Internal revenue code section 162 starts out with a general rule of allowing a deduction for all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.
But when the business expenses are fines and penalties paid to a government for the violation of any law, the general rule no longer applies. Those expenses are not deductible (section 162(f)).
What is a “fine” or “penalty”? Treasury regulation 1.162-2 says fines and penalties include amounts “paid as a civil penalty imposed by federal, state, or local law” and amounts “paid in settlement of actual or potential liability for a fine or penalty (civil or criminal).” However, “compensatory damages…paid to a government do not constitute a fine or penalty.”
“Government” includes the government of the United States, a state, a territory or possession of the United States, the District of Columbia, or the Commonwealth of Puerto Rico, and foreign governments, as well as a political subdivision of, or corporation or other entity serving as an agency or instrumentality of, any of the above.
So, break the law, civilly or criminally, intentionally or not, in the US or abroad, and you get no business deduction for fines and penalties you pay for doing so.
Here are three cases involving fines and penalties. Are they deductible or not?
1. In 2006, aerospace company Boeing agreed to pay a $615 million settlement to the US government for violations of federal ethics laws. The settlement included a $565 million civil settlement and a $50 million monetary penalty under a separate criminal agreement.
2. On January 18, 2000, Fresenius Medical Care Holdings, Inc. entered into a settlement agreement with the US government resolving claims of Medicare fraud. Fresenius agreed to pay $101,186,898 pursuant to the criminal agreements and $385,147,334 pursuant to the civil agreements.
Fresenius claimed tax deductions for the $385,147,334, saying the payment was compensatory (to repay the government for losses).
The IRS said $192,550,517 of the civil settlement payment was properly deductible, but that $126,796,262 of the amount was punitive, and not deductible.
The settlement agreement didn’t specify the nature of the payments and the case went to jury trial.
3. In 2010, financial firm Goldman Sachs reached a $550 million settlement with the US Securities and Exchange Commission. The penalty was assessed because the SEC said Goldman misled investors in a subprime mortgage product (Goldman did not admit or deny the allegations). Of the $550 million, $250 million was returned to harmed investors and $300 million was paid to the US Treasury.
And here’s the case that brought up the topic: 143 T.C. No. 1 (Guardian Industries Corp.),
In this case, the taxpayer did not dispute that $30,260,000 paid to the Commission of the European Community was a “fine or similar penalty” or that the payment was made “for the violation of * * * [a] law.”
Instead, the taxpayer raised another question: What is a government?
The taxpayer argued the IRS was wrong to disallow a deduction for the payment, which was assessed for price fixing, because the Commission of the European Community was not a government.
The IRS agreed that the Commission is neither “the government of a foreign country” nor “a political subdivision” of the government of a foreign country. However, the IRS said the Commission is an “entity serving as an agency or instrumentality” of the government of a foreign country.
The tax court sided with the IRS, describing the Commission as the executive branch of the European Community (now known as the European Union), tasked with enforcing rules governing competition and free trade.
$50 million of the settlement represented a penalty to resolve criminal charges and was not deductible. The $565 million could be classified as compensatory damages that were tax deductible.
Boeing voluntarily did not take the deduction.
The jury returned a verdict in favor of Fresenius, finding that $95,000,000 of the disputed settlement payments was compensatory and deductible as an ordinary and necessary business expense.
The settlement could be classified as compensatory damages that were tax deductible.
However, the agreement with the SEC stipulated that Goldman would not “claim, assert or apply for a tax deduction” for any penalty amounts.