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No Deduction Allowed in 2012 for Lawsuit Settlement Check Delivered in 2013

(Parker Tax Publishing May 2023)

The Tax Court held that taxpayers who tentatively settled a lawsuit in 2012 with United States Department of Housing and Urban Development (HUD) and delivered a cashier's check to their attorney to pay the settlement amount were not entitled to a deduction for the payment in 2012 because their attorney did not deliver the check to the government until 2013. However, the court held that the taxpayers were not liable for a penalty under Code Sec. 6662 because they acted reasonably and in good faith in claiming the deduction on their 2012 tax return. Gage v. Comm'r. T.C. Memo. 2023-47.


In 1995 Edwin Gage incorporated RMG, Inc. as an Oklahoma corporation. He also incorporated Heartland Care Group, Inc., and it became RMG's parent company. Edwin and his wife, Elaine, jointly owned 30 percent of both RMG and Heartland Care.

RMG paid $7.25 million for Heartland Health Care Center of Bethany (Center), a nursing home in Bethany, Oklahoma. In 1996, Heartland of Bethany was incorporated as a wholly-owned subsidiary of RMG to help win a refinancing of the Center that would be insured by the U.S. Department of Housing and Urban Development (HUD). Heartland of Bethany borrowed nearly $5 million from Harry Mortgage Co. Harry Mortgage secured the loan with a nonrecourse mortgage. HUD insured the mortgage and required RMG to operate as an identity-of-interest management agent for the management of the Center. HUD also got both RMG and Heartland of Bethany to sign regulatory agreements with HUD. The Gages themselves did not sign, but the regulatory agreements designated them as owners.

In 2003, Heartland of Bethany defaulted on the mortgage. That same year, Harry Mortgage assigned the mortgage on the Center to HUD. HUD foreclosed in 2004 and then sold the Center for just over $600,000. HUD's loss ended up being about $4 million. In 2010, the government sued RMG's owners in federal district court. It sought double damages, costs, and fees under two federal statutes, the National Housing Act and the Housing and Community Development Act of 1987, for the recovery of Center assets and income. The government's complaint alleged that the owners used the Center's assets and income in breach of the regulatory agreement terms. The complaint also included a claim under federal common law for unjust enrichment.

In 2012, the Gages, RMG's other owners, and counsel for the United States tentatively agreed to settle the case for $1.75 million, of which the Gages would pay $875,000. The magistrate judge who supervised the settlement talks entered an order in which he noted that a settlement conference was held and that the settlement was contingent upon acceptance and approval by the Department of Justice (DOJ). The district court then entered an administrative closing order, which terminated the suit without prejudice.

On December 27, 2012, the Gages purchased a cashier's check in the amount of $875,000 and delivered it to their lawyer. Their lawyer emailed the Assistant U.S. Attorney who represented the government to inform him that the check would soon be delivered. The Assistant U.S. Attorney, however, explained that the United States did not have authority to receive the cashier's check before the settlement was finally approved. The Gages' lawyer held onto the check. The DOJ reviewed the settlement agreement and finally signed it in March 2013. On March 18, 2023, the Gages' attorney finally delivered the cashier's check, dated December 12, 2012, to the United States.

The settlement agreement stated that the owners had used the Center's assets and income in violation of the regulatory agreements but that the owners denied any wrongdoing. The settlement agreement also expressly stated that the United States was not agreeing to or in any way representing how the settlement amount would affect the owners' tax bill. It instead stated that nothing in the agreement constituted a representation as to the character of the settlement payment or the agreement for federal income tax purposes.

On their 2012 income tax return the Gages claimed the $875,000 payment as a business loss under Code Sec. 162(a). The Gages included the payment as a 2012 loss because they delivered the check to their attorney before the end of that year. The IRS disagreed, and added a substantial-understatement penalty under Code Sec. 6662. The IRS sent the Gages a notice of deficiency, which the Gages challenged in the Tax Court.

