Settlement labels did not control Section 162(f) treatment of payments

Plain-English summary

A taxpayer sought business-expense deductions for payments resolving government lawsuits and for a separate disgorgement payment. Chief Counsel advised that language in the settlement agreement did not control whether the payments were deductible under Section 162(a) or barred as fines or similar penalties under Section 162(f). The analysis instead turns on the origin and primary purpose of each liability, including whether it was compensatory or punitive. The settlement covered statutes and requested remedies with both compensatory and punitive features, and it did not allocate the payments between them. Disgorgement can also be compensatory or punitive depending on the facts, and depositing funds for possible victim compensation does not by itself decide the issue. The taxpayer bore the burden of substantiating a compensatory purpose, and Chief Counsel concluded that additional factual development was needed for the disgorgement payment.

Ruling snapshot

• Question: Did settlement language control deductibility, and was the disgorgement payment deductible rather than a Section 162(f) penalty?
• Outcome: Advice given: the settlement language was not controlling, and the disgorgement issue required more facts.
• Key authorities: IRC § 162(a) and (f); Treas. Reg. § 1.162-21; Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497 (1980); Bailey v. Commissioner, 756 F.2d 44 (6th Cir. 1985)

Full text (IRS public release)

           Office of Chief Counsel
           Internal Revenue Service
           Memorandum
           Number: 201825027
           Release Date: 6/22/2018
           CC:ITA:B02: CJWrobel
           PREF-101675-16

 UILC:     162.00-00, 162.05-03, 162.21-01

  date:    November 18, 2016

     to:   -------------------------------------------------------------
           (Large Business & International)

  from:    Norma Rotunno
           Senior Technician Reviewer
           Branch 2
           (Income Tax & Accounting)


subject:   Tax Treatment of Settlement Payments

           This Chief Counsel Advice responds to your request for assistance. This advice may
           not be used or cited as precedent.

           LEGEND

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           -------------- = ----------------
           -------------- = ------------
           ---------------= --------------
           ---------------= ------------
PREF-101675-16                                           2

---------------= ---
---------------= --
---------------= --
Business 1 = ------------------------------------------------
Court 1 = -----------------------------------------------------------------------------------
Date 1 = -----------------------
Date 2 = -----------------------
Entity 1 = ----------------------------------------------------------------
----------------------------= --------------------------------------------------------------------------------------
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---------------------------------------------------------------------------------------------------------
 ----------------------------= -------------
--------------------------- = ------------
--------------------------- = -------------
----------------------------= --------
----------------------------= --------------
 ----------------------------= ---------------
 --------------------------- = ----------
 --------------------------- = ----------------
 --------------------------- = ------
 ----------------------------- = --------
-----------------------------= -------------------
-----------------------------= ------------------
-----------------------------= ----------------
Subsidiary 1= --------------------------------------------------------
Subsidiary 2 = --------------------------------------------
Taxpayer = -----------------------------------------------------------------------------------------------------
Year 1 = ------

ISSUES

(1) Whether certain language in the settlement agreement at issue is controlling for
purposes of characterizing the settlement payments as deductible under section 162(a)
of the Internal Revenue Code or nondeductible under section 162(f) for federal income
tax purposes; and

(2) Whether a disgorgement payment to settle proceedings initiated by ----------------------
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---------------------------------------------------------------------- is deductible under section 162(a)
or nondeductible under section 162(f).

CONCLUSIONS
PREF-101675-16                                           3

(1) The provisions in the settlement agreement at issue are not controlling for purposes
of characterizing the settlement payments as deductible or not deductible for federal tax
purposes.


(2) Additional factual development is necessary to determine whether the disgorgement
payment to ------------is deductible under section 162(a) or nondeductible under section
162(f).

FACTS

         In Year 1, Subsidiary 2 made payments to settle lawsuits brought by ----------------
-----------------------------------------------. The complaints in the lawsuits brought by the
----------------------------------alleged ------- and violations of ------ ------------------------statutes
in connection with ------------------------------- Subsidiary 1 and Subsidiary 2 of, for
example, --------------------------------------------------------------------------------------------------------
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----------------------- (the Lawsuits).

