United States

IRS releases proposed regulations under section 162(f)

Provides guidance on disallowed deductions for fines and penalties

TAX ALERT  | 

Today the IRS issued proposed regulations (REG-104591-18), addressing the disallowance of deductions for amounts paid or incurred for fines, penalties and other amounts. In addition, the IRS released the information reporting requirements under section 6050X, enacted by the tax law changes commonly referred to as the Tax Cuts and Jobs Act (TCJA). 

Background

The TCJA amended section 162(f) to disallow deductions for amounts paid or incurred to any government or governmental entity, including nongovernmental entities that exercise self-regulatory powers in connection with a qualified board or exchange or as part of performing an essential governmental function, in relation to the violation of a law or the investigation or inquiry into the potential violation of a law. There are, of course, exceptions to the general rule, including exceptions related to amounts constituting restitution or paid to come into compliance with law, amounts paid or incurred as the result of certain court orders in which no government or governmental entity is a party, and amounts paid or incurred as taxes due.

The TCJA also implemented information reporting requirements through the addition of new section 6050X. Section 6050X requires the appropriate official of any government or entity to report amounts greater than $50,000, in aggregate, required to be paid as a result of the suit or agreement. This is irrespective of whether section 162(f)(1) applies or if the payments constitute restitution or remediation of property or are payments required to come into compliance with law. Section 6050X(b) requires the entity completing the information return to furnish to each party to the suit, agreement or otherwise a written statement that includes (1) the amount required to be paid as a result of the order or agreement; (2) any amount required to be paid as a result of the order or agreement that constitutes restitution or remediation of property; and (3) any amount required to be paid as a result of the order or agreement for the purpose of coming into compliance with a law that was violated or involved in the investigation or inquiry. The information return must be filed at the time the agreement is entered into. 

The proposed regulations increased the reporting threshold from $600 to $50,000 to address comments received from governments and governmental entities concerned about the burden of information reporting requirements.

The IRS published Notice 2018-23 to provide transitional guidance on the identification requirement of section 162(f)(2)(A)(ii), in which the taxpayer identifies the amounts paid as restitution or to come into compliance with such law, and the information reporting requirement under section 6050X. Notice 2018-23 provides that, until the Treasury Department and the IRS issue proposed regulations, the identification requirement is treated as satisfied if the order or agreement specifically states on its face that an amount is paid or incurred as restitution, remediation or to come into compliance with a law. The proposed changes do not update this guidance. Instead, the identification requirement remains in effect until after the date the proposed regulations are adopted as final, thus taxpayers, governments and governmental entities may rely on the identification requirement as provided in Notice 2018-23. 

Updated Guidance

The proposed regulations revise Treas. Reg. 1.162-21(a) to disallow deductions for amounts paid or incurred by suit, agreement or otherwise, to a government or governmental entity, in relation to the violation, or investigation or inquiry into the potential violation, of any civil or criminal law. Prop. Treas. Reg. 1.162-21(b) provides guidance related to exceptions to the general rule, as discussed in section 162(f)(2). Prop. Treas. Reg. 1.162-21 also provides definitions and explanations relating to section 162(f) and expands upon the amended guidance under section 162(f).

The IRS notes that, in response to Notice 2018-23, commenters disagreed about whether restitution, for purposes of section 162(f), includes forfeiture and disgorgement. In the proposed regulations, the IRS states that forfeiture and disgorgement focus on the unjust enrichment of the wrongdoer, not the harm to the victim. As such, under the proposed regulations, restitution, remediation and amounts paid to come into compliance with a law do not include any amount paid or incurred which the taxpayer elects to pay in lieu of a fine or penalty as forfeiture or disgorgement, or to an entity, fund, group or government or governmental entity, if it was not harmed by the taxpayer’s violation or potential violation of a law. Prop. Treas. Reg. 1.162-21(f)(3)(iii) lists amounts that will not be treated as paid or incurred to come into compliance with a law.

Taxpayers who made payments related to restitution or remediation, or to come into compliance with a law, must, under Prop. Treas. Reg. 1.162-21(b)(3)(i) provide documentary evidence that they were legally obligated, under an order or agreement, to pay the amounts identified as restitution, remediation or to come into compliance with law and the date on which the amount was paid or incurred. Prop. Treas. Reg. 1.162-21(b)(3)(ii) provides a non-exhaustive list of documents that taxpayers may use to satisfy the establishment requirement. The proposed regulations further clarify that taxpayers may not rely on the government or governmental entity’s reporting under section 6050X to satisfy the requirements of Prop. Treas. Reg. 1.162-21(b)(3).

Prop. Treas. Reg. 1.6050X-1 provides the form, manner, and time of reporting. Governments and governmental entities must file Form 1098-F, Fines, Penalties, and Other Amounts, with Form 1096, Annual Summary and Transmittal of U.S. Information Returns, with the IRS on or before January 31 of the year following the calendar year in which the order or agreement becomes binding under applicable law. Governments and governmental entities must also provide each payor with a written statement identifying the information reported to the IRS and a legend that identifies the statement as important tax information that is being furnished to the IRS. Prop. Treas. Reg. 1.6050X-1(c)(2) allows for the Form 1098-F to satisfy the requirement of the written statement that must be provided to each payor. 

Prop. Treas. Reg. 1.6050X-1 also provides guidance related to situations that involve multiple payors, what to do in instances if the payment amount is not identified, and when material changes are made to terms of an agreement following the filing of Form 1098-F.

Conclusion

The newly proposed regulations, while extensive, leave many questions open for taxpayers. Prop. Treas. Reg. 1.162-21 will apply to taxable years beginning on or after the date of publication of the Treasury decision adopting the rules of proposed section 1.162-21 as final regulations in the Federal Register. However, taxpayers may rely on the rules of proposed section 1.162-21, for any order or agreement, but only if the taxpayers apply the rules in their entirety and in a consistent manner. Prop. Treas. Reg. 1.6050X-1 is applicable only to orders and agreements that become binding under applicable law on or after Jan. 1, 2022. The IRS requests that interested parties submit written or electronic comments and requests for a public hearing by July 13, 2020. 

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