Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments
Published: 2005-09-15T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: Although some civil settlement payments are deductible, their deterrence factor could be lessened if companies can deduct certain settlement payments from their income taxes. GAO was asked to (1) identify federal agencies that negotiated some of the largest dollar civil settlements, (2) determine whether selected federal agencies take tax consequences into account when negotiating settlements and officials' views on whether they should address payment deductibility in settlement agreements, (3) determine whether companies with some of the largest civil settlement payments deducted any of the payments on their federal income taxes, and (4) determine what information the Internal Revenue Service (IRS) collects on civil settlements reached by federal agencies.
section_title: What GAO Found
paragraphs: The Environmental Protection Agency (EPA), Securities and Exchange Commission (SEC), and Department of Justice (DOJ) negotiated civil settlements that were among the largest in the federal government in fiscal years 2001 and 2002. Also, the Department of Health and Human Services (HHS) was involved in negotiating some of the largest dollar False Claims Act (FCA) health-care civil settlements for which DOJ has primary responsibility. The largest civil settlements at these agencies ranged from about $870 thousand to over $1 billion. Officials in the four agencies we surveyed said that they do not negotiate with settling companies about whether settlement amounts are tax deductible. They said it was IRS's role to determine deductibility. In preparing to negotiate environmental settlements, EPA and DOJ may consider certain tax issues in calculating the amounts they propose to seek. This calculation estimates a company's economic benefit, that is, the financial gain from not complying with the law. Some DOJ environmental settlements with civil penalties have language stating that penalties are not deductible. DOJ officials said since the law is generally clear that civil penalties paid to a government are not deductible, stating so in the agreement was merely restating the law and is not necessary. The majority of companies responding to GAO's survey on how they treated civil settlement payments for federal income tax purposes deducted civil settlement payments when their settlement agreements did not label the payments as penalties. GAO received responses on 34 settlements totaling over $1 billion. For 20 settlements, companies reported deducting some portion or all of their settlement payments. IRS does not systematically receive civil settlement information from all four agencies. IRS officials said that a permanent system for agencies to provide information would be useful. IRS obtains information on a case-by-case basis from public sources and agencies. IRS also has two temporary compliance projects focusing on tax issues that affect settlement payment deductibility. In 2004, IRS introduced a tax schedule to provide information on a company's fines, penalties, and punitive damages.

section_title: Letter
paragraphs: The value of civil settlements that federal regulatory agencies annually  reach with those who violate laws or regulations can exceed billions of  dollars. Civil settlements, which can be used to avoid litigation, are one of  the enforcement tools some agencies can use to correct violations and  punish those who violate laws or regulations by imposing penalties or  other actions. Many civil settlements with federal agencies may require  that the entities settling with the agencies make monetary payments. When  negotiating settlements, agencies consider many factors, which may  include whether payments are sufficient in size to deter the violator or  others from violating applicable laws or regulations in the future and  mitigate any economic benefit that the violator gained from not complying.
The deterrence effect of monetary payments could be lessened if violators  are able to deduct the civil settlement payments from their income taxes  since deductions reduce the amount of tax violators would otherwise pay.  In general, payments that are intended to punish (punitive payments) a  violator are not deductible and payments made to compensate  (compensatory payments) those who were harmed by a violation are  deductible under federal law. Nevertheless, it may not always be clear  which payments are deductible, in part because the Internal Revenue Code  (IRC) does not address the deductibility of all types of payments that may  be made pursuant to a civil settlement and the statutes imposing the  payments may be unclear regarding whether they are punitive,  compensatory, or both. Over the last several years, concerns that some  companies deducted, or planned to deduct, large civil settlement payments  from their federal income taxes have heightened Congress’s interest in this  area.
Because of your interest in obtaining information on how agencies address  tax issues for civil settlements and how companies have treated civil  settlement payments on their federal income tax returns, you asked us to  review some of the largest settlement agreements and determine how  some companies have treated their civil settlement payments for federal  tax purposes. As agreed, the objectives of this report are to (1) identify  federal agencies that negotiated some of the largest dollar civil settlements  in recent years, (2) determine whether the selected federal agencies  having some of the largest civil settlements take tax consequences into  account when negotiating settlements and officials’ views on whether they  should address the deductibility of payments in the agreements,   (3) determine whether the companies that paid some of the largest civil  settlement payments deducted any of the payments on their federal  income tax returns, and (4) determine what information the Internal  Revenue Service (IRS) collects on civil settlements reached by federal  agencies.
To identify federal agencies that negotiated the largest dollar civil  settlements in recent years, we analyzed information from various  sources, including agencies’ Web sites, annual reports and enforcement  reports, and other available information. Based on our analysis of the  information, we concluded that the Environmental Protection Agency  (EPA), the Securities and Exchange Commission (SEC), and the  Department of Justice (DOJ) negotiated some of largest civil settlements  in fiscal years 2001 and 2002. We also included the Department of Health  and Human Services (HHS) because HHS was involved in negotiating  some of the largest dollar False Claims Act (FCA) health care civil  settlements that DOJ has primary responsibility to negotiate. We selected  this time frame since it would allow the settling companies time to pay the  settlements; determine the applicable tax treatments, if any; and file  federal income tax returns. We interviewed officials in these agencies to  identify and obtain copies of their largest civil settlements.
To determine whether the four federal agencies having some of the largest  civil settlements take tax consequences into account when negotiating  civil settlements, we determined whether the agencies negotiate with  companies about whether civil settlement amounts are tax deductible and  whether the agencies considered any aspects of taxes when internally  deciding on what settlement amounts they should present for the  negotiations. In making these determinations, we reviewed the underlying  agreements and obtained information on the agencies’ civil settlement  policies and procedures, including whether they address tax issues, and  interviewed officials. We also obtained agency officials’ views on whether  they should address the deductibility of payments in the agreements.
