Taxpayer may not deduct penalties imposed for violating a law

Editor: Susan M. Grais, CPA, J.D., LL.M.

In Technical Advice Memorandum (TAM) 202434011, the IRS ruled a taxpayer may not deduct under Sec. 162(a), or capitalize and depreciate under Sec. 263 or 263A, fines or similar penalties paid to the government for violating a law. Although the TAM is heavily redacted, it appears that a state agency required the taxpayer to make payments or incur costs that were in lieu of paying fines or penalties directly to the state agency or government.

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 the 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 Sec. 162(f) and the related regulations as in effect before the Tax Cuts and Jobs Act (TCJA), P.L. 115-97. Unlike prior law, which simply denied a deduction for a fine or penalty paid to a government, the current statute, Sec. 162(f)(1), expressly provides that an amount paid “at the direction of” a governmental authority can be a nondeductible penalty. Further, the current statute provides that a payment may be deductible if it constitutes restitution, remediation, or coming into compliance with the law and satisfies the identification and establishment requirements.

Facts

As identified in the TAM, the facts are as follows: Parent, a publicly traded corporation, is a holding company and files a consolidated U.S. 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. It appears the agency also required that certain payments be made in lieu of payments to the agency as fines or penalties. The IRS and Taxpayer agreed that Sec. 162(f)(1) prohibits taxpayers from deducting certain penalties but disagreed on whether the payments in lieu of the fines or penalties were deductible or recoverable after being capitalized.

Analysis

In the TAM, the IRS’s analysis and findings address two major categories: (1) costs otherwise currently deductible under Sec. 162, involving fines and amounts paid to the government; and (2) costs that are otherwise capital expenditures, involving capital expenditures and reimbursements to the state agency, as related to Sec. 162 in light of the public policy doctrine and Secs. 263(a) and 263A.

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

Citing Waldman, 88 T.C. 1384 (1987), aff’d, 850 F.2d 611 (9th Cir. 1988), the IRS noted that courts “have long held that section 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 Sec. 162(f) prohibitions. If a penalty could be both punitive and nonpunitive, courts consider the primary purpose of the penalty (Waldman, 88 T.C. at 1387).

After analyzing 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 Sec. 162(f ).

In Allied-Signal, Inc., 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 did not 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 analyzed 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, according to the TAM, “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 Sec. 162(f).

In the TAM, 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’s 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 Sec. 162(f).

Capital expenditures: The IRS ruled Taxpayer could not capitalize the amounts paid as fines because the public policy doctrine and Secs. 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 TAM noted (quoting Tank Truck Rentals, 356 U.S. 30, 34 (1958)). The IRS noted that Sec. 162(f) effectively codifies the public policy doctrine, but “courts continue to 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 Secs. 263(a) and 263A because the capital expenditures stemmed from a fine or other penalty under Sec. 162(f). Therefore, Taxpayer could not take those expenditures into account when determining its taxable income.

In the TAM, the IRS noted that the last sentence of Sec. 263A(a)(2) expressly states, “Any 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 further noted that, according to the legislative history of the statute, “Congress intended section 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 sections 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 Sec. 263A(a)(2)’s legislative history “clarifies that an amount that is not otherwise 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 Regs. Sec. 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 the reimbursements Taxpayer paid to reimburse the state agency for costs associated with its investigation of Taxpayer’s violations fall under the exception in Regs. Sec. 1.162-21(b)(2), and Sec. 162(f) will not prohibit a deduction for those costs. Therefore, the IRS ruled Taxpayer could deduct those costs

Implications

This TAM demonstrates the IRS’s ongoing efforts to distinguish between currently deductible compensatory amounts and nondeductible fines and penalties that are subject to Sec. 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’s alleviating the harms caused by its violations in some other way, was required for a payment to be characterized as a fine or penalty. The IRS further ruled that Secs. 263(a) and 263A do not offer a path to capitalization of nondeductible fines and penalties subject to Sec. 162(f ).

As noted above, this TAM dealt with Sec. 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 Sec. 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.

Editor Notes

Susan M. Grais, CPA, J.D., LL.M., is a managing director at Ernst & Young LLP in Washington, D.C. For additional information about these items, contact Grais at susan.grais@ey.com. Contributors are members of or associated with Ernst & Young LLP.

The views expressed are those of the authors and are not necessarily those of Ernst & Young LLP or other members of the global EY organization. This information is provided solely for the purpose of enhancing knowledge on tax matters. It does not provide accounting, tax, or other professional advice.