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In TAM 202434011, the IRS has ruled a taxpayer may neither deduct under IRC Section 162(a), nor capitalize and depreciate under IRC Sections 263 or 263A, fines or similar penalties paid to the government for violating a law. The IRS rejected the taxpayer’s assertion that a quid pro quo, in which the state agency would reduce or eliminate the fine in exchange for Taxpayer alleviating the harms caused by its violations in some other way (such as making a payment other than to the government), was required for a payment to be characterized as a fine or penalty. (Note, this TAM addresses and applies IRC Section 162(f) and the related regulations as in effect before the Tax Cuts and Jobs Act (TCJA).  Current law would require a deductible payment constituting restitution, remediation or coming into compliance with the law, to satisfy the identification and establishment requirements).

Facts

Parent, a publicly traded corporation, is a holding company and files a consolidated US federal income tax return for an affiliated group (Taxpayer) that includes Subsidiary, Parent’s primary operating subsidiary.

In a civil proceeding conducted by a state agency, Subsidiary was found to have violated several provisions of the State Code, and the agency imposed penalties. Additionally, the IRS is auditing Taxpayer’s Year 1 and Year 2 tax returns. The IRS and Taxpayer agree that IRC Section 162(f)(1) prohibits taxpayers from deducting certain penalties.

Analysis

Fines or similar penalties

IRC Section 162(f) does not allow taxpayers to claim a deduction under IRC Section 162(a) for fines or similar penalties paid to the government for violating a law.

Citing Waldman v. Commissioner, 88 T.C. 1384, 1387 (1987), aff’d, 850 F.2d 611 (9th Cir. 1988), the IRS noted that courts “have long held that [IRC S]ection 162(f) prohibits a deduction for liabilities ‘imposed for purposes of enforcing the law and as punishment for the violation thereof,’ or otherwise imposed for the purpose of deterring future proscribed conduct.” Nonpunitive penalties, such as those to compensate another party, do not fall under the IRC Section 162(f) prohibitions. If a penalty could be both punitive and nonpunitive, courts consider the primary purpose of the penalty. See Waldman, 88 T.C. at 1387.

After assessing the primary purpose of the penalties imposed on Subsidiary, the IRS ruled the state agency imposed the penalties for punitive purposes because Subsidiary violated the law.

Amounts paid to the government

In Waldman, the taxpayer pleaded guilty to conspiracy to commit grand theft, and the trial court stayed the taxpayer’s prison sentence if the taxpayer agreed to pay restitution to his victims. The Tax Court found the trial court’s primary purpose for imposing the restitution, instead of incarceration, was punishment for a crime. Therefore, the Tax Court held the restitution was a nondeductible penalty under IRC Section 162(f).

In Allied-Signal, Inc. v. Commissioner, T.C. Memo. 1992-204, aff’d in unpublished opinion, 54 F.3d 767 (3d Cir. 1995), the taxpayer violated environmental laws, and the trial court sentenced the taxpayer to the maximum criminal fine. The trial court, however, wanted the fine allocated to the parties harmed by the taxpayer’s violations, but didn’t have the authority to allocate the fine. As a result, the trial court indicated it would be receptive to reducing the fine if the taxpayer took action to alleviate the harms caused by the violations. The taxpayer established an environmental endowment to research and remedy the effects of its crimes and contributed $8 million to the endowment. The trial court reduced the fine by approximately $8 million. The Tax Court assessed the arrangement that resulted in the $8 million contribution and ruled the primary purpose of the contribution and the statute giving rise to the penalty “was to enforce the law and exact punishment, and that on balance this purpose outweighed any remedial purpose or other effect served by the endowment arrangement.” Thus, the Tax Court held the $8 million contribution to the environmental endowment was a fine or similar penalty for purposes of IRC Section 162(f).

Citing Waldman and Allied-Signal, Taxpayer argued the state agency could not impose the fine without offering a quid pro quo in which the state agency would reduce or eliminate the fine in exchange for Taxpayer alleviating the harms caused by its violations in some other way. The IRS rejected Taxpayer’s argument and ruled that, unlike the trial court in Allied-Signal, the state agency was authorized to impose the significant fine and did not need to obtain Taxpayer’s agreement.  Accordingly, the IRS concluded Taxpayer must pay the fines to the government under IRC Section 162(f).

Capital expenditures

The IRS ruled Taxpayer may not capitalize the amounts paid as fines because the public policy doctrine and IRC Sections 263(a) and 263A prohibit amounts that are analogous to fines or penalties from being capitalized.

Under the public policy doctrine, deductions are disallowed when allowing them “‘would frustrate sharply defined national or state policies proscribing particular types of conduct, evidenced by some governmental declaration thereof.’” The IRS noted that IRC Section 162(f) effectively codifies the public policy doctrine, but courts also “apply the judicial public policy doctrine to limit tax benefits when warranted.”

Because the fine resulted from Taxpayer’s violation of the law, the IRS ruled Taxpayer could not capitalize the amounts paid out in fines because allowing those amounts to be capitalized “would undermine State’s ability to enforce that policy as intended by blunting the punitive and deterrent effect of State’s penalty provisions.”

Additionally, the IRS ruled Taxpayer could not capitalize its costs of complying with the state laws under IRC Sections 263(a) and 263A because the capital expenditures stem from a fine or other penalty under IRC Section 162(f), so Taxpayer cannot take those expenditures into account when determining its taxable income.  The last sentence of IRC Section 263A(a)(2) expressly states that, “[a]ny cost which (but for this subsection) could not be taken into account in computing taxable income for any taxable year shall not be treated as a cost described in this paragraph.”  The IRS noted that “Congress intended [IRC S]ection 263A to provide a uniform approach to determining the types of costs that must be capitalized to property produced by a taxpayer, and within that uniform approach, costs could not be capitalized under [IRC S]ections 263(a) or 263A unless they may be taken into account in determining taxable income under another provision of the Code.” The IRS also pointed out that IRC Section 263A(a)(2)’s legislative history clarifies that an amount that is not allowable in determining taxable income “may not be capitalized and recovered through depreciation or amortization deductions, as a cost of sales, or in any other manner.”

Costs incurred to reimburse state agency

Under Treas. Reg. Section 1.162-21(b)(2), fines and penalties do not include legal fees and expenses related to a civil action arising from the violation of a law. Fines and penalties also do not include compensatory damages paid to a government. The IRS noted reimbursements fall under the exception in Treas. Reg. Section 1.162-21(b)(2), and IRC Section 162(f) will not prohibit a deduction for those costs.

Therefore, the IRS ruled Taxpayer may deduct the costs paid to reimburse the state agency for costs associated with the investigation of Taxpayer’s violations.

Implications

This technical advice memorandum demonstrates the ongoing scrutiny by the IRS in distinguishing between currently deductible compensatory amounts and nondeductible fines and penalties, which are subject to IRC Section 162(f). The IRS clearly rejected the taxpayer’s assertion that a quid pro quo, in which the state agency would reduce or eliminate the fine in exchange for Taxpayer alleviating the harms caused by its violations in some other way (such as making a payment other than to the government), was required for a payment to be characterized as a fine or penalty. The IRS further ruled that IRC Sections 263(a) and 263A do not offer a path to capitalization of nondeductible fines and penalties subject to IRC Section 162(f).

As noted, this TAM dealt with IRC Section 162(f) before it was amended by the TCJA.  These continued controversies underscore the importance of carefully negotiating and documenting settlements to meet the identification and establishment provisions of IRC Section 162(f), as revised by the TCJA, and the underlying regulations to the extent the settlements in whole or in part relate to restitution (including remediation of property) and/or coming into compliance with the law.