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By Christopher Weeg
Christopher Weeg is an LL.M. candidate in the University of Florida Graduate Tax Program.
From 2009 to 2015, False Claims Act (FCA) settlements and judgments have resulted in more than $26 billion in recoveries to the government. Reaching an FCA settlement is an exhausting and expensive process, and its tax implications can't be understated.
Although companies may breathe a sigh of relief because the war with the Department of Justice is over, a new battle with the Internal Revenue Service as to the deductibility of this payment may be on the horizon.
The complication of deducting a settlement is rooted in the FCA's multiple damages provision. Single damages under the FCA are designed to compensate the government for its actual losses sustained as a result of the fraudulent conduct.1 Multiple damages may serve a dual purpose of further compensating for loss and also punishing the wrongdoer.
The punitive portion of FCA damages is nondeductible under tax code Section 162(f) as a fine or penalty, and the compensatory element is deductible under Section 162(a) as an ordinary and necessary business expense.2
FCA settlements generally include a criminal portion and a civil portion. The civil portion is composed of two elements—statutory civil fines and up to three times the damages sustained by the government.3 The criminal portion of the settlement and the civil fines are clearly nondeductible under Section 162(f). The damages, however, are less straightforward.
Single damages are compensatory in nature and thus deductible under Section 162(a). Multiple damages may either be compensatory, punitive or, more likely, a combination of both. As the U.S. Court of Appeals for the First Circuit aptly put it, “plotting the sometimes hazy line that separates the compensatory from the punitive can be tricky business.”4
Doubt as to deductibility arises where the parties haven't expressly stipulated to the compensatory and punitive damages amounts in the settlement, usually in the form of a tax characterization agreement. In the absence of an agreement, the IRS may assert the taxpayer has failed to carry its burden of proving deductibility and thereby deny the deduction.
Talley Indus. Inc. v. Commissioner , 116 F.3d 382 (9th Cir. 1997), is the seminal—and, until recently, the only—case to address this issue, and since Talley the government has treated the taxpayer's failure to obtain a characterization agreement as fatal to an FCA settlement deduction.
In 2014, however, the First Circuit in Fresenius Med. Care Holdings, Inc. v. United States, 2014 BL 224832, 763 F.3d 64 (1st Cir. 2014), rejected the government's interpretation of Talley, and in doing so, restored bargaining power to the taxpayer.
Turning first to Talley, the issue was whether and to what extent an FCA double damages civil payment was compensatory (deductible) or punitive (nondeductible). The Ninth Circuit held where an FCA settlement is ambiguous as to the characterization of the payment, such ambiguity may be resolved by determining the intent of the parties.
The government has interpreted Talley’s holding as setting a high bar for the taxpayer.
On remand, the Tax Court ruled the payment wasn't deductible based on the parties' unsuccessful back-and-forth negotiations, as well as the government's characterization of the payment as a penalty in internal memos.5 Ultimately, the settlement was silent on the issue of characterization and thus the Tax Court found the taxpayer failed to carry its burden of justifying the deduction.
Going forward, the government has interpreted Talley’s holding as setting a high bar for the taxpayer. Under the government's rationale, any FCA settlement in excess of single damages is punitive, unless the taxpayer can prove the parties intended the amounts to be compensatory. Intent, the government contends, can only be proven by a tax characterization agreement, and the economic reality of the transaction has no bearing.
The First Circuit in Fresenius rejected the government's interpretation of Talley requiring a tax characterization agreement as a precondition to deductibility. The court observed the government enjoys “unprecedented ferocity” to foreclose the taxpayer's deduction by simply refusing to enter into a characterization agreement.
Cutting back on this unequal bargaining power, the First Circuit held the “common-sense approach” is to objectively determine the economic reality of the settlement by permitting a court to consider factors beyond the mere presence or absence of a tax characterization agreement.
Whether Fresenius actually created a circuit split is arguable. The Fresenius court made clear that Talley’s “message is unclear.” Indeed, it carefully chooses to split with the Ninth Circuit only if the government's “debatable” interpretation of Talley requiring a tax characterization agreement for deductibility is correct.
Perhaps the better takeaway from Fresenius is that it puts the parties back on even ground by providing fresh motivation for the government to work toward an agreement.
FCA settlements hurt, but losing the future deduction by failing to consider the tax consequences during negotiations adds insult to injury. Post-Fresenius, the taxpayer is in a better position to obtain a tax characterization agreement that will provide assurance at tax time and prevent more conflict down the road.
If, however, a characterization agreement can't be reached, the taxpayer carries the burden of deductibility. This burden requires the taxpayer to prove based on extrinsic evidence the portion of the settlement intended to be a compensatory payment versus a punitive fine or penalty. The economic reality of the deal can be illustrative of the intent of the parties. This may require breaking down the numbers by comparing the criminal and civil fines and the government's actual loss to the entire settlement.
Looking beyond the numbers, most everything is likely on the table to help manifest the intent of the parties. We learned from the Tax Court in Talley that offers, counteroffers, other external communication between the parties and even internal memos can be considered. Therefore, the taxpayer's careful documentation of both formal and informal interactions is key to carrying the deductibility burden.
Because internal memos are fair game, the taxpayer should also avoid land mines of mischaracterization; words matter, and carelessly referring to a settlement as a “fine” or “penalty” without appreciating the tax nuances and economic reality could be quite costly.
Finally, requests under the Freedom of Information Act and other discovery tools may be useful to determine how the government has discussed and interpreted the settlement internally.
In conclusion, to avoid a second round with the government, parties to an FCA settlement should strive to obtain a tax characterization agreement, or at least keep comprehensive records of the negotiations. In deducting an FCA settlement, an ounce of prevention in securing a tax agreement is worth a pound of cure of proving the amorphous “intent” of the parties.
2 Treas. Reg. Section 1.162-21(b)(2). For a discussion of compensatory versus penal purpose in the context of Section 162(f), see Tax Management Portfolio 524-1st: Deductibility of Illegal Payments, Fines, and Penalties, Detailed Analysis, V. Deductibility of Fines and Similar Penalties under §162(f), C. “Fine or Similar Penalty.”
4 Fresenius Med. Care Holdings, Inc. v. United States , 2014 BL 224832, 763 F.3d 64, 69 (1st Cir. 2014),
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