the annual due date as provided in the final regulations. The information return must include: (1) the 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.

The appropriate official does not have to file information returns for each tax year in which a payor makes a payment under a single order or agreement. The final regulations require only one information return to report the amounts required by IRC Section 6050X(a)(1).

Multiple payors

Under an order or agreement, if more than one payor is individually liable for some or all of the payment amount, the final regulations require the appropriate official to file an information return for the separate amount each payor is required to pay. This provision applies even if the payor's amount is below the threshold amount. The appropriate official also must provide a written statement with this information to each payor. If multiple persons are parties to an order or agreement, the final regulations do not require information reporting or a written statement for "any person who does not have a payment obligation or obligation for costs to provide services or to provide property."

If an order or agreement identifies multiple jointly and severally liable payors, the final regulations require the appropriate official to file an information return for each payor and provide a written statement with this information to each payor.

Due dates

The final regulations require the appropriate official to file paper information returns on or before February 28 of the year following the calendar year in which the order or agreement becomes binding under law. For electronically filed information returns, the appropriate official must file on or before March 31 of that year. Appropriate officials must provide written statements to payors on or before January 31 of that year.

The final regulations eliminated the material change rule, which would have required 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 and provide an amended written statement to the payor on or before the date the corrected information return is filed.

Applicable dates

Treas. Reg. Section 1.162-21 applies to tax years beginning on or after the date the final regulations are published in the Federal Register, except that such rules do not apply to amounts under any order or agreement that became binding before such date.

Treas. Reg. Section 1.6050X-1 applies only to orders and agreements that are binding on or after January 1, 2022.

Implications

The final regulations under IRC Section 162(f), in general, include many taxpayer-favorable modifications to the proposed regulations that were released May 13, 2020. However, many of these provisions require a careful, nuanced analysis of a taxpayer's facts. Further, the final regulations provide a very broad definition of "suit, agreement, or otherwise," providing an expansive reach as to the payments to which the deduction disallowance under IRC Section 162(f) may apply. Also, the final regulation definitions of governmental and non-governmental entities, as well as regulation examples, warrant careful consideration. As such, the regulations have broad application across industries.

Most notably, the final regulations seem to adopt an "origin of the claim" analysis approach to determining whether an amount constitutes restitution, remediation, or paid to come into compliance such that it is excepted from the general disallowance of a deduction. This origin of the claim analysis is adopted under the "origin of the liability" prong of the establishment requirement. Under this analysis, a taxpayer will need to consider not only the settlement agreement or order, for example, but also the underlying legal claim and statutory provisions that give rise to the liability and determine whether the purpose of such claim is compensatory or related to compliance with the law or, alternatively, punitive in nature (or whether both aspects are involved in more complex, diversified controversies). Consideration of applicable laws is necessary and can be complicated in the context of class action settlements that involve multiple jurisdictions.

Further, while the final regulations removed a number of per se rules set forth in the proposed regulations, such as for disgorgement, forfeiture, and the identification requirement, the modified definitions often require a nuanced facts and circumstances analysis to determine whether a taxpayer's specific facts fall under the exceptions. For example, while the identification requirement no longer mandates a settlement agreement or order use the specific terms from the statute (restitution, remediation, or to come into compliance), the modified test may require a detailed analysis of a taxpayer's settlement agreement or order to determine whether this requirement is satisfied. Further, while the elimination of the disgorgement and forfeiture per se rules may benefit taxpayers, determination as to whether disgorgement or forfeiture may qualify for the exception to the general disallowance will now rely on an origin of the claim analysis of the underlying claims. Also, the establishment requirement requires a taxpayer to provide documentary evidence to support (1) its legal liability to make the payment; (2) the amount of the payment; and (3) the date the amount was paid or incurred. In addition, the document evidence must prove that the origin of the liability supports its classification as restitution, remediation, or paid to come into compliance. Because of the necessary documentary evidence and the need for appropriate language in the agreement or order, taxpayers may want to confer with tax advisors early in the process.

While the preamble to the final regulations briefly addresses qui tam litigation and relator fees, this issue does not seem entirely settled. The preamble seems to take the position that qui tam litigation resulting in an amount being paid to a government (and then from the government to the relator) would generally be disallowed under IRC Section 162(f) because the government is generally the real party in interest. However, this fails to consider the variety of forms qui tam litigation can take under various federal, state, and local statutes or regulations.

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