         For its Year 1 taxable year, Taxpayer seeks to deduct under section 162(a) a
total of Amount paid to settle the Lawsuits brought against Subsidiary 1 and Subsidiary
2 by the ---------------------------. The Lawsuits involved losses incurred by the
---------------------------------themselves, -------------------------------------------------------------------
--------------------------------, in connection with ----------------------------------------------------------
Subsidiary 1 and Subsidiary 2 of -----------------------. In addition, Taxpayer seeks to
deduct -------------in disgorgement paid to --------------------------------------------------------------
----------------------------------------------------------.

            1. The Lawsuits

         On Date 1---------------------------------------------filed a complaint in Court 1 against
Subsidiaries 1 and 2, pursuant to the -------------------------------------------------------------------
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----------------------------------------------------, ------------in connection with --------------------------
----------------- -------------Subsidiary 1 and Business 1 for -----------------------. In addition,
the --------------------------------------------------------------------------------------------------.

         The ------ statutes on which the --------------------------- based the Lawsuits include
various ----------------------------------------------------------------------------------------------------------
-------------------------------------- statutes that generally provide both punitive and
compensatory remedies. For example, in their prayers for relief, most of the complaints
in the Lawsuits asserted claims for civil penalties; most of the ---------------------------
asserted claims for injunctive relief, attorneys’ fees and costs of litigation, an
accounting, and disgorgement; ---------------of the ----------------------------asserted claims
PREF-101675-16                                                             4

for restitution; -------------- of the ----------------------------asserted claims for pre-judgment
and post-judgment interest; and ---------------of the ----------------------------requested treble
damages.

         On Date 2, Subsidiaries 1 and 2 entered into a settlement agreement with --------
and the ----------------------------in order to settle the ------Lawsuit and all claims alleged in
the complaints in the Lawsuits (the Settlement Agreement). The Settlement Agreement
contains no admissions of violations of any law by Subsidiary 1 or Subsidiary 2. ----------
---------------------------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------------- -- Under
the terms of the Settlement Agreement, Subsidiary 1 and Subsidiary 2 agreed to pay a
total of -------------, consisting of an -------------payment to ------and an additional ------------
-- to --------------------among the ---------------------------.1

         The Settlement Agreement specifically characterizes the -------------payment to ---
-------as a -----------------------------recovered pursuant to the ---------------------------------------
----------------------------------------------------. Taxpayer has not deducted this amount for
federal income tax purposes.

         With respect to the ------------- payable to the ---------------------------, however,
---------------- ----- ----------------------------------------------------------------------------------------------
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--------------------------------------------

         -------------- ----------- ---------------------------------------------------------------------------------
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----------------------------------------

         In addition---------------------------- ----------------------------------------------------------, of
the ------------- received by -----------------------------, -------------is -------------------under
------------------------------------law. The remaining ------------ of the payment will be used for
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--------------.

         However, -------------- ------- ---------------------------------------------------that ---------------
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1
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PREF-101675-16                                                       5

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--------

         The Settlement Agreement also sets forth the specific portions of the -------------
paid to --------------------------------. Each -------------------------received -------------, except
the following ---------------------------: ----------------------------(-----------------------------------------
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--------------------------------------------; and ---------------------------------------------.

         The Settlement Agreement also describes the purposes for which some of the
-------------------------------would use ------share of the settlement payment, as set forth in
greater detail in your request. Funds would be used for purposes such as ------------------
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--------------------------------------. Some ----------------------------indicated that the amounts
would be deposited in --------------------------or used at the discretion of the -------------------
---------. The Settlement Agreement indicates that for ----------------------------------------------
--------------------------- and -----------------------------, part of the settlement proceeds would
be used to reimburse --------------------------for ----------------------------------------------------in
Subsidiary 1 and Subsidiary 2---------------------. Regarding the share of the settlement
proceeds that was designated for ---------------------------, the Settlement Agreement
provides that a portion would be deposited in ------------------------------------------ --

      Some of the ------------------------------by the ----------------------------shortly after the
execution of the settlement agreement describe the purposes for which the settlement
proceeds would be used. For example:

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2
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         ----------------------------for which the use of the settlement proceeds were
described in both the Settlement Agreement and --------------------included: ------------------
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-------------------------------------------------------------------------------.

