IRS Issues Regulations on the Non-Deduction of Fines and Penalties Under the New More Complex Section 162(f) by Robert S. Horwitz
Occasionally I feel sorry for the attorneys in IRS National Office who have to write regulations for the tax laws enacted by Congress. Gone are the days when Congress had members who could write simple, logical statutes, like the original sec. 162(f), enacted in 1969:
No deduction shall be allowed under subsection (a) for any fine or similar penalty paid to a government for the violation of any law.
That’s it. Under 25 words and it said all that needed to be said. In 1975, the IRS promulgated regulations under sec. 162(f) that defined what was a “fine or similar penalty,” what was “a government” and what constituted a “violation of any law”, all in under 1000 words.
So things stood for 48 years, until late 2017, when Congress got it into its head to amend sec. 162(f) as part of the Tax Cut and Jobs Act (TCJA). Gone was the simple, elegant language of subsection (f), replaced by a 410-word subsection with exceptions with multi-prong tests and exceptions to the exception. The main provision of sec. 162(f), carving out the prohibition on the deduction of fines or similar penalties, now reads:
(1) In general-Except as provided in the following paragraphs of this subsection, no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.
The exception to this general rule are for (a) payments of restitution (determined by application of a multi-prong test and which has an exception for reimbursement to the government for the costs of any investigation or litigation), (b) payments ordered by a court in a suit in which the government is not a party, and (c) payments for “taxes due.” And then there is a subparagraph under which certain nongovernmental entities are treated as governmental entities.
TCJA also added sec. 6050X to the Code, which imposes a reporting requirement on any government or governmental entity for any suit or agreement concerning the violation of a law within the government or governmental entity’s authority or any investigation or inquiry concerning such a violation if the amount involved with respect to the violation or any investigation or inquiry is over $600.
The final regulations under the NEW! IMPROVED! subsection 162(f) were released on January 12, 2021. A few of the highlights of the final regulations are discussed below.
Under the general rule of non-deductibility, 26 CFR sec. 162-21(a), the regulation makes it clear that (i) a fine or penalty is “an amount paid or incurred in relation to the violation of any civil or criminal law” and (ii) a routine investigation or inquiry, such as an audit or inspection, of a regulated business that is not related to evidence of wrongdoing or suspected wrongdoing is not “an investigation or inquiry … into the potential violation of any law.”
The second part of the regulation, 26 CFR sec. 162-21(b), deals with amounts that will be treated as deductible as restitution, remediation or “to come into compliance with a law.” First the taxpayer must meet an “identification requirement, which requires a court order or agreement that
(i) States that a payment is restitution, remediation or to comply with a law
(ii) States the purpose for which the restitution or remediation will be paid or the law with which the taxpayer must comply
This part is met if the order or agreement describes (i) the damage done, harm suffered or manner in which the taxpayer failed to comply with the law and (ii) the action required by the taxpayer. The order or agreement need not identify the amount the taxpayer must pay or incur in order to be treated as a restitution, remediation or for the taxpayer to come into compliance with a law.
The regulations further provide that to deduct an amount paid as restitution, remediation or for compliance with a law, the taxpayer must provide documentary evidence to prove that it was obligated by an order or agreement to pay the amount identified as restitution, remediation or to come into compliance with the law, the amounts paid or incurred and the dates; and that “based on the origin of the liability and the nature and purpose of the amount paid or incurred,” the amount was paid or incurred for restitution, remediation or to come into compliance with a law. A taxpayer must meet both this test and the identification test to come within the exception to the disallowance of a deduction for the payment of an amount in relation to the violation of a civil or criminal law of sec. 162(f)(1).
The third part of the regulation, 26 CFR sec. 162-21(c), deals with “other exceptions” and makes it clear that the prohibition on deducting amounts paid in relation to a violation of a law does not apply to a suit in which a government or governmental entity is not a party or a suit in which a government or governmental entity “enforces its rights as a private party.” It also clarifies that it does not apply to amounts paid as tax or interest on tax, but it does apply to penalties imposed relating to tax and interest on the penalties. Amounts paid or incurred as restitution for taxes under the Internal Revenue Code are deductible if the tax itself would otherwise be deductible, such as the payment of employment or excise taxes.
The fourth part of the regulation, 26 CFR sec. 162-21(d) concerns accounting for deductible payments, such as restitution. The timing of the deduction is determined under sec. 461 (general rules for the taxable year of deduction) and related sections and regulations under those provisions. And the tax benefit rule applies.
The fifth part of the regulation, 26 CFR sec. 162-21(e), contains definitions: government, nongovernmental entity treated as a governmental entity, remediation, disgorgement, amounts to come into compliance with a law, etc. a whole smorgasbord of words and terms used in sec. 162(f) and the regulations are defined, including “Amounts not included,” which is reimbursement of a governmental entity for investigatory or litigation costs concerning the violation or potential violation of any law and amounts paid, at the taxpayer’s election, in lieu of a fine or penalty. The sixth and final part, 26 CFR sec. 162-21(f), is a baker’s dozen of examples of how the regulations are to be applied.
What is to be learned from all of this, other than the fact that the regulations are reasonably to the point and intelligible? If a client is involved in an administrative proceeding or litigation with the federal or a state government, a governmental entity, a foreign government or a securities exchange or board of trade, the client’s attorney should make sure that any settlement agreement, order or judgment clearly imposing a financial or other obligation on the client sets out what the nature of the obligation is (i.e., remediation, restitution, compliance with law), why the obligation is imposed and that the client keeps documentation establishing the amounts expended and the dates. Otherwise, the client may not be able to deduct the amount paid or incurred under the agreement, order or judgment.
Contact Robert S. Horwitz at email@example.com or 310.281.3200 Mr. Horwitz is a principal at Hochman Salkin Toscher Perez P.C., former Chair of the Taxation Section, California Lawyers’ Association, a Fellow of the American College of Tax Counsel, a former Assistant United States Attorney and a former Trial Attorney, United States Department of Justice Tax Division. He represents clients throughout the United States and elsewhere involving federal and state administrative civil tax disputes and tax litigation as well as defending criminal tax investigations and prosecutions. Additional information is available at http://www.taxlitigator.com.