To determine whether the companies that paid some of the largest civil  settlement payments deducted any of the payments on their federal  income tax returns, we developed a questionnaire to survey the  companies. We did not independently verify the responses of the surveyed  companies.
To determine what information IRS collects on civil settlements reached  by federal agencies, we interviewed knowledgeable officials from IRS and  the four agencies and reviewed supporting documentation about what  information, if any, IRS obtains from the four selected agencies regarding  their civil settlement agreements.
You also asked us to provide information on whether corporate taxpayers’  deductions for settlement payments were being examined in IRS audits  and the outcome of the audits. To obtain this information, we interviewed  IRS officials concerning our work and requested information on whether  corporate taxpayers’ deductions for settlement payments were being  examined in audits and the outcome of the audits. Appendix II provides  this information.
We assessed the reliability of the lists of the largest settlement agreements  identified by the agencies and found them to be sufficiently reliable for the  purposes of our reporting objectives. Our work was conducted from  February 2004 through June 2005 in accordance with generally accepted  government auditing standards. (See app. I for a more detailed description  of our scope and methodology.)
subsections: section_title: Background
paragraphs: Civil settlements are one of several enforcement tools used by some  federal agencies to help ensure that individuals and companies comply  with the laws and regulations they enforce. For purposes of this report,  civil settlements involve negotiations by federal agencies with companies  to resolve issues about their compliance with laws and regulations. The  negotiation process can involve discussions between agency officials and  a company about each party’s proposals to address the compliance  problem and can end with a written agreement that reflects the terms  reached by the settling parties. In such cases, the civil settlements  generally require a company to agree to perform certain activities or stop  engaging in certain activities. Some settlements also require that monetary  payments be made to the government and to others. When determining  settlement amounts, agencies consider various factors, including  thresholds for fines and penalties set by federal statutes for violations and  the severity of the violation.
While some agencies have administrative authority to enter into civil  settlements, some cases are required to be referred to DOJ for resolution.  For these cases, DOJ may settle with the defendant or take the defendant  to court. Of the four agencies we contacted, DOJ is responsible for certain  environmental settlements on behalf of EPA and certain civil health care  fraud cases on behalf of HHS.
Section 162 of the IRC provides a deduction for all ordinary and necessary  business expenses, including settlements and similar payments. This  provision is subject to an exception in IRC § 162(f) that denies a deduction  for any fine or similar penalty paid to the government for the violation of  any law. The definition of “fine or similar” penalty includes an amount  paid in the settlement of the taxpayer’s actual or potential liability for a  fine or penalty (civil or criminal). Furthermore, Treasury regulations  provide that payments made as compensatory damages paid to a  government do not constitute a fine or penalty. In general, IRS views  punitive payments as being nondeductible and compensatory payments as  being deductible.
Although the terms used to describe a payment required as part of a civil  settlement may provide an indication of whether the amount is deductible  or not, according to IRS, often it is necessary to look to the intent of the  law requiring the payment or the facts and circumstances of the settlement  to determine whether a payment is deductible. Civil settlement agreements  we reviewed use terms other than “compensatory” or “punitive” to  describe settlement payments. For instance, some agencies use terms like  restitution or disgorgement for payments that are intended to compensate  the government or others. Even when a term used to describe a payment  may seem to indicate that a payment is not deductible, in fact, the opposite  may be the case. For example, a payment labeled as a civil penalty and  that seems not deductible may be deductible if it is imposed as a remedial  measure to compensate the government or other party. Or, payments that  will be used for remedial or compensatory purposes and seem deductible  may not be so if the law requiring the payment indicates the payment is to  have a punitive or deterrent effect. IRS and courts look to the purpose of  the statute, including the legislative history and administrative and judicial  interpretation, to determine whether a payment serves a punitive or  compensatory purpose. If the law is unclear, or if the statute serves both  punitive and compensatory purposes, the facts and circumstances of the  specific settlement payment, including the terms of the settlement  agreement, often need to be examined to determine the purpose the  parties intended the payment to serve.
Until recently, IRS did not have a tax form that could be used to identify  whether a fine or penalty had been deducted for tax purposes. Effective  for any tax year ending on or after December 31, 2004, corporations with  consolidated assets of $10 million or more that are required to file IRS  Form 1120, the corporate income tax return, must also file Schedule M-3.  Schedule M-3 requires companies to reconcile financial accounting net  income (or loss) with taxable net income and expense and deduction  items. The 2004 Schedule M-3 line items for reconciliation include fines,  penalties, and punitive damages.
section_title: Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were among the Largest in Fiscal Years 2001 and 2002
paragraphs: In fiscal years 2001 and 2002, EPA, SEC, HHS, and DOJ negotiated some of  the largest civil settlements in the federal government. The civil  settlements we examined ranged in size from about $870 thousand to over  $1 billion. (See table 1.) For example, a 2001 EPA judicial settlement  related to the Clean Air Act required a utility company to significantly  reduce harmful air pollution from its power plants at an estimated cost of  over $1 billion and pay a $3.5 million fine. The cumulative value for the 20  largest settlements for fiscal year 2001 and the 20 largest settlements for  fiscal year 2002 at the four agencies—a total of 160 settlements—exceeded  $9 billion.