            2. ------ Disgorgement Payment

         -------------brought an ----------------------------------------------------------------against
Business 1, a business unit of Subsidiary 1. In an --------------------------------------------------
------------------------------------------------------determined that Business 1 violated certain
provisions of the ----------------------------------------------------------------------------------------in
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connection with Business 1’s -------------------------------------------------. --------------------------
---------------------------------------------------------------------------------------------------------------------
---------------------------------------------------. -------------also determined that Business 1
received approximately ---------------in compensation from the -----------------------------------
---------------------------------------------------------------------------------------------------------------------
---------------- at issue. As a result of these violations-------------ordered Business 1 to
make the following payments: (1) a civil monetary penalty in the amount --------------------
(2) ------------- in disgorgement; and (3) ---------------in pre-judgment interest. Taxpayer
intends to claim a deduction for the disgorgement payment. Taxpayer did not deduct
the ---------------civil monetary penalty. -----------------------------------------------------------------
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----------------------------

LAW AND ANALYSIS

    1. Section 162(f)

        Section 162(f) of the Code provides that no deduction shall be allowed under
section 162(a) for any fine or similar penalty paid to a government for the violation of
any law. Section 1.162-21(b)(1) of the Income Tax Regulations provides that a fine or
similar penalty includes an amount: (i) paid pursuant to conviction or a plea of guilty or
nolo contendere for a crime (felony or misdemeanor) in a criminal proceeding; (ii) paid
as a civil penalty imposed by federal, state, or local law; (iii) paid in settlement of the
taxpayer’s actual or potential liability for a fine or penalty (civil or criminal); or (iv)
forfeited as collateral posted in connection with a proceeding that could result in
imposition of such a fine or penalty. Section 1.162-21(b)(2) provides, in part, that
compensatory damages paid to a government do not constitute a fine or penalty.

        Courts have held that section 162(f) prohibits a deduction for civil penalties
“imposed for purposes of enforcing the law and as punishment for the violation thereof.”
Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497, 652 (1980). Courts
also have held that some payments, although labeled as “civil penalties,” are deductible
if they are “imposed to encourage prompt compliance with a requirement of the law or
as a remedial measure to compensate another party for expenses incurred as a result
of the violation.” Id. See also Stephens v. Commissioner, 905 F.2d 667, 672-73 (2d Cir.
1990); Waldman v. Commissioner, 88 T.C. 1384, 1387 (1987), aff’d without opinion, 850
F.2d 611 (9th Cir. 1988). Compensatory payments generally “return the parties to the
status quo ante.” Stephens, 905 F.2d at 673. In contrast, a payment imposed primarily
for purposes of deterrence and punishment is not deductible under section 162(f).
Middle Atlantic Distributors Inc. v. Commissioner, 72 T.C. 1136, 1150 (1979), acq.,
1980-2 C.B. 2 (1980) (“if the deduction of a civil fine (or similar penalty) is to fall within
the proscription of section 162(f), the fine must be one which punishes and/or deters”).
See also Waldman, 88 T.C. at 1389. If a payment serves both a nondeductible purpose
PREF-101675-16                                           8

and a deductible purpose, it is necessary to determine which purpose the payment
primarily serves. Middle Atlantic Distributors Inc., 72 T.C. at 1145.

       In general, the characterization of a payment for purposes of section 162(f)
depends on the origin of the liability giving rise to it, not the ultimate use of the funds.
Bailey v. Commissioner, 756 F.2d 44, 47 (6th Cir. 1985) (holding that civil penalties that
a court permitted a taxpayer to apply to the settlement of a class action suit against the
taxpayer were not deductible under section 162(f) because the amount originally was
characterized by the court as a civil penalty).

        The taxpayer has the burden to show that the settlement payments were made to
compensate the parties harmed by its conduct through, for example, examining whether
the provisions of the statutes cited in the complaints on which the settlement payments
were based had largely compensatory, as opposed to punitive, purposes, the language
in the settlement agreement, and other evidence that demonstrates the parties’ intent.
Middle Atlantic Distributors Inc., 72 T.C. at 1150-53.

