The IRS has issued proposed reliance regulations
“) that provide guidance on the nondeductible penalties and fines provisions under IRC §162(f) and on the required information reporting for those penalties and fines under IRC §6050X.
Background – IRC §162(f)
Prior to enactment of the Tax Cuts and Jobs Act (the “TCJA“) in 2017, IRC §162(f) generally disallowed a deduction for any fine or similar penalty paid to a government for the violation of a law. As amended by the TCJA, the general rule in IRC §162(f)(1) disallows an otherwise allowable deduction for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government, governmental entity, or certain nongovernmental entities (collectively “Government“) in relation to the violation of a law or the investigation or inquiry by such Government into the potential violation of a law (the “General Rule“).
IRC §162(f)(2)(A) provides the following exceptions to the General Rule and allows a taxpayer to deduct certain otherwise deductible amounts paid or incurred for restitution, remediation, or paid to come into compliance with a law:
(1) If the taxpayer establishes the amounts were paid or incurred as restitution (including remediation of property) or to come into compliance with a law (the “Establishment Requirement“);
(2) Those amounts are identified in the court order (“Order“) or settlement agreement (“Agreement“) as restitution, remediation, or amounts paid or incurred to come into compliance with a law (the “Identification Requirement“); and
(3) In the case of any amount of restitution for failure to pay any tax imposed by the Internal Revenue Code (the “IRC“), if the payment would have been allowed as a deduction if it had been timely paid.
Generally, under IRC §162(f)(2)(B), amounts paid or incurred as reimbursement to a Government for the costs of any investigation or litigation are not deductible. However, under IRC §162(f)(3), IRC §162(f)(1) does not apply to any amount paid or incurred by reason of any order of a court in a suit in which no Government or governmental entity is a party (i.e. private party suits).
In addition, IRC §162(f)(4) allows a deduction for certain taxes due.
Proposed Reliance Regulations on Deductible Penalties and Fines
Prop Reg. §1.162-21(a) generally restates the General Rule in IRC §162(f)(1) (the “Proposed General Rule“).
According to the Regulations, this Proposed General Rule would apply regardless of whether the taxpayer admits guilt or liability or why the taxpayer pays the amount imposed.
The Regulations state that Prop. Reg. §1.162-21(b) would provide an exception to the Proposed General Rule similar to that of IRC §162(f)(2) and allow taxpayers to deduct amounts paid or incurred as restitution, remediation, or to come into compliance with a law (hereinafter collectively referred to as “Restitution“) that satisfy:
(1) The Identification Requirement, and
(2) The Establishment Requirement.
Under the Regulations, Restitution would mean to restore the person or property, in whole or in part, to the same or substantially similar position or condition as before the harm caused by the taxpayer’s violation, or potential violation, of a law.
Restitution would exclude any amount that a taxpayer elects to pay in lieu of a fine or penalty or as forfeiture or disgorgement or any amount the taxpayer paid or incurred to the extent the payee was not harmed by the taxpayer’s violation or potential violation of a law.
Under the Regulations, taxpayers would be able to satisfy the Establishment Requirement by providing documentary evidence:
(1) That the taxpayer was legally obligated to pay the amount the Order or Agreement identified as Restitution;
(2) Of the amount paid or incurred; and
(3) Of the date on which the amount was paid or incurred.
Taxpayers would be able to satisfy the Identification Requirement if the Order or Agreement to make the payment specifically states that the payment constitutes Restitution. The Identification Requirement would be met even if the Order or Agreement uses a different form of the requisite words, such as “remediate” or “comply with a law.”
If an Order or Agreement identifies a payment as Restitution but does not identify the aggregate amount the taxpayer must pay to satisfy the Identification Requirement, the Order or Agreement would be required to describe the damage done, harm suffered, or manner of noncompliance with a law, and describe the action required by the taxpayer (such as incurring costs to provide services or to provide property) with respect to the damage, harm, or noncompliance.
In addition, while IRC §162(f)(4) allows a taxpayer to deduct amounts paid or incurred as otherwise deductible taxes or related interest, Prop. Reg. §1.162-21(a) would disallow a deduction for any interest paid on penalties.
Finally, if a deduction allowed under Prop. Reg. §1.162-21(b) or Prop. Reg. §1.162-21(c) results in a tax benefit to the taxpayer, Prop. Reg. §1.162-21(d)(2) would require the taxpayer to include in income the recovery of any amount deducted in a prior tax year to the extent the prior year’s deduction reduced the taxpayer’s tax liability.
Background – IRC §6050X
IRC §6050X(a), which was added to the IRC by the TCJA, generally requires the appropriate official of any Government that receives a payment to which IRC §162(f) applies, to file an information return if the aggregate amount involved in all orders or agreements with respect to the violation, investigation, or inquiry is above a $600 threshold.
Under IRC §6050X(c), an appropriate official of a Government is the officer or employee having control of the suit, investigation, or inquiry, or an appropriately designated person.
IRC §6050X(a)(2)(B) authorizes the IRS to adjust the threshold amount for filing the information return as necessary to ensure the efficient administration of the internal revenue laws.
Per IRC §6050X(a)(1), the information return must set forth:
(1) The amount required to be paid as a result of the Order or Agreement (see above);
(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.
IRC §6050X(a)(3) provides that the Government must file the information return at the time it enters into such an agreement, and IRC §6050X(b) requires the Government to furnish to the payor a written statement that includes:
(1) The name of the Government or entity, and
(2) The information submitted to the IRS.
Regulations on Required Information Reporting
Under the Regulations, the required information return would need to provide:
(1) The aggregate amount a payor is required to pay as a result of the Order or Agreement;
(2) The separate amounts required to be paid as Restitution as a result of the Order or Agreement; and
(3) Any additional information required by the information return and the related instructions.
The appropriate official would be allowed to comply with the information reporting requirement by filing Form 1098-F, Fines, Penalties, and Other Amounts (or any successor form), with Form 1096, Annual Summary and Transmittal of U.S. Information Returns, with the IRS on or before the annual due date. The annual due date for filing Form 1098-F with the IRS is January 31 of the year following the calendar year in which the Order or Agreement becomes binding.
The appropriate official would also be required to furnish a written statement with the same information to the payor. The Regulations would permit the appropriate official to comply with this requirement by furnishing a copy of Form 1098-F to the payor on or before January 31.
In addition to the individual described in IRC §6050X(c), an appropriate official may be any officer or employee the Government assigns to comply with the IRC §6050X reporting requirements.
Under Prop Reg. §1.6050X-1(g)(5), the threshold amount for required information reporting is $50,000. Prop Reg. §1.6050X-1(d) would provide special rules for situations where pursuant to the Order or Agreement, the aggregate amount multiple payors are required to pay, or the costs to provide the property or the service, equals or exceeds the $50,000 threshold amount. For example, Prop Reg. §1.6050X-1(d)(1) would require the appropriate official to file an information return for the separate amount that each individually liable payor is required to pay, even if a payor’s payment liability is less than the threshold amount, and to furnish a written statement containing this information to each payor.