United States

Court opinion tackles treatment of payments under the False Claims Act

TAX ALERT  | 

The First Circuit Court of Appeals recently released its opinion in Fresenius Medical Care Holdings, Inc. v. United States, 114 AFTR2d 2014-5699 (1st Cir. 2014), in which it held that in determining the extent to which a settlement under the False Claims Act (the FCA) is allocable to deductible, compensatory payments, a court may look to factors beyond the presence or absence of a tax characterization agreement between the settling party and the government. Although a taxpayer-favorable decision in an area that often causes controversy with the IRS, Fresenius represents a potential circuit split regarding the ability to look beyond the absence of an explicit agreement with the government specifying the intended characterization of settlements under the FCA. Thus, to support the deductibility of settlement amounts under the FCA, taxpayers should, if possible, take steps to enter into an agreement with the government that specifies the intended allocation of the settlement between compensatory and punitive amounts. 

Under section 162, taxpayers are generally allowed a deduction for ordinary and necessary business expenses. However, no deduction is allowed for penalties resulting from the violation of a law. Thus, punitive damages (and settlements representing punitive payments) are generally nondeductible. However, compensatory damages are allowed as a deduction if they meet the ordinary and necessary business expense test of section 162, as such damages are not meant to punish the payor but rather to compensate the payee for losses. 

Under the FCA, a whistleblower may bring a civil action against a company accused of engaging in fraudulent activities against the government. After governmental investigation, the government may choose to bring its own action or may intervene in the existing complaint. Where a defendant is found liable under the FCA, treble damages are generally awarded. These damages are intended not only to compensate the government for its losses but also to punish the defendant for its wrongdoing. While single damages under the FCA are treated as compensatory, some portion of the multiplier is generally viewed as compensating the government for the costs and time incurred in pursuing the action.

Because some portion beyond single damages is thus considered compensatory, the determination of the portion of treble damages that are deductible often causes controversy with the IRS. Likewise, settlements under the FCA also often result in controversy when determining which portion of the settlement amount should be allocated to deductible, compensatory amounts and which portion should be allocated to non-deductible, punitive amounts. In order to reduce this controversy, as part of the settlement proceedings, taxpayers may be able to enter into agreements with the government that specify the intended tax characterization of the settlement. However, such agreements are not available in all cases, and taxpayers are often left to determine the deductibility of the settlement amounts in the absence of an explicit agreement with the government.

In Fresenius, several actions under the FCA were brought against the taxpayer that were eventually settled with the government. No tax characterization agreement was provided as part of the settlement, and the taxpayer attempted to deduct a portion in excess of the single damages amount as a deductible expense under section 162. In challenging the deduction for this excess amount, the government argued that in the absence of a tax characterization agreement between the taxpayer and the government, any amounts in excess of the single damages amount should be treated as punitive and, therefore, nondeductible. The government's argument was based on Talley Industries, Inc. v. Commissioner, 79 AFTR2d 97-3096 (9th Cir. 1997), where the Ninth Circuit Court of Appeals reversed a Tax Court decision granting summary judgment to a taxpayer that claimed a large settlement portion under the FCA in excess of single damages as a deductible expense. In reversing the Tax Court decision, the court stated that the government does not have the burden of characterizing a settlement payment, and instead, the "taxpayer has the burden to demonstrate ‘entitlement to a particular deduction' [and] . . . [i]f evidence to establish a deduction is lacking, the taxpayer, not the government, suffers the consequence." (Talley at 97-3101). The government in Fresenius asserted that Talley thus created a rule that in the absence of an explicit agreement between the settling party and the government, any amounts in excess of the single damages amount should be treated as punitive.

The court in Fresenius disagreed with the government's interpretation of Talley, stating that while the government's interpretation was a natural one, the court's view was that Talley did not create a rule that no deduction would be allowed in the absence of a tax characterization agreement, but rather that in the absence of such an agreement, the taxpayer must be able to show the economic realities of the settlement in order to support any deduction under section 162. The Fresenius court thus ruled that in order to illustrate that FCA settlement amounts in excess of the single damages amount are compensatory in nature, relevant evidence showing the economic realities of the settlement amount, beyond the existence or absence of a tax characterization agreement, is appropriate to consider.1

Implications

Fresenius thus favorably provides taxpayers within the First Circuit's jurisdiction with the ability to support the deductibility of settlement amounts under the FCA through evidence outside of tax characterization agreements with the government. However, in light of the potential conflict this ruling creates with Talley,  to avoid ambiguity with respect to bifurcating any settlements between compensatory and punitive amounts, taxpayers both in and outside of the First Circuit's jurisdiction should try to ensure that a tax characterization agreement is included as part of the settlement. Taxpayers that are currently, or have been, engaged in actions under the FCA should work with their tax advisors to determine the appropriate federal income tax treatment of any damages or settlements incurred.

1 In Fresenius's case, the lower court (Fresenius Medical Care Holdings, Inc. v. United States, 111 AFTR2d 2013-1938 (D. Mass)) noted that documentation and testimony were presented establishing that a significant amount of pre-judgment interest over the single damages amount was required to make the government whole. As a result (and because no pre-judgment interest outside of multiple damages was sought by the government as part of the settlement proceedings), the lower court found that a jury could reasonably conclude that a large portion of the settlement over the single damages amount should be treated as compensatory.

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