In a new memo released by the Internal Revenue Service on September 25, the tax agency provided clear guidance on whether fines and penalties arising out of a corporate lawsuit are tax deductible. According to the advisory — released as Field Attorney Advice Memorandum 20084301F — three states, dubbed X, Y, and Z, each filed a lawsuit against a corporate taxpayer in federal court. The suit accuses the corporation of fixing a minimum price for one of its more sought after products.
According to the company’s policy, it forbade retailers from advertising the product below a dictated price. Further, the corporate policy said that any retailer that violated the policy would lose access to the company’s product for a period of one year.
After the lawsuits were filed, the parties filed a consent decree and a final judgment. The corporation agreed to an injunction against dictating the price of its products to retailers. The company also agreed to pay “$1″ to the states which had brought the suits to be used in each jurisdiction for: (1) anti-trust enforcement; (2) a consumer protection fund; or (3) any other function allowable under state law.
Fines and Penalties
The tax code, specifically Section 162(a), provides that there shall be allowed as a deduction all of the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business. However, Section 162(f) notes that “fines and penalties” paid to any government for “violation of the law” are not deductible.
Courts generally differentiate between amounts paid as fines and money paid as damages with money paid as damages being deductible. When, as in the case described in the IRS memo, a civil settlement payment is at issue, it is first necessary to determine whether the payment constitutes a fine or penalty or some other type of damages.
If the payment is found to constitute a fine or penalty, then the purpose of the payment must be analyzed to determine whether it is punitive or remedial in nature because only punitive fines are disallowed under Section 162(f). Under the punitive versus remedial test, a payment imposed for the purpose of enforcing the law or as punishment for its violation is not deductible. Meanwhile, a payment imposed as a remedial measure — to compensate the government or another party — is deductible, even if it is labeled as a fine or penalty. (See Talley Industries, Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997).)
In the case discussed in the advisory, the question is whether the “$1″ that the corporation paid should be considered an ordinary business expense or a non-deductible penalty. The answer to the question turns on whether the payment was made to cover the actual damages that the plaintiffs incurred through the defendant’s conduct, or if the payment is meant to be a punitive measure to discourage future anti-competitive behavior. The Field Attorney Advice memo concludes that the payment falls within the punitive category.
Indeed, the FAA notes that the settlement document that the parties executed did not explicitly allocate the money into one category or another. However, the federal statute, as well as the state X statute that the lawsuit invoked, speak only of fines and not of damages. In addition, the amount paid was below the maximum that either act allows for a penalty.
In the advisory, the laws of states Y and Z law are “less clear” about whether an anti-trust judgment is a penalty or damages. However, the payments can reasonably be treated as penalties for two reasons. First, states Y and Z filed their complaint under federal anti-trust statutes. Second, the amount that the corporation paid was “well within” the penalty limits of that law. Moreover, the FAA notes that the lawsuit specifically requests civil penalties and does not specifically request compensatory damages.
The FAA observes that the corporation, in its attempt to secure a deduction for the payment, may point to the fact that the settlement agreement does not admit any wrongdoing on the company’s part. Nevertheless, the FAA correctly concludes that the admission of wrongdoing is not necessary for Section 162(f) to apply. To be sure, all that is necessary is that the payment be “most properly” characterized as a penalty. Accordingly, the payment made by the corporation to the states which had brought a lawsuit alleging anti-competitive behavior was judged to be non-deductible.
A better result, no doubt, could have been secured if the settlement agreement had allocated the payment between its penalty and damages components. Apparently, the IRS will “respect” such an allocation even though the parties to the agreement are not “adverse” from a tax perspective, in the sense that what provides a tax benefit to the payor gives rise to a tax detriment to the payee. In other contexts, such adversity is necessary for the allocation of a payment in an agreement reached between private parties to be given credence by the IRS.
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.