Challenges to Deducting Settlement Payments Under the False Claims Act: Fresenius Sheds Light on the Burden

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By Lisa B. Petkun, Esq., and Annika M. Chin,

Pepper Hamilton LLP, Philadelphia, PA

Whether a business may deduct litigation settlement payments can
have a substantial real dollar impact on the business. In the midst
of combating potential litigation, companies rarely first focus on
the potential tax impact of settlement payments. Some businesses
mistakenly assume that the Internal Revenue Service (IRS) will not
challenge a deduction of settlement payments, and later find
themselves in a dispute with the IRS over the characterization. The
recent case of Fresenius Medical Care Holdings Inc. v. United
, involving payments under the False Claims Act (FCA),
underlines that tax planning can reduce surprises in the tax
treatment of such payments.1

Deductible Expenses  

Ordinary and necessary business expenses are deductible under
§162. Although settlement payments made by a business are generally
deductible expenses, a business must look to the origin and
character of the claim with respect to which the expense is
incurred to make the determination.2 Amounts paid to
settle a legal action may be deductible as ordinary and necessary
expenses if the acts that gave rise to the litigation were
performed in the ordinary course of the taxpayer's business,
provided that the amounts were not fines or similar penalties paid
to a government for the violation of any law. Settlement payments
to the government may be compensatory or punitive. When a business
pays the government to compensate the government for losses as a
result of violations of the law, a business is allowed to deduct
such payments as ordinary and necessary business expenses.
Conversely, settlement payments that are not directly related to
the losses sustained by the government are usually for the purpose
of punishing the lawbreaker and deterring similar violations. These
payments are nondeductible. Allocating settlement payments between
deductible compensatory payments and nondeductible fines and
penalties can be a difficult exercise without an express agreement
between the parties regarding the intent of the settlement
payments. A hurdle for taxpayers is that the taxpayer bears the
burden of proving that it is entitled to any deduction claimed.

The government normally does not agree to an allocation for tax
purposes of settlement payments under the FCA. Although allocations
agreed to in a settlement agreement are generally respected, the
IRS is not bound by allocations set forth by a taxpayer or in a
settlement agreement to which it is not a party.3 Without an
express agreement, the tax allocation of the payments boils down to
the intent of the parties, which can be difficult for the taxpayer
to establish.

Damages under the FCA may be single, double, or treble, and are
assessed on a case-by-case basis. Single damages are awarded for
actual losses sustained by the government. An award of multiple
damages typically adds layers of complexity, since determining the
purpose for such damages may not be clear. For instance, the U.S.
Supreme Court in United States v. Bornstein characterized
double damages as compensatory since they were necessary to
compensate the government completely for the "costs, delays, and
inconveniences occasioned by fraudulent claims."4
Subsequent to Bornstein, the FCA was amended to allow
treble damages, and courts expressed different views on the purpose
of multiple damages. The Court in Cook County v. United
 observed that FCA damage multipliers can have both
compensatory and punitive traits.5 Double and treble
damages may be necessary to make the government whole by providing
compensation for the secondary costs of detecting and deterring
fraud and also may serve the purpose of penalizing a violator of
the law.


In Fresenius, the court considered whether payments
made by Fresenius Medical Care Holdings, Inc., a provider of kidney
dialysis services, pursuant to a civil settlement with the
government under the FCA, were deductible by the company. To
resolve the claims of civil and criminal fraud, Fresenius agreed to
pay fines of $101 million to settle the criminal aspect and to make
a payment of $385 million to settle the civil case. Fresenius
deducted the entire civil settlement payment on its 2000 and 2001
returns. The IRS disallowed $127 million of the civil payment as a
nondeductible penalty. Fresenius challenged the disallowance by
filing for a refund.

The company asserted that the payments were compensatory in
nature and therefore, deductible as ordinary and necessary business
expenses. The government, on the other hand, claimed that the
payments were nondeductible because the amounts were intended as
punitive damages.

The agreement between Fresenius and the government failed to
specify the allocation of the payments between compensatory damages
and penalties. The language in the civil agreements did not provide
insight as to the intent of the parties. Each agreement contained a
provision that stated "nothing in this Agreement constitutes an
agreement by the United States concerning the characterization of
the amounts paid hereunder for purposes of any proceeding under
Title 26 of the Internal Revenue Code." This is consistent with the
government's policy of declining to include an allocation in
agreements involving FCA settlements. Further, each agreement
contained a provision in which the company agreed that nothing in
the agreement was punitive in purpose or effect. Notably, the
government did not agree to the statement.

