IRS Finalizes Regs on TCJA Disallowance of Deduction for Fines and Penalties

(Parker Tax Publishing February 2021)

The IRS issued final regulations providing guidance on Code Sec. 162(f), as amended by the Tax Cuts and Jobs Act (TCJA), concerning the deduction of certain fines, penalties, and other amounts. The final regulations also provide guidance relating to the information reporting requirements under Code Sec. 6050X, which was enacted by TCJA, with respect to those fines, penalties, and other amounts. T.D. 9946.

Background

Prior to its amendment in 2017, Code Sec. 162(f) disallowed an ordinary and necessary business expense deduction under Code Sec. 162(a) for any fine or similar penalty paid to a government for the violation of any law. Code Sec. 162(f) was amended by the Tax Cuts and Jobs Act (TCJA). As amended by the TCJA, the general rule of Code Sec. 162(f)(1) provides that no deduction is allowed for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or governmental entity into the potential violation of any law.

Code Sec. 162(f)(2) provides an exception to the general disallowance rule in Code Sec. 162(f)(1) for certain amounts paid or incurred for restitution, remediation, or to come into compliance with a law. Under Code Sec. 162(f)(2)(A)(i) and (ii), Code Sec. 162(f)(1) does not apply to amounts that (1) the taxpayer establishes were paid or incurred as restitution (including remediation of property) or to come into compliance with a law (establishment requirement), and (2) are identified in a court order or settlement agreement as restitution, remediation, or amounts paid or incurred to come into compliance with a law (identification requirement).

TCJA also added Code Sec. 6050X, which generally requires the appropriate official of any government or governmental entity involved in a suit or agreement with respect to a violation of any law over which the government or entity has authority, and with respect to which there has been a court order, to file an information return on Form 1098-F, Fines, Penalties, and Other Amounts, if the aggregate amount involved in all orders or agreements with respect to the violation, investigation, or inquiry is $600 or more.

Under a transition rule, the TCJA amendments to Code Sec. 162(f) and new Code Sec. 6050X apply to amounts paid or incurred on or after December 22, 2017. However, they do not apply to amounts paid or incurred under any binding order issued or agreement entered into before December 22, 2017, and, if such order or agreement requires court approval, the required approval is obtained before December 22, 2017.

On May 13, 2020, the IRS published proposed regulations (REG-104591-18) providing guidance on the deduction disallowance rules in Code Sec. 162(f) and the associated reporting requirements in Code Sec. 6050X. In T.D. 9946, the IRS finalized the proposed regulations with modifications in response to practitioners' comments.

Final Regulations

Reg. Sec. 1.162-21(a) of the final regulations provides generally that a taxpayer may not take a deduction for amounts: (1) paid or incurred by suit, agreement, or otherwise; (2) to, or at the direction of, a government or governmental entity; (3) in relation to the violation, or investigation or inquiry by such government or governmental entity into the potential violation, of any civil or criminal law. Under the final regulations, this general rule applies whether or not the taxpayer admits guilt or liability or pays the amount imposed for any other reason, including to avoid the expense or uncertain outcome of an investigation or litigation. The IRS stated in the preamble to T.D. 9946 that an admission of guilt or liability is not necessary because Code Sec. 162(f)(1) contemplates a broader disallowance, as demonstrated by the disallowance of any amount paid or incurred, to, or at the direction of, a government or governmental entity in relation to the "investigation or inquiry" into the "potential violation of any law."

Regarding the "the investigation or inquiry" by a government or governmental entity, the final regulations clarify that, in general, amounts paid or incurred for routine investigations or inquiries, such as audits or inspections, required to ensure compliance with rules and regulations applicable to a business or industry, which are not related to any evidence of wrongdoing or suspected wrongdoing, are not amounts paid or incurred relating to the potential violation of any law.

