Dear Readers: Among the nuggets contained in the recent Tax Bill passed by Congress is a provision that will have a tremendous impact on how damages in False Claims Act ("FCA") settlements must be characterized in the settlement documents if a defendant seeks to deduct any portion of its payment on its taxes.
As many of you have experienced, FCA settlements usually just list a settlement amount for the defendant to pay and normally do not attribute which portion constitutes damages and penalties. In fact, among the many provisions that the government insists on including in an FCA settlement, the government usually includes a provision stating that "nothing" in the FCA settlement "constitutes an agreement by the United States concerning the characterization of the Settlement Amount for purposes of the Internal Revenue laws, Title 26 of the United States Code." Stated simply, the government previously did not comment on whether the defendant could deduct any portion of an FCA settlement. To deduct the damages or restitution portion of an FCA settlement was something worked out between a defendant and its accountant.
As my colleague and friend Bob Warchola recently brought to my attention, the Tax Act changed the rules for deducting the damages portion of any FCA settlement by amending 26 U.S.C. § 162 which governs deductions of trade and business expenses. Previously, Section 162 of Title 26 prohibited the deduction "of any fine or similar penalty paid to a government for the violation of any law.” The Tax Act, however, expanded that prohibition, and it now generally prohibits "a taxpayer from deducting any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity in to the potential violation of any law." With this general prohibition as a backdrop, Congress then carved out an exception for deducting restitution, so long as the taxpayer establishes that the amount at issue (1) "constitutes restitution . . . for damage or harm which was or may be caused by the violation of any law or the potential violation of any law, or . . . is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry . . . "; and (2) "is identified as restitution or as an amount paid to come into compliance with such law, as the case may be, in the court order or settlement agreement."(emphasis added). In addition, the revisions to Section 162 specifically prohibit a defendant from deducting "any amount [paid] as reimbursement to the government or entity for the costs of any investigation or litigation." Finally, the Tax Act imposed a requirement on the affected government agency to report to the IRS the settlement (or judgment) and to specify what portion of it is restitution or the costs to come into compliance with the law at issue in the settlement.