- The Final Regulations clarify and provide examples showing that “an investigation or inquiry” for purposes of the general rule does not include routine investigations or inquiries of regulated business or industries, such as audits or inspections, conducted to ensure compliance with applicable rules and regulations but not related to any evidence or suspicion of wrongdoing. Expenses incurred in connection with such routine investigations generally may be deducted, provided they are otherwise deductible as ordinary and necessary business expenses.
- The Treasury and IRS did not adopt certain other suggestions from commenters. For example, the Final Regulations do not exclude certain administrative or other proceedings from the definition of “suit, agreement, or otherwise,” because Congress meant for Section 162(f)(1) to “apply broadly to both formal legal proceedings as well as other less formal proceedings.” In addition, one commenter suggested providing an express exclusion for legal fees and related expenses. The Final Regulations do not adopt this recommendation, but the preamble clarifies that such amounts generally should not be considered to be paid “to, or at the direction of,” the government or a governmental entity.
Exception for restitution and amounts paid or incurred to come into compliance with the law. The Final Regulations provide additional guidance on this exception, adopting several suggestions made by commenters with respect to the Establishment Requirement and the Identification Requirement, among other items.
- The Final Regulations adopt recommendations to clarify that the exception in Section 162(f)(2) permitting the deductibility of amounts paid for restitution or remediation, or to come into compliance with the law, broadly applies to payments for the remediation of environmental harm (e.g., an amount paid for the purpose of restoring an ecosystem that was harmed by the taxpayer’s violation of a law). The preamble also explains that Section 162(f) does not apply to amounts incurred pursuant to provisions of certain statutes that may apply without any finding of a violation of law, such as the cleanup requirements under the Comprehensive Environmental Response, Compensation, and Liability Act of 1980 (CERCLA) but does apply to penalties required to be paid under such statutes for any violation of law, such as a penalty imposed for a violation of a specific CERCLA provision.
- Reversing the Proposed Regulations, the Final Regulations eliminate the per se prohibition on the deductibility of amounts paid as disgorgement or forfeiture. Accordingly, such amounts may be deductible provided that the Establishment Requirement and Identification Requirement are met, and they are otherwise deductible as ordinary and necessary business expenses. The preamble to the Final Regulations describes recent Supreme Court authority that influenced this reversal, as well as circumstances under which disgorgements or forfeitures might be deductible.
- The Proposed Regulations provided that Section 162(f)(2) does not apply to allow a deduction for amounts paid to a settlement fund, entity, group, government, or governmental entity to the extent the payee was not harmed by the taxpayer’s violation. The rule thus would have prohibited a deduction for payments made through an intermediary fund or entity, even if the arrangement were designed ultimately to facilitate restitution to the harmed party. After commenters asked for reconsideration, the bright-line rule prohibiting a deduction when a payment was made to a fund was withdrawn. The Final Regulations still prohibit a deduction to the extent the fund is for general enforcement efforts or other discretionary purposes, as opposed to specific restitution or remediation. The preamble to the Final Regulations clarifies that if an amount paid into a fund established for permissible purposes and deducted by the taxpayer later reverts to the benefit of the taxpayer, that amount then would be included in income.
- In certain circumstances, additional documentation may be necessary to establish that an amount was paid as restitution or remediation, or to come into compliance with a law. The Final Regulations expand the list provided in the Proposed Regulations of types of documentary evidence that may be used to satisfy the Establishment Requirement and include such things as court pleadings filed by the government specifically requesting payment for one of the qualified purposes and correspondence exchanged between the taxpayer and the government or governmental entity before the order or agreement became binding.
- In response to comments on the Proposed Regulations, the Final Regulations take a more permissive approach regarding the precise language that may be included in an agreement or order to satisfy the Identification Requirement. For example, an agreement will satisfy the requirement if it unambiguously aims to restore the injured party or correct the noncompliance, even without using the specific words found in the statute (e.g., “restitution,” “remediation,” or “come into compliance”).
Government as a private party. Section 162(f)(3) provides that the general rule disallowing a deduction does not apply to amounts paid in proceedings in which no government or governmental entity is a party. Commenters on the Proposed Regulations suggested that Treasury and the IRS clarify that Section 162(f) does not apply to amounts paid in connection with proceedings in which a government or governmental entity enforces its rights as a private party (e.g., payments related to a contract for goods or services where fraud is not alleged). The Final Regulations adopt this recommendation. However, the Final Regulations do not adopt a specific rule for qui tam cases (i.e., cases brought by private parties (relators) on behalf of the government). Rather, the preamble to the Final Regulations states that general principles should apply to such cases and suggests that any payments made to a government or governmental entity that is the real party in interest, and any share of that amount ultimately paid to a relator, generally are not deductible unless an exception to Section 162(f)(1) applies.
Penalties on taxes. Under Section 162(f)(4), amounts paid or incurred as taxes due are not subject to the general prohibition on deductibility. The Final Regulations clarify that where a penalty is imposed with respect to otherwise deductible taxes, the taxpayer may not deduct the penalty or interest paid with respect to such penalty.
Modification of pre-TCJA agreements. The Proposed Regulations provided that agreements or orders entered into before the TCJA was enacted would be subject to the post-TCJA Section 162(f) if such agreement or order underwent a “material change” (as defined in the Proposed Regulations) following the passage of the TCJA. Commenters suggested the definition of “material change” in the Proposed Regulations was overly broad. The Final Regulations do not adopt the Proposed Regulations’ material change rule, but the preamble notes that “material changes to an order or agreement will generally result in a new order or agreement subject to Section 162(f).”
Section 6050X. The Final Regulations under Section 6050X also provide guidance for governments, governmental entities, and certain nongovernmental entities in order for them to comply with the statutory information reporting requirements related to payments contemplated in Section 162(f). Notably, the preamble to the Final Regulations makes clear that a properly filed information return under Section 6050X may not be used to satisfy the Identification Requirement. Further detail on Section 6050X and the related guidance under the Final Regulations is beyond the scope of this discussion.
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