section_title: The Four Agencies Do Not Negotiate the Tax Deductibility of Settlement Amounts, but Two Agencies Consider Aspects of Taxes in Determining Amounts for Negotiations
paragraphs: Officials in the four agencies said that they do not take tax consequences  into account during negotiations with settling parties, that is, they do not  negotiate with companies about the deductibility of settlement amounts.  They said they generally do not have tax expertise and that determining  deductibility of settlement amounts is IRS’s role. When negotiating,  officials said they look to the relevant laws and regulations and the facts  and circumstances of the case, including the severity of the violation and  the strength of the evidence against the violator to determine the  settlement amount to seek. In preparing for negotiations, two agencies— EPA and DOJ—consider certain tax issues in calculating the amounts they  propose to seek in negotiating environmental settlements. This calculation  estimates a company’s financial gain from not complying with the law, that  is, their economic benefit. The agencies factor in whether the company  would have incurred tax deductible expenses to stay in compliance and  apply the violator’s year-specific combined state and federal marginal tax  rates to the costs of complying on time and complying late. Except for  some settlement agreements stating that civil penalties are not deductible,  the agencies’ written civil settlement agreements we reviewed generally  did not specify the deductibility of settlement amounts. As an exception to  this general practice, we found that some DOJ environmental settlements  with civil penalties included language indicating that the penalties would  not be deducted for federal income tax purposes. DOJ Environmental and  Natural Resources (ENR) Division officials explained that when a  settlement agreement includes civil penalties, their attorneys have  discretion about whether to include such language in an agreement. The  officials emphasized that the law is generally clear that civil penalties paid  to a government are not deductible and stating so in the agreement is  essentially restating the law and is not necessary. In addition, in 2003,  subsequent to the time frame of the settlements we reviewed, SEC  adopted a policy of requiring settlement agreements with civil penalties to  include language stating that the settling parties would not deduct civil  penalties for tax purposes.
Table 2 describes the four agencies’ practices regarding how they consider  tax issues during their settlement negotiation processes, including drafting  the terms of their settlement agreements. The settlement agreements we  reviewed were consistent with the practices described to us by the  agencies’ officials. These practices are current as of June 2005. Because  each settlement agreement is unique, settlements negotiated by these  agencies can have some exceptions to the practices listed in the table.
As table 2 shows, the selected agencies do not negotiate with companies  about whether they can deduct any portion of their settlement from their  income taxes. In determining their negotiating position and any changes to  agree to during negotiations, officials generally look to factors such as the  relevant laws and regulations and the facts and circumstances of the case,  including the severity of the violation and the strength of evidence against  the violator. Officials in the four agencies said that determining  deductibility is IRS’s role, and they generally do not have the expertise to  address the deductibility of payments during negotiations or to specify the  tax consequences of amounts in the settlements. IRS staff agreed and said  that if agencies were to specify whether a settlement amount is deductible,  there could be a risk that the agencies might concede tax consequences in  order to reach a settlement.
The following information summarizes the policies, procedures, and views  of the agencies on taking taxes into account during negotiations and  specifying the tax deductibility of settlement payments in the agreements.
EPA’s mission is to protect the environment and address related human  health impacts. EPA can reach civil administrative and judicial  enforcement settlements against violators of environmental laws, and its  priorities in negotiating settlements are to ensure that violators come into  compliance with the law, punish past violations and deter future  violations, obtain restoration of environmental damage resulting from  violations, and impose civil penalties sufficient to recover any economic  benefit gained as a result of the violator’s noncompliance and deter future  violations. EPA negotiated the civil administrative settlements under its  own authority without a judicial process. Cases that are brought and  settled by DOJ on behalf of EPA are referred to as civil judicial  enforcement settlements. DOJ’s policies, procedures, and officials’ views  for these cases are discussed in the DOJ section of this report.
All EPA civil settlements we reviewed included payments labeled as civil  penalties for violations of environmental laws or regulations. In addition,  the value of the settlements sometimes included estimated amounts a  company may incur to achieve and maintain compliance with the  environmental laws and regulations, such as installing a new pollution  control device to reduce air pollution or prevent emissions of a pollutant.  Also, some settlements included SEPs, which are projects a company  agrees to undertake in addition to complying actions. IRS is currently  reviewing the deductibility of SEPs.
Civil penalties in EPA settlements are generally composed of two parts:  economic benefit and gravity. Economic benefit represents the financial  gains that a violator accrues by delaying expenditures necessary to comply  with environmental regulations, avoiding them, or both. Under EPA’s civil  penalty policy, the goal of recovering the economic benefit of  noncompliance is to place the violator in the same position as if  compliance had been achieved from the start. The amount EPA includes in  a civil penalty to account for the seriousness of the violation is referred to  as the gravity portion of the penalty. EPA includes the gravity portion of  the penalty to provide deterrence against future noncompliance. When  calculating the gravity portion of the initial civil penalty amount, EPA  adjusts the gravity-based penalty on various case-specific factors,  including the strength of evidence against the company and the company’s  degree of cooperation and history of noncompliance.
When calculating the economic benefit portion of civil penalties, EPA uses  an economic computer model to estimate any financial advantage a  company gained from not complying with environmental laws. EPA’s  economic computer model takes into account whether a company would  have incurred tax deductible costs if it had complied with the law, such as  a one-time nondepreciable expenditure, in estimating the economic  benefit a company gained by not complying with environmental laws or  regulations. The computer model applies the appropriate year-specific  combined state and federal marginal tax rates of the violator in calculating  economic benefit along with standard financial cash flow and net present  value analysis techniques to calculate the costs of complying on time and  of complying late.
When calculating the gravity portion of civil penalties, EPA officials  consider the facts surrounding each violation, including factors such as  the actual or possible harm caused by the violation, the size of the  violation, and the goals of the specific environmental program. EPA  officials acknowledged that they negotiate with violators about the size of  the gravity portion of the penalty, but said in doing so they consider  factors such as the strength of their position and not whether the violator  may be able to claim a tax deduction.
