Historically, taxpayers who made settlement payments to the government or relator under False Claims Act actions could offset those often considerable costs by deducting all or part of the payment for federal income tax purposes. But the Tax Cuts and Jobs Act, enacted in December, dramatically shifted the tax treatment of such payments, resulting in the potential loss of valuable tax benefits. Now more than ever, companies must carefully consider the tax treatment of these payments when negotiating False Claims Act settlements with the DOJ.
DEDUCTIBILITY of settlement payments under the new tax act
You and your company have been involved in a qui tam/False Claims Act complaint for the last few years. You have responded to civil investigative demands (subpoenas) and produced documents to the government. The government has interviewed your employees. You and your company, assisted by outside counsel, have conducted an extensive internal investigation, including reviewing documents and interviewing employees. As a result of all this work, you and your company have decided to resolve this matter and negotiate a settlement with the U.S. Department of Justice (DOJ). Along with the multitude of considerations that are part of the negotiations, there is an additional important concern: how will any settlement payments be treated for tax purposes?
Historically, a taxpayer who made a settlement payment to the government or relator under a False Claims Act action was permitted to offset such costs by deducting all or a portion of the payment for federal income tax purposes. The enactment of the Tax Cuts and Jobs Act (the Tax Act) on December 22, 2017, dramatically shifted the tax treatment of such payments. Now, under the Tax Act, unless certain amounts are specifically identified in the settlement agreement and the government timely reports such amounts to the Internal Revenue Service (IRS), your company may lose valuable tax benefits. This tax “cost” could be significant to your company, particularly as many qui tam/False Claims Act settlements require payment of considerable sums to the government.
Settlement Payments Under Prior Law
Prior to the enactment of the Tax Act, under Section 162(f) of the Internal Revenue Code (the Code), taxpayers were not permitted to deduct fines or penalties paid to a government for the violation of any law. For purposes of Code Section 162(f), however, compensatory damages “paid to a government [did] not constitute a fine or penalty” and were therefore generally deductible as ordinary and necessary business expenses.
In the context of qui tam/False Claims Act settlements, the deductibility of payments made to the government has historically depended on whether the payment was for “single” or “multiple” damages. Single damages paid under an agreed settlement or court order have generally been considered compensatory and, as a result, deductible by the payor. Any statutory penalties or “multiple” damages imposed in excess of the single damages could be treated as compensatory (deductible), punitive (non-deductible), or both depending on the facts of the case and the terms of the settlement agreement or court order. Since qui tam/False Claims Act settlement agreements do not typically apportion settlement payment amounts between single and multiple damages, it often has been left to the taxpayer-payor to allocate payments for tax purposes in a manner consistent with the forgoing deductibility rules. In this way, defendants of qui tam/False Claims Act claims have generally been able to recoup at least a portion of their payments to the government in the form of tax deductions.
Deductibility of Qui Tam/False Claims Act Payments Under the Tax Act
The Tax Act amended Code Section 162(f) by significantly expanding its scope to prohibit deductions for many types of payments made to the government. Under Code Section 162(f)(1), as amended by the Tax Act, a taxpayer is generally not allowed to deduct “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 into the potential violation of any law.” In other words, payments resulting from violations of the law and investigatory costs are now generally non-deductible expenses.
However, the Tax Act includes an exception to this broad prohibition on deductions for amounts paid to the government that are either restitution or expended in order to come into compliance with any law that was violated or involved in the investigation or inquiry, and that are identified as such in a court order or settlement agreement. In order to claim a deduction pursuant to this exception, the taxpayer must: 1) establish the facts to support the deduction; and 2) the governmental agency that receives the payment must specifically identify any amounts that are for restitution or correction of noncompliance on an IRS information return provided to both the taxpayer and the IRS. The Tax Act provisions are effective for any amounts paid or incurred after December 22, 2017 (except for amounts paid or incurred under any binding order or agreement entered into before such date).
Depending on the particular settlement terms of a case, the Tax Act provisions may considerably limit a defendant’s ability to deduct qui tam/False Claims Act payments. The defendant’s payment is now deductible only to the extent that the defendant establishes that a payment amount is (i) restitution or necessary to come into compliance with any law, and (ii) specifically identified in the court order or settlement agreement as restitution or required to come in compliance. Deductibility of the payment also is contingent on the DOJ timely reporting such amounts as restitution or correction of noncompliance to the IRS.
In light of the Tax Act, a company that is negotiating a qui tam/False Claims Act settlement with the DOJ should consider the tax treatment of the settlement payments. Without proper attention to the tax consequences of the settlement, companies could be left paying out-of-pocket expenses without the benefit of a deduction that otherwise could have been used to offset taxable income. Given the often substantial amounts payable under a qui tam/False Claims Act settlement, the opportunity cost of lost deductions could be severe to a company already burdened with making a settlement payment.
A company preparing to settle a qui tam/False Claims Act case is advised to urge the DOJ to allocate a sum of the payment to restitution or compliance to allow for a potential deduction of the payment. This may be an uphill battle considering the DOJ’s past reluctance to exclude any provisions relative to allocations in a settlement agreement. The company would also need to ensure that the DOJ adequately reports the settlement payment, or a portion thereof, as restitution to the IRS in accordance with the new reporting requirements under the Code.
Taking these steps will be critical to a company in order to secure a tax deduction to mitigate the expenditure of settling a qui tam/False Claims Act claim. Now more than ever, in-house counsel, defense attorneys, and management personnel negotiating a qui tam/False Claims Act settlement should consider consulting with a tax advisor to assess the tax implications of the settlement under the Tax Act.
 31 U.S.C. §§ 3729-3733.
 Pub. L. No. 115-97.
 A fine or penalty included amounts paid “as a civil penalty imposed by Federal, State, or local law” and “in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).” Treas. Reg. § 1.162-21(b)(1)(ii), (iii).
See Fresenius Medical Care Holdings, Inc. v. U.S., 763 F.3d 64 (1st Cir. 2014).
 Code Section 162(f)(2)(A); Conference Rep’t 115-466, 430 (Dec. 15, 2017).
See Code Section 6050X.