Last week, in Fresenius Medical Care Holdings, Inc. v. United States, No. 13-2144, __ F. 3d __ (1st Cir. Aug. 13, 2014), the Court of Appeals for the First Circuit affirmed a district court opinion that had allowed a defendant in an FCA action to deduct for federal income tax purposes amounts in excess of both single damages and relator payments. This affirmance is of considerable import because, in a well-reasoned opinion, the First Circuit expressly rejected the government’s “Catch-22” argument that the ability of a taxpayer to deduct at least a portion of this excess was precluded by the absence of an agreement between the parties.

For some time, the law had been relatively clear that, for federal income tax purposes, a taxpayer could deduct amounts in excess of single damages to the extent that the taxpayer could prove the excess represented compensatory rather than punitive damages. See, e.g., Cook County v. United States ex rel. Chandler, 538 U.S. 119, 130-31 (2003). However, the Internal Revenue Service has traditionally taken the position that, at least apart from amounts paid the relator, a taxpayer cannot carry its burden of proof as to the compensatory nature of any part of the excess absent agreement with the government on this point. This was a Catch-22 argument because, in settling FCA cases, the Department of Justice procedures generally proscribe any agreement as to the deductibility of amounts paid.

The First Circuit would have none of the government’s argument. Stating that, in tax matters, “[s]ubstance matters,” the court refused to give the government “a whip hand of unprecedented ferocity” that would enable it to “always defeat deductibility by the simple expedient of refusing to agree . . . to the tax characterization of a payment.” The Court then held that, so long as a taxpayer like the one before it had proven that a portion of the excess was compensatory, that portion was deductible.

While important and helpful, the First Circuit opinion is not a panacea. First, a Ninth Circuit opinion distinguished by the court, Talley Industries Inc. v. Commissioner, 116 F.3d 382 (9th Cir. 1997), arguably is to the contrary – a point the First Circuit expressly conceded. Second, the First Circuit’s opinion reiterates that the burden lies with the taxpayer to establish the compensatory nature of the excess. Third, the First Circuit said that one argument by the government – that reductions to the government’s original compensatory and punitive claims in a settlement should be done proportionally rather than first to punitive claims – had a “patina of plausibility.” (The court did not need to contend with this argument in the case before it because the government had raised it too late in the proceedings.)

Thus, while the First Circuit’s decision in Fresenius is very good news, careful planning and analysis are still necessary to maximize the deductibility of FCA payments for federal income tax purposes.