The process of ironing out settlements of state attorney general (“AG”) investigations and litigations is likely to get more complicated. The 2017 Tax Cuts and Jobs Act (“Act”), among the many other things it did, amended a key provision of the Internal Revenue Code (“Code”), 26 U.S.C. § 162, which governs deductions allowed as trade or business expenses—including settlements reached by businesses with government regulators and enforcement agencies. The IRS has issued transitional guidance regarding this amendment, and is seeking public comment on the amendment and potential regulations published thereunder.
Prior to the Act’s enactment, businesses that reached settlement agreements with government entities, like state AGs and federal agencies (such as the Federal Trade Commission), were allowed to take tax deductions for compensatory damages, but not fines or penalties. The Act amended the Code to prohibit all deductions of settlement costs as trade or business expenses with two important exceptions: amounts (1) “constitut[ing]” restitution or (2) “paid to come into compliance with [the] law.” Importantly, AGs will have to provide to the IRS the amounts the business will pay in each of those deductible categories. Specifically, the Act added Section 6050X to the Code, which requires any government entity involved in settlement agreements over violations of laws involving amounts of $600 or more to submit a report (current draft Form 1098-F) setting forth three amounts: the amounts (1) “required to be paid as a result of the suit or agreement,” (2) “constitut[ing] restitution,” and (3) “paid … for the purpose of coming into compliance with [the] law.” The government entity must file this return at the time the agreement is entered and provide a copy to the business involved.
These new restrictions on businesses and requirements for government entities raise many questions and concerns for those in the public and private sectors. State AGs will now be forced to identify and categorize the nature of settlement payments made. It is unclear from the face of the Act how much certainty the AG must have at the time of settlement regarding the actual restitution total to be paid. Under current practices, restitution often is agreed upon on a “per consumer” basis, with the number of consumers that seek and receive the payments unknown at the time of settlement. There is a further question as to how an AG can determine the costs a private business will incur to address an alleged violation of law. As a result, the AG may have to negotiate with the business over the amount “paid to come into compliance with the law.” State AGs and other government entities also should be concerned about the Act’s lack of direction as to how much information they must amass to support the amounts they report, how much information must be kept after the written report is made, and the implications on confidentiality under open records laws.
Because the government’s identification and characterization of settlement payments will ultimately impact the business’s tax deduction options, new topics suddenly appear on the negotiation “punch list.” Businesses should be especially concerned about whether pre-settlement expenses to comport with AGs’ positions on necessary compliance activities ultimately can be deducted. Furthermore, the Act is unclear as to how it will treat in-kind payments. The Act is also silent as to how the reporting requirement would operate in multistate AG settlements, where states have varied rules as to the appropriate designation of settlement funds.
The IRS intends to publish proposed regulations with respect to these amendments to the Code, and is seeking input about potential regulations, particularly the government entity reporting requirement. All written comments must be submitted to the IRS before November 13, 2018.