When EPA settlements include civil penalty payments, EPA’s practice is  to explicitly label these payments as civil penalties. In some settlements  with civil penalties, the settlement agreements also reference IRC § 162(f),  which states that penalties payable to a government are nondeductible.  Officials noted that including language referencing IRC § 162(f) is not  EPA’s usual practice. EPA officials said that they believe the law is clear  that civil penalties payable to a government are generally nondeductible,  so they do not see inclusion of such language in settlement agreements as  necessary.
As part of some settlements, companies perform SEPs, which are projects  not required by law, that are voluntarily undertaken by a respondent in  exchange for possible penalty mitigation. EPA may mitigate the civil  penalty ultimately assessed as part of the settlement, when a respondent  agrees to undertake a SEP. EPA still collects a civil penalty as part of the  settlement in accordance with its 1998 SEP policy, which calls for  collecting the greater of 25 percent of the gravity component of the  penalty, or 10 percent of the gravity, plus economic benefit. To determine  the value of SEPs, EPA uses an economic computer model, and if a  company tells EPA that it plans to deduct the SEP costs, EPA factors the  company’s decision into valuing the SEP through the model. EPA officials  said that they are not involved in a violator’s decision to deduct the SEP  costs and that they take the violator’s decision at face value.
SEC is responsible for administering and enforcing federal securities laws  and regulations and fostering fair and efficient markets for the trading of  securities. SEC enforcement officials told us that in enforcing the  securities laws, they aim to protect investors and punish violators. In  performing its enforcement role, SEC may, among other actions, negotiate  civil settlements with those who violate securities laws. When appropriate,  SEC provides that violators make monetary payments that generally  include amounts for civil penalties and disgorgement. The SEC settlement  agreements we reviewed included penalties for violations of the securities  laws. These settlements also included disgorgement, in which SEC  attempts to ensure that violators of securities laws or regulations do not  profit from their illegal activity, and when appropriate, these disgorged  profits are returned to investors.
The IRC does not specifically address the deductibility of disgorgement.  Although IRS looks at the individual facts and circumstances of a case to  determine deductibility, it has generally regarded disgorgement payments  as compensatory, and therefore tax deductible. As previously discussed,  Treasury regulations provide that in civil actions, compensatory damages  paid to a government do not constitute a fine or a penalty.
SEC’s Chief Counsel for Enforcement emphasized that SEC’s decision on  how much of a settlement payment is penalty versus disgorgement is  based solely on the facts and circumstances of the case, including the law  violated, the degree of harm, and the seriousness of the violation.  However, the official further said that although SEC does not negotiate  with settling parties about the deductibility of settlement payments,  settling parties may initiate negotiations with SEC about how the  settlement payment is to be allocated between penalty and disgorgement.  Although settling parties may seek a larger disgorgement amount because  it is generally tax deductible, SEC staff make recommendations for  disgorgement and penalties based on their analysis.
In 2003, SEC implemented a policy requiring all civil settlement  agreements with penalties to include language that expressly prohibits the  settling party from taking a tax deduction or seeking to recover from an  insurance carrier the penalty portions of the settlement payment. SEC  adopted standardized language prohibiting deductions as a result of the  Global Research settlement, in which 10 Wall Street companies settled for  a combined $875 million in civil penalties and disgorgement. There were  reports that some of the settling companies were planning to take  deductions for the civil penalty portion of the settlement payments that  would be placed into funds for investors who were harmed by the  companies’ violations. The Sarbanes-Oxley Act of 2002 allows SEC, in  appropriate cases, to add penalties to the disgorgement fund for the  benefit of harmed investors, pursuant to the “fair fund” provisions of the  act. SEC provides in its standardized settlement language that such  amounts are to be treated as penalties for tax purposes. SEC’s settlement  agreements are silent on the tax deductibility of disgorgement. Senior SEC  officials noted that in their view, decisions about the deductibility of  disgorgement should be left to IRS.
HHS is the principal federal agency responsible for protecting the health of  American citizens and providing essential human services. HHS’s largest  civil settlements are generally FCA cases relating to civil health care fraud.  FCA generally provides that anyone who knowingly submits false claims  to the government is liable for damages up to three times the amount of  the damages sustained by the government plus penalties from $5,500 to  $11,000 for each false claim submitted. Although many FCA cases involve  civil health care fraud against the Medicare and Medicaid programs that  HHS administers, the act is also used in settling other types of fraud  perpetrated against the federal government, such as defense contractor  fraud. A civil health care FCA case, for example, could involve a health  care provider who grossly overcharged for medical services rendered and  then filed claims for reimbursement at the overcharged rates. Usually, civil  health care fraud cases are based on referrals from federal and state  investigative agencies and private persons.
DOJ is responsible for representing the United States in FCA cases and  therefore negotiates the FCA settlements. DOJ’s Civil Division carries out  those responsibilities along with U.S. Attorneys’ Offices located across the  country. Accordingly, DOJ sets the overall policy for civil health care fraud  FCA settlements. For health care settlements, HHS’s Office of Inspector  General (OIG) provides DOJ assistance in several ways, including  investigating individuals and companies that may have abused the HHS  health care programs, and sometimes works with DOJ to determine the  amount of single damages, that is, the amount of loss sustained by the  government due to the violator’s actions.
DOJ negotiates settlement agreements on behalf of other federal agencies,  including some cases involving HHS and EPA. The DOJ settlement  agreements we reviewed were limited to FCA settlements negotiated by  DOJ’s Civil Division and judicial environmental settlements negotiated by  DOJ’s ENR Division. The FCA cases negotiated by DOJ that we reviewed  contained a single payment labeled as a settlement amount, which does  not characterize the extent to which payments are for single or multiple  damages or civil penalties. All of the DOJ-led environmental settlement  agreements that we reviewed included amounts labeled as penalties and  some included SEPs.
