Internal Legal Memorandum (ILM) 201825027 provides a reminder that the intent of the parties as documented in an agreement does not necessarily govern the applicable federal tax treatment. The ILM addressed a lawsuit settlement agreement in which the parties agreed the settlement payments would be deductible to the payor. The IRS held that deductibility would not necessarily result, and additional investigation was warranted.
The ultimate question at issue was whether the payments represented nondeductible fines or penalties. Fines or penalties paid to governments are generally nondeductible under section 162(f) of the tax code. Treasury regulations extend this prohibition to fines or penalties imposed by entities that are acting as agencies or instrumentalities of a government.
Whether an entity receiving a payment is acting as an instrumentality of a government generally is determined under case law. Taxpayers and the IRS have from time to time held differing views on the subject. For prior coverage regarding the tax treatment of certain FINRA fines, please see our prior alert on CCA 201623006. As discussed in another prior alert, a 2017 Supreme Court case addressing fines paid to the Securities and Exchange Commission may be relevant, even though it is not a tax case.
Deductibility determinations in this area can hinge on the degree to which a payment should be considered compensatory rather than punitive. The determination may be difficult, particularly in cases where payments are computed-based on a principle of compensation for damages, but can be characterized as punitively motivated.
In ILM 201825027, the IRS concluded that the lawsuit settlement payments should be subjected to a similar analysis. The IRS noted that the complaints in the lawsuits involved sought remedies of a compensatory nature and some or a punitive nature. It held that the taxpayer seeking to deduct the payment would be required to provide specific reasons why they believe the legal remedy sought in the lawsuit disgorgement was compensatory rather than punitive.
The taxpayer presented the argument that the settlement agreement payments were intended by the parties to be compensatory and deductible by the taxpayer. The IRS, however, concluded that this argument was by itself not sufficient to support deductibility. The IRS instead would require that the taxpayer present a detailed analysis of the underlying legal claims and the law authorizing them, as well as facts surrounding the settlement agreement.
This ILM accordingly presents a reminder of the principle that the rights underlying a payment obligation generally govern its federal tax treatment. The tax treatment intended by the payor and payee generally does not override that principle. Taxpayers determining the tax characterization of payments made and received generally should seek tax advice where these questions arise.