         Taxpayer argues that the -------------------------------------------------------------------------
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------------------------------------------------------------------- indicates that the parties intended
the settlement payments not to be a fine or similar penalty. However, Taxpayer ignores
-------------- ------- ----------------------------------------which provides that ---------------------------
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------------. Because the language of -------------------------is specific with respect to ---------
---------------------------------------------------------------------------------------------------------------------
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-------------------------------is, therefore, not determinative of the character of the settlement
payments for purposes of section 162(f).

         ------------------------------------------------------------------------------------------------------------
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---------------------------------------------------” but Taxpayer did not elaborate regarding how
the settlement payments further the compensatory and remedial goals of those statutes.
The statutes on which the ----------------------------based the Lawsuits contain both
punitive and compensatory forms of relief. In addition, the ----------------------------------
requested both punitive and compensatory relief ----------complaints. For example,
---------------------------------------------asked for restitution, which could be compensatory in
nature; disgorgement, which could be either compensatory or punitive; and civil
penalties, which could be punitive. ---------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
--------------------------------------------------------------------------. The Settlement Agreement
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does not apportion the settlement payments between compensatory and punitive
remedies --------------------------------------------------, yet Taxpayer argues that the
settlement payments were not intended by the parties to be fines, penalties, or
payments in lieu thereof. It is Taxpayer’s burden to substantiate why it believes that the
settlement payments it made to the ----------------------------are compensatory.

    2. Disgorgement

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         -----------------------------------------------

       For purposes of section 162(f), disgorgement in -------------------------------------can
be primarily compensatory or primarily punitive, depending on the facts and
circumstances of a particular case. In some cases, there may be certain facts that
weigh in favor of treating disgorgement as primarily compensatory for tax purposes. In
some cases, for example, the amount of the wrongdoer's profit may equal the victims'
losses. Furthermore-------------may be using disgorgement as a means to obtain
compensation -----------------------------who can receive distributions through a ---------------
PREF-101675-16                                          10

-----------------------Fund. See generally ------------------------------------------------------------------
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-------------------------------------------------------------

         Nevertheless, the fact that disgorgement goes to a fund does not always mean
that it is primarily compensatory. Bailey, 756 F.2d at 47 (the characterization of a
payment for purposes of section 162(f) depends on the origin of the liability giving rise to
it, not the ultimate use of the funds). By comparison, when ------------adds civil penalties
to a -----------------------------------------------------------, those amounts are not deductible by
the wrongdoer.

         On the other hand, disgorgement can be primarily punitive for tax purposes in
some cases, where it serves primarily to prevent wrongdoers from profiting from their
illegal conduct and deters subsequent illegal conduct. Courts may consider the amount
of the disgorgement ordered in determining the appropriate amount of a civil penalty to
be imposed for violation of -------------------, and such penalty amount may be less when
there is substantial disgorgement. See, e.g., --------------------------------------------------------
-------------------------------------------------------- Consequently, disgorgement can serve as a
direct substitute for a civil penalty when it reduces the amount of the penalty that would
otherwise be imposed. Additionally, some cases that impose disgorgement as a
discretionary equitable remedy can have similarities to some cases that impose
forfeiture as required by statute. Cf. --------------------------------------------------------------------
---------------------------------------------------------------------------------------------------------------------
We note that forfeiture is not deductible even when it is used by the government to
compensate victims. See Bailey, 756 F.2d at 47. Forfeiture and restitution to a victim
serve different purposes, and a criminal defendant can be required to pay restitution
and also forfeit an equal amount. United States v. Newman, 659 F.3d 1235, 1239-42
(9th Cir. 2011). Although it is not obligated to do so, the government has discretion to
use forfeited assets to restore a victim whom the defendant has failed to compensate.
See 28 U.S.C. § 2461(c) (cross-referencing 21 U.S.C. § 853); 21 U.S.C. § 853(i)(1)
(authorizing the Attorney General to grant remission of criminal forfeitures to victims); 28
C.F.R. Part 9 (§§ 9.1-9.9) (providing procedures for remission).

      Taxpayer argues generally that the disgorgement payment it made ------------------
was meant to compensate a --------------------------who were purportedly harmed by
Taxpayer’s conduct. However, similar to its argument with respect to the settlement
payments made to the ---------------------------, Taxpayer is required to provide specific
reasons why it believes the disgorgement is compensatory rather than punitive.

   CASE DEVELOPMENT, HAZARDS AND OTHER CONSIDERATIONS
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