Code Sec. 162(a) allows taxpayers to deduct all ordinary and necessary business expenses. However, under Code Sec. 162(f) no deduction is allowed for any fine or similar penalty paid to a government for the violation of any law. Reg. Sec. 1.162-21(b)(1) defines "fine or similar penalty" as including an amount paid as a civil penalty imposed by federal, state, or local law and an amount paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (civil or criminal). On the other hand, Reg. Sec. 1.162-21(b)(2) provides that compensatory damages paid to a government do not constitute a fine or penalty. The characterization of a settlement payment depends on the origin of the liability giving rise to it. If the origin of the liability is a law designed to compensate an injured party for its damages, then Code Sec. 162(f) is inapplicable. If the origin of the liability is a law designed to punish and deter conduct committed by the taxpayer, then the payment is nondeductible under Code Sec. 162(f).

The IRS contended that the Gages' settlement payment was not deductible for 2012 because (1) their check was not actually received by the government until 2013 and (2) regardless of the timing, the settlement was one for punitive damages. The Gages contended that the settlement was for compensatory damages and that under Oklahoma law, a payment is made when there is a tender of payment, which occurred in 2012 when they purchased a cashier's check and delivered it to their attorney.


The Tax Court held that the Gages were not entitled to deduct their $875,000 settlement payment in 2012. However, the court found that they acted reasonably and in good faith and therefore were not liable for a penalty under Code Sec. 6662(a).

The court found that the Gages' payment was not deductible in 2012 because their attorney did not deliver the check to the government until 2013. According to the court, as cash method taxpayers the Gages could take deductions only for expenses that they actually paid, not that they merely incurred, during a particular tax year. The court also noted that under federal tax law, a payment made by check is treated as made when the check is delivered. If the check is dated in one year and cashed in the next year, the deduction will not be allowed absent proof of delivery in the year of the deduction.

The court said that it did not need to review Oklahoma law because what constitutes delivery of a check made in settlement of a federal lawsuit brought by the federal government is a matter of federal, not state, law. The court noted that the litigation was between an agency of the federal government and a taxpayer, which in the court's view was not decisive but weighed in favor of using federal law. Further, the court found that settlements are contracts, and this contract was entered into under federal law. It was between a federal government agency and the Gages, and it was brought under a federal statute to protect a federal financial interest by the DOJ under its own procedures for approval of settlements. Having disallowed the Gages' deduction on timing alone, the court said that it did not need to decide whether the settlement was for punitive or compensatory damages.

The court agreed with the Gages, however, that they claimed the deduction on their 2012 return with reasonable cause and in good faith. The court found that although the Gages are competent, skilled businesspeople, they are not learned in tax law. It was more likely than not, in the court's view, that they delivered the check to their attorney with the intent of fulfilling the terms of the settlement agreement. The court said that from their perspective, they were out the $875,000 when they bought the cashier's check and gave it to their lawyer. Their reporting position on the timing issue was therefore reasonable under the circumstances, and they acted in good faith in thinking they made the payment in 2012.

The court further found that the Gages acted reasonably in believing the settlement payment was deductible. The origin of the liability, the court explained, was federal law allowing the United States to recover double damages, costs, and fees for breach of a regulatory agreement with HUD. The double damages provision, the court found, may serve both to compensate the government and to punish, and it was not clear to the court which purpose was present in the Gage's settlement. The court noted that the Gages' settlement amount was far less than the actual damages claimed, and much less than double those damages; therefore, it was reasonable for the Gages to think their payment was more compensatory than punitive. The court concluded that, when the text of the statute creating a cause of action is ambiguous, the specific text of the parties' settlement avoids giving an answer, and even the amount of the settlement can be read both ways, it was more likely than not that the Gages' return position was at least reasonable and taken in good faith.

For a discussion of the deductibility of fines and penalties, see Parker Tax ¶96,510. For a discussion of the reasonable cause defense to accuracy-related penalties, see Parker Tax ¶262,127.

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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