Practitioners asked the IRS to reconsider a rule in the proposed regulations which excluded disgorgement and forfeiture from the definition of "restitution, remediation, and coming into compliance." Practitioners noted that, in Liu v. Securities and Exchange Commission, 140 S. Ct. 1936 (2020), which was decided after the publication of the proposed regulations, the Supreme Court recognized that amounts paid through disgorgement that do not exceed the wrongdoer's net profits and that are awarded to individual victims may constitute an equitable remedy. In consideration of practitioners' comments and the Supreme Court's decision in Liu, the final regulations do not treat disgorgement of net profits as, per se, nondeductible under Code Sec. 162(f)(1). Instead, a taxpayer's claim for a deduction for amounts paid or incurred through disgorgement will not be disallowed if (1) the amount is otherwise deductible; (2) the order or agreement identifies the payment, not in excess of net profits, as restitution, remediation, or an amount paid to come into compliance with a law; (3) the taxpayer establishes that the amount was paid as restitution, remediation, or an amount paid to come into compliance with a law; and (4) the origin of the taxpayer's liability is restitution, remediation, or an amount paid to come into compliance with a law. However, the final regulations provide that amounts paid or incurred through disgorgement will be disallowed if, under the order or agreement, the amounts are disbursed to the general account of the government or governmental entity for general enforcement efforts or other discretionary purposes.

Practitioners also requested clarification about how a taxpayer may meet the identification requirement in Code Sec. 162(f)(2)(A)(ii). The final regulations provide that the order or agreement, not the taxpayer, must meet the identification requirement and that the identification requirement is met, not presumed to be met, if the order or agreement specifically states that the payment constitutes restitution, remediation, or an amount paid to come into compliance with a law. Under the final regulations, an order or agreement will also meet the identification requirement, despite not using the words "restitution," "remediation," "remediate," "come into compliance", or "comply," if the nature and purpose of the payment, as described in the order or agreement, are clearly and unambiguously to restore the injured party or property or to correct the noncompliance. An order or agreement will also meet the identification requirement if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer to (1) restore, in whole or in part, the party, property, environment, wildlife, or natural resources harmed, injured, or damaged by the violation or potential violation of that law or (2) to perform services, take action, provide property, or doing any combination thereof to come into compliance with that law.

The final regulations clarify that the establishment requirement in Code Sec. 162(f)(2)(A)(i) is met if the documentary evidence submitted by the taxpayer proves that the taxpayer was legally obligated to pay the amount identified in the order or agreement as restitution, remediation, or to come into compliance with a law and that it was paid or incurred for the nature and purpose identified. However, under the final regulations, a government or governmental entity's submission of a Form 1098-F does not satisfy either the identification requirement or the establishment requirement. The IRS explained that the reporting requirement imposed by Code Sec. 6050X is for tax administration purposes and does not serve as documentation that the taxpayer has met the identification requirement or the establishment requirement.

The proposed regulations contained a material change rule under which some orders issued, or agreements entered, before December 22, 2017, were subject to Code Sec. 162(f)(1) as amended by TCJA. A practitioner commented that the transition rule provided in the TCJA precluded the IRS from adopting a material change rule for any binding orders issued or agreements entered into before December 22, 2017. In response, the IRS determined that Code Sec. 162(f), as amended by TCJA, does not apply to any pre-December 22, 2017, binding order or agreement - even if modified on or after December 22, 2017. In addition, the IRS noted that material changes to an order or agreement will generally result in a new order or agreement subject to Code Sec. 162(f). For these reasons, the final regulations do not include the material change rule included in the proposed regulations.

Effective Dates

The rules of Reg Sec. 1.162-21 apply to tax years beginning on or after January 19, 2021, except that such rules do not apply to amounts paid or incurred under any order or agreement, pursuant to a suit, agreement, or otherwise, that became binding under applicable law before January 19, 2021, determined without regard to whether all appeals have been exhausted or the time for filing an appeal has expired. The rules of Reg. Sec. 1.6050X-1 apply only to orders and agreements, pursuant to suits and agreements, that become binding under applicable law on or after January 1, 2022, determined without regard to whether all appeals have been exhausted or the time for filing an appeal has expired.

For a discussion of the deductibility of fines and penalties, see Parker Tax ¶96,510. For a discussion of the information reporting requirements under Code Sec. 6050X, see Parker Tax ¶252,558.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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