In negotiating FCA civil settlement agreements, DOJ Civil Division officials  said that they do not consider or discuss any aspects of taxes. In  calculating the settlement amount for FCA cases, DOJ first assesses the  amount of damages the violation cost the government and seeks to  recover the full amount. It also considers the severity of the violation in  determining whether the settling company should pay a multiple of the  assessed damages and civil penalties.
DOJ Civil Division officials stated that they do not include language on the  deductibility of payments in their written FCA settlement agreements. In  fact, according to the officials, all FCA settlements contain DOJ’s standard  settlement agreement language, which states that nothing in the agreement  characterizes the payments for federal income tax purposes. DOJ Civil  Division officials said that this language supports the agency’s policy of  not addressing the tax treatment of settlement payments in settlements  agreements.
DOJ Civil Division and IRS officials told us that the agencies came to a  mutual agreement that DOJ’s tax-neutral practices on the deductibility of  civil settlement payments are appropriate. Furthermore, officials added  that the settlement agreements refer to the payments as a settlement  amount because the negotiations with the settling party usually involved  agreeing on a lump sum amount without characterizing the payment into  categories such as single, double, or treble damages and civil penalties.  Officials said they do not categorize the payments more specifically  because doing so would add complexity to the negotiation process by  adding additional factors on which to obtain agreement between the  parties. Thus, the agreement does not characterize the extent to which the  settlement payment is punitive or compensatory. According to IRS staff,  single damages are generally considered compensatory and therefore tax  deductible, and any multiple damages and civil penalties are generally  considered punitive and therefore nondeductible.
Officials in DOJ’s Civil Division and HHS’s OIG said that even though FCA  allows for the assessment of penalties in addition to multiple damages,  penalties are not always sought. The HHS officials said that penalties are  not generally sought in FCA settlements because collecting a multiplier of  damages is sufficient to compensate the government and provide a  deterrence.
DOJ also negotiates environmental cases on behalf of EPA. EPA refers to  cases it sends to DOJ to settle as judicial cases since they are not resolved  under EPA’s administrative authority. EPA staff assist DOJ staff in  building these cases and EPA’s civil penalty policies generally apply to  DOJ environmental settlements. However, DOJ—not EPA—has primary  settlement authority for these cases, and DOJ is not bound by EPA’s  penalty policies.
Like EPA, in preparing for negotiations and determining the amount to  seek at settlement, DOJ considers aspects of taxes in calculating the  economic benefit a violator received from not complying with  environmental laws. However, DOJ ENR Division officials told us that  their position is to be neutral on tax issues. DOJ sometimes uses the EPA  economic benefit computer model to calculate economic benefit amounts  but may also obtain outside experts. Similar to EPA’s administrative  settlements, some DOJ-negotiated environmental settlements may involve  SEPs, which can be used to offset a portion of the civil penalty that DOJ  would otherwise seek. The officials reiterated that they do not negotiate  with the violator about the deductibility of the SEP costs, but would factor  in the violator’s stated intentions about deducting the SEP costs in  establishing its value as part of the settlement.
As with EPA civil administrative settlements, when DOJ-negotiated  environmental settlements include civil penalties, the practice is to  explicitly label these payments as civil penalties. Also, in some settlements  with civil penalties, DOJ-negotiated environmental settlement agreements  reference IRC § 162(f), which states that fines or similar penalties payable  to a government are nondeductible. DOJ ENR Division officials said that  having settlement agreements reference IRC § 162(f) is not standard  practice and would be at the discretion of officials involved in the  settlement negotiations. According to these officials, the law is generally  clear that civil penalties payable to the government are nondeductible and  stating so in agreements is merely restating the law. The officials said they  do not negotiate with the settling companies about whether the amounts  are deductible.
We observed that one large settlement agreement negotiated by DOJ’s  ENR Division contained language stating that the settling company was  not allowed to take a deduction for funding of remediation work and that  its chief financial officer must submit a certification that deductions were  not taken. DOJ’s ENR Division officials told us that a case such as this one  likely involved particular negotiating circumstances and strategies. They  emphasized that this was an exception rather than their usual practice of  not specifying the tax treatment of settlement amounts in the settlement  agreement.
section_title: A Majority of the Surveyed Companies Deducted Civil Settlement Payments, Generally When Settlement Agreements Did Not Label Payments as Civil Penalties
paragraphs: In responding to our survey, companies that paid some of the largest civil  settlement payments at the four agencies we reviewed generally reported  that they deducted civil settlement payments when the settlement  agreements did not label the payments as penalties. Conversely, when the  settlement agreements labeled the payments as penalties, the companies  generally reported that they did not deduct the payments. Overall, for 20 of  the 34 settlements for which we received survey responses, companies  stated that they deducted some or all of their civil settlement payments.  The total value of settlement amounts of the 34 settlements for which we  received responses was over $1 billion. Table 3 summarizes the overall  responses from the companies, and table 4 provides survey results on  deductions categorized according to how the settlement agreements  labeled the settlement payments.
As shown in table 4, for 15 of the 16 DOJ FCA settlements, companies  reported deducting their payments. Of these 15 settlements, 12 survey  responses showed that companies deducted the full amount of the  payment, while 3 responses showed they deducted a percentage of the full  amount—ranging from 43 to 89 percent. Consistent with DOJ’s usual  practice for FCA civil settlements, these FCA settlement agreements  referred to the settlement payment as the settlement amount, which does  not characterize whether the settlement amount included a penalty or was  punitive or compensatory in nature.