Since an allocation was not specified in the agreement, the
court determined that the issue should be decided by a jury. The
jury decided that $95 million of the disputed $127 million
settlement payment was compensatory in nature, and therefore
deductible as an ordinary business expense. The court in
Fresenius acknowledged that an agreement with the
government is not necessary to establish that all or a portion of a
payment made in FCA litigation is non-punitive. The jury considered
both the language in the settlement agreement and other evidence
regarding the purpose of the settlement payment, including
documents exchanged during settlement negotiations. Such other
evidence included documents that indicated that making the
government whole would require payment of a substantial amount of
pre-judgment interest in order to compensate the government for the
loss of the use of the money due as damages. The court concluded
that from the evidence a jury could reasonably infer that the
multiple damages pursuant to the FCA settlement included
pre-judgment interest as compensation to the government. The
Fresenius decision marked a turn from prior cases
that discussed the allocation of FCA settlement payments, such as
the decision in Talley Industries Inc. v. Commissioner.6 In these prior
cases, a judge determined the proper treatment of the settlement
payment, as opposed to Fresenius, in which a jury made the


Talley Industries, Inc. did not fare as well as Fresenius in its
dispute with the government over the tax treatment of its FCA
settlement payments. Tally, through its subsidiary, manufactured
ejection seats for military aircraft. The company obtained several
government contracts for the production of ejection seats and for
research and development projects. Talley faced potential civil
liability under the FCA for making alleged false billing claims for
payments on a number of government contracts. The government
estimated its actual loss to be approximately $1.56 million. After
several rounds of negotiation with the government, the parties
agreed to a settlement amount of $2.5 million with respect to the
government's civil claims. Although the settlement agreement was
silent on the subject of characterizing the settlement payment, the
company reported the $2.5 million settlement payment as a
deductible ordinary and necessary business expense. The IRS
subsequently disallowed $940,000 of the deduction taken by the
company. Initially, the Tax Court granted summary judgment for the
taxpayer, reasoning that the $2.5 million settlement was less than
double the $1.56 million loss that the government suffered, and the
payment was intended be to compensatory.

On appeal by the government, the Ninth Circuit Court of Appeals
noted that the double damage provision of the FCA has both
compensatory and deterrence purposes. Characterizing double or
multiple damages depends on the intent of the parties. The Ninth
Circuit overturned the decision of the Tax Court and remanded the
case for further consideration, since there was a genuine issue of
fact as to the nature and purpose of the disputed settlement
payment. On remand, the Tax Court found for the IRS and determined
that the company failed to establish it was entitled to the
disputed deduction. In reaching its decision, the Tax Court
considered the documents produced by the parties during the
negotiation process, including an offer letter by the company that
included a statement that the offer was intended to represent
compensatory damages. The court noted that the government rejected
that offer. In fact, in the government's counteroffer, the
government expressly adopted specific portions of the company's
offer but not the characterization of the settlement payment as
compensation. The court found this counteroffer probative as to
whether the parties agreed to any allocation of the FCA settlement
payment. In addition, the court observed that the taxpayer suffers
the consequence if the evidence to establish entitlement to the
disputed deduction is lacking.

Pepper Perspective  

The government is unlikely to agree to any allocation in an FCA
settlement agreement. Therefore, the case for deductibility must be
made on the basis of the record. Prior to Fresenius, the
task of establishing that the primary purpose of a settlement
payment to the government was compensatory often seemed too steep
of a hill to surmount. Fresenius, unlike other cases,
allowed the jury to be the trier of fact in a situation in which no
allocation was made in the settlement agreement. The jury then
considered all of the correspondence that was exchanged during the
settlement process. In order to prevail on the deduction issues,
taxpayers should consider all of their settlement negotiations
through the lens of the tax consequences. The record is made during
the negotiation stage, and it is too late to alter the record once
that process has been completed.

For more information, in the Tax Management Portfolios, see
Wood, 522 T.M.
, Tax Aspects of Judgments and Settlements,
and in Tax Practice Series, see ¶1340, Payments Made Pursuant
to Judgments and Settlements.

© 2013 Pepper Hamilton LLP. All Rights Reserved.



  1 No. 1:08-cv-12118, 2013 BL 123019 (D. Mass.

  2 U.S. v. Gilmore, 372 U.S. 39 (1963).

  3 See Robinson v.
, 102 T.C. 116 (1994), rev'd in part on other
grounds, 70 F.3d 34 (5th Cir. 1995), cert. denied, 519 U.S. 824

  4 423 U.S. 303 (1976).

  5 538 U.S. 119 (2003).

  6 T.C. Memo 1999-200, aff'd, 18 Fed. App'x 661 (9th
Cir. 2001).