In addition, of the 15 settlements for which companies settled DOJ FCA  cases and deducted payments, companies in 7 settlements told us that they  deducted payments because, in their view, the settlement amounts were  restitution or compensatory in nature. However, minutes of a healthcare  fraud settlements meeting between IRS and DOJ show that IRS believes  FCA settlement payments usually include a punitive portion to punish  violators and to deter future violations. Also, according to DOJ’s technical  comments on the draft of this report, in most FCA settlements (apart from  those that recover strictly penalties), some of the amounts paid are in the  nature of compensatory reimbursement and may be deductible.
Five companies we surveyed reported that a sentence in their FCA  settlement agreements indicating that the settlement was not punitive in  purpose or effect was a basis for them taking deductions. The settlement  amounts deducted by these five companies totaled over $100 million.  According to a director in DOJ’s Civil Division, DOJ does not intend for  the language in FCA settlement agreements that the companies mentioned  to refer to tax treatment. The DOJ official said that this sentence is not  intended to imply that the settlement amounts are compensatory for tax  purposes, but rather to ensure that the amounts are not punitive for  double jeopardy purposes or prohibitions on excessive fines. The DOJ  official added that a subsequent statement that is standard in all FCA  settlement agreements articulates DOJ’s position on deductibility, that is,  that the agreement does not characterize the payment for federal income  tax purposes. Based on our discussions with DOJ and our survey evidence  showing that some companies cited this sentence in support of their tax  deductions, DOJ revised the relevant portions of the FCA settlement  agreement model language. Effective June 2005, the new language  removes references to the settlement not being punitive in purpose or  effect.
Furthermore, three companies that deducted FCA settlement payments  reported that they did so in whole or in part because their settlement  agreements contained language stating that the company denied  wrongdoing.  Their deductions totaled about $15.5 million.  Two of these  three companies also cited the sentence discussed in the prior paragraph  as another reason for deducting the amounts.
Also, as shown in table 4, three other companies reported deducting  settlement payments even though they were labeled as civil penalties. Two  of these companies reported that our survey made them aware that their  deductions were improperly taken, and they plan to file amended tax  returns. These deductions totaled about $1.9 million. The other company  reported that it deducted the civil penalty because it was paid to a self- regulatory organization, which the company believed was not a  government agency. This settlement agreement contained language  indicating that the self-regulatory organization settled with the company  on behalf of a federal agency.
Ten companies that responded to our survey had environmental  settlement agreements negotiated by DOJ that contained SEPs. Our  analysis of the settlement agreements for the 10 companies showed that  four agreements contained language stating that the SEP costs are not  deductible. Two companies with settlements that contained this language  reported to us that they did not deduct the costs, and the other 2  companies did not respond to the survey question. Of the 6 companies  with SEPs for which the settlement agreements did not state whether the  costs were deductible, 2 companies reported deducting the SEP costs and  the other 4 companies did not indicate whether they deducted SEP costs.
Some of the companies that reported not deducting any settlement  payments gave us varying reasons for not taking deductions. The reasons  included references to IRC § 162(f), which states, in part, that penalties  paid to a government are not deductible, and provisions in their settlement  agreements specifying that they would not deduct the settlement  payments.
section_title: No Permanent System Is in Place for Agencies to Routinely Inform IRS of Civil Settlements or Provide Other Settlement Information That IRS Would Find Useful
paragraphs: The four federal agencies do not systematically provide IRS with civil  settlement information that would be useful to IRS for compliance  purposes, although the agencies do provide such information on a case-by- case basis at IRS’s request, such as for audits of companies with  settlement agreements. The agencies told us they were willing to work  with IRS to develop a permanent system for routinely providing  appropriate information. DOJ Civil Division and EPA have established  means for providing IRS with information on civil settlement agreements  as part of IRS’s temporary compliance research projects. In 2004, IRS  introduced Schedule M-3, which could potentially help IRS identify  corporations with some settlements because it captures information on  fines, penalties, and punitive damages from companies with assets of   $10 million or more.
subsections: section_title: Settlement Information from Agencies Could Help IRS with Its Audit Strategy and Facilitate Pre-filing Agreements
paragraphs: In general, the four federal agencies do not routinely notify IRS when a  civil settlement has been reached or provide other settlement-related  information that IRS would find useful, although they provide IRS with  settlement information on a case-by-case basis. To identify settlements  that have been reached, IRS officials search agency Web sites and press  releases. DOJ ENR Division, EPA, and SEC officials said that their Web  sites generally post most of their civil settlement agreements. IRS usually  contacts the agencies on a case-by-case basis to obtain information to use  during audits in assessing whether companies properly treated their  settlement payments on their income tax returns. For example, to  determine the facts and circumstances of a settlement, IRS contacts DOJ  officials to obtain information on FCA settlements, including written  exchanges between the agency and the company and the tracking forms  that are used by DOJ to allocate settlement amounts to various  government accounts. According to IRS staff, the tracking form and the  other information it obtains from DOJ about a settlement can provide  leads for determining nondeductible punitive damages in FCA cases.
The agencies have expressed willingness to notify IRS when a settlement  has been reached and to work with IRS on providing other appropriate  information. Some steps in this direction have already been taken. For  example, EPA has designated staff to work with IRS to provide specific  settlement information.
IRS officials said that it would help IRS’s compliance efforts if agencies  systematically notified IRS that a settlement has been reached and  provided additional information, such as their intent regarding the  breakdown of the settlement payment by category (i.e., punitive versus  compensatory). According to an IRS Director in the Large and Mid-Size  Business Division, such information could play a role in determining  which firms to audit and, when an audit occurs, whether a settlement  should be covered. Further, the IRS Director said that in some cases IRS  would like to offer pre-filing agreements to settling companies, which  would resolve the tax treatment of settlement payments before tax returns  are filed. The Director focused on large settlements for which IRS  enforcement action was more likely than on smaller settlements.
section_title: DOJ and EPA Are Providing IRS Settlement Information as Part of IRS’s Temporary Compliance Research Projects
paragraphs: IRS is collecting information on certain settlements through two  compliance projects. IRS uses compliance projects to collect information  and conduct research in order to target audits in particular issue areas. It  intends to use the project results on the degree to which companies  incorrectly deduct civil settlement payments to make data-driven business  decisions on how to correct the noncompliance.
In 2003, IRS initiated a fraud settlements compliance project focusing on  the deductibility of payments made in the settlements involving fraud,  primarily FCA settlements. The fraud settlements compliance project  targets multimillion-dollar settlements where at least part of the  settlement payment may be punitive although the agreements may not  specify punitive damages. During February 2005 discussions between IRS  and DOJ, DOJ officials agreed to notify IRS promptly of FCA settlements  they reach of $10 million and more and provide a list of smaller dollar FCA  settlement agreements annually for the duration of the project. DOJ  officials told us they would be willing to continue providing IRS with this  information after the completion of this compliance project. IRS officials  said that this information would be useful to them in targeting and  conducting audits. According to the compliance project description, IRS  staff have found that for settlements involving Medicare fraud, companies  are claiming deductions for the full amount of the settlement. However,  IRS staff told us that these settlement payments generally contain a  punitive portion. This compliance project is scheduled to be completed in  2006.
In 2004, IRS initiated an environmental settlements compliance project,  which focuses on four components of environmental settlements that may  result in an income tax issue—civil penalties; SEP costs; complying  actions; and other payments and requirements, which may include  punitive sanctions. For the project, IRS says it needs access to negotiating  files, court documents, settlement documents, databases, personnel, and  attorneys at the relevant settling agencies. EPA has agreed to provide IRS  with certain case-specific information. To obtain an initial sample of  approximately 30 recently negotiated significant environmental  settlements, IRS staff searched agency press releases and Web sites and  contacted EPA and DOJ staff for settlement information on a case-by-case  basis. The initial review of this sample suggests that companies may be  noncompliant when deducting, capitalizing, amortizing, or depreciating  SEP costs. The compliance initiative description also said that some IRS  staff have questioned the appropriateness of deducting SEP costs if SEP  costs are payments in lieu of a penalty because it appears that such costs  are not deductible under IRC § 162(f). IRS officials said that IRS’s  National Office plans to issue a technical advice memorandum (TAM) that  will address SEP deductibility and capitalization issues. The compliance  project staff told us that this compliance project is scheduled to be  completed in late 2005, although it may be extended.
According to IRS’s fraud settlements compliance project description, the  compliance projects also provide IRS with the necessary information to  evaluate the potential for negotiating pre-filing agreements with settling  companies. Under pre-filing agreements, IRS and companies resolve  whether all or a portion of a settlement payment can be deducted before  the companies file their tax returns. The project description says that for  those cases for which a pre-filing agreement is not executed, IRS  examiners can more timely develop the facts and reach a position on  deductibility, which can reduce examination time on this issue while  enhancing IRS compliance results. IRS officials told us they are in  discussions with one company that reached a civil settlement regarding a  pre-filing agreement and are offering pre-filing agreements to other settling  companies.
section_title: Schedule M-3 Provides IRS with Some Settlement Information from Companies
paragraphs: IRS has a new source of information that could help it identify companies  with settlements. In 2004, IRS introduced Schedule M-3, which is designed  to reconcile differences in financial accounting and taxable income (or  loss). The schedule is being used by corporations with assets of   $10 million or more and is to be phased in for use by other corporations in  2005 and 2006. Because Schedule M-3 collects information on fines,  penalties, and punitive damages, it may help IRS identify settlements that  should be considered if a company is audited. Schedule M-3 as currently  designed may not capture settlement payments that were not labeled as  fines, penalties, or punitive damages in the written settlement agreement.  Based on our discussions, IRS officials responsible for Schedule M-3 said  that they were considering options to address this situation.
section_title: Conclusions
paragraphs: When settlement agreements specify civil penalties, the law is generally  clear that they are nondeductible. However, when the settlements do not  contain penalties, deductibility may be less clear because the IRC and the  statutes imposing the payments may be silent regarding whether the  payments are punitive or compensatory in nature. Moreover, many  settlement agreements do not contain language addressing the tax  deductibility of settlement payments. To determine the deductibility of  settlement payments during audits or in reaching pre-filing agreements,  IRS examines settlement information that would provide the relevant facts  and circumstances in a particular case.
Given this situation, one way to help IRS better ensure that companies are  properly treating settlement payments for tax purposes is to have agencies  systematically notify IRS when they have reached a settlement that  requires significant dollar payments and provide information that IRS may  find useful. With such information, IRS can better determine which  companies to examine and whether settlement payments should be part of  the examination. In addition, with a regular flow of information on  settlements as they are reached, IRS would be able to contact companies  when appropriate to obtain pre-filing agreements on how the settlement  payments should be treated on their tax returns. This may be especially  useful in cases such as the DOJ FCA settlement agreements, which may  not contain useful information for the settling company and IRS to  determine the tax treatment of the settlement amounts.
section_title: Recommendation for Executive Action
paragraphs: We recommend that the Commissioner of Internal Revenue direct the  appropriate officials to work with federal agencies that reach large civil  settlements to develop a cost effective permanent mechanism to notify IRS  when such settlements have been completed and to provide IRS with other  settlement information that it deems useful in ensuring the proper tax  treatment of settlement payments.
section_title: Agency Comments and Our Evaluation
paragraphs: We sent a draft of this report to IRS, EPA, SEC, HHS, and DOJ for  comment. We received written comments from IRS, EPA, SEC, and HHS.  DOJ provided written technical comments.
In his August 26, 2005, letter, the Commissioner of Internal Revenue (see  app. III) said that he agreed with our recommendation and said that it  would be beneficial for IRS to work with federal agencies to develop a  systematic method for obtaining information on civil settlements  contemporaneous with those settlements. He said that IRS will form an  executive led team to work with each agency with significant civil  settlements to reach agreement on what information will be provided, the  format of the information, and the frequency of delivery. IRS also provided  technical comments which we incorporated in our report.
EPA’s Assistant Administrator, Office of Enforcement and Compliance  Assurance stated in an August 26, 2005, letter (see app. IV) that EPA  generally supports our recommendation and believes that EPA already has  mechanisms to provide IRS with settlement information useful in  determining the proper tax treatment of settlement amounts. The Assistant  Administrator said that EPA’s publicly available Web site contains 3 years  of information on concluded enforcement settlements and other EPA  online enforcement databases with settlement information could be made  available to IRS. EPA believes that these mechanisms are more cost  effective than developing a specific notification process for IRS. While we  agree that EPA has mechanisms in place to provide IRS a means to access  its settlement information, we believe that it would be useful if EPA  notified IRS directly of its significant settlements contemporaneously so  IRS could ensure that it is aware of all significant settlements and be  better positioned to contact companies sooner to initiate pre-filing  agreements with them. Regarding our reference to IRS officials needing  access to information such as negotiating files and documents to help  determine the proper tax treatment of settlement payments, the Assistant  Administrator expressed concern that making such information available  to IRS could result in a waiver of any protective privilege associated with  such information and might jeopardize pending settlements and ongoing  enforcement actions. This issue was not within the scope of our study and  in our view is among the type of issues that can be addressed as IRS and  agency officials work together to establish information sharing  arrangements regarding significant settlement agreements.
The Assistant Administrator also commented on how we characterized the  value of EPA settlements and, in particular, stated that our comparison of  EPA settlement values to those of the other agencies we surveyed is  dissimilar. The Assistant Administrator said that we should only include  monetary payments for EPA civil penalties in valuing EPA settlements to  make them comparable to the value of settlements in the other agencies.  In our view, and as consistently reflected in our report, the value of an  agency’s settlements includes all components that are reflected in  settlement agreements. This was also consistent with how the agencies we  surveyed valued their settlements. We believe it would be misleading to  show the value of settlements based on civil penalties alone when the  negotiated settlement agreement clearly included other components.  Further, some settlements we reviewed, such as DOJ FCA settlements, did  not contain penalties. EPA also made some technical comments which we  have incorporated into the report to clarify and more fully present certain  information.
In a letter dated September 1, 2005, an SEC Enforcement Division director  did not specifically comment on our recommendation but said that the  Commission takes seriously the importance of meaningful sanctions in its  enforcement program (see app. V). HHS provided a letter stating they had  no comment on the draft but sent technical comments which we  incorporated into our report (see app. VI). DOJ provided some technical  comments which we included in our report to more accurately reflect  information about their settlements.
As agreed with your offices, unless you publicly release its contents earlier  we plan no further distribution of this report until 30 days from its date. At  that time, we will send copies to interested congressional committees, the  Secretary of the Treasury, the Commissioner of Internal Revenue, and  other interested parties. We will also make copies available to others on  request. In addition, the report will be available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact me  at (202) 512-9110 or brostekm@gao.gov. Contact points for our Offices of  Congressional Relations and Public Affairs may be found on the last page  of this report. GAO staff who made major contributions to this report are  listed in appendix VII.
section_title: Appendix I: Scope and Methodology
paragraphs: The objectives of this report were to (1) identify federal agencies that  negotiated some of the largest dollar civil settlements in recent years,   (2) determine whether the selected federal agencies having some of the  largest civil settlements take the tax consequences of the companies into  account when negotiating civil settlements and officials’ views on whether  they should address the deductibility of payments in the agreements,   (3) determine whether the companies that paid some of the largest civil  settlement payments deducted any of the payments on their federal  income tax returns, and (4) determine what information the Internal  Revenue Service (IRS) collects on companies with civil settlements  reached by federal agencies. In addition, we sought to identify whether  companies’ deductions for settlement payments were being examined in  audits and the outcome of the audits.
To identify federal agencies that negotiated civil settlements involving  companies with some of the largest civil settlement payments, we  analyzed information on settlements reached by various federal agencies  because we were unable to identify any single, reliably searchable,  comprehensive source or database that was known to contain such  information governmentwide. We limited our scope to settlements that  were negotiated in fiscal years 2001 and 2002 involving companies that file  IRS Form 1120, U.S. Federal Corporate Tax Return. We selected this time  frame since it would allow the settling companies time to pay the  settlements; determine applicable tax treatments, if any; and file federal  income tax returns.
As a starting point to identify agencies with large settlements in those  years, we used information in the 1998 Federal Financial Management  Status Report and Five-Year Plan that summarized assessments and  collections of civil monetary penalties by federal agencies for fiscal year  1997. The information in the report was based on data compiled from 76  federal agencies and showed which of those agencies were responsible for  the majority of the civil monetary penalty assessments and collections in  fiscal year 1997. Consolidated information on federal agency assessments  of civil penalties was not available for subsequent years because the  Federal Reports Elimination Act of 1998 eliminated the annual  requirements for federal agencies to report this information.
Generally, we then sought to determine if the same agencies that were  responsible for the majority of the civil monetary assessments and  collections in fiscal year 1997 were likely to have some of the largest  settlement amounts in fiscal years 2001 and 2002. We did this by reviewing  such material as agency press releases on settlement agreements, annual  reports, enforcement reports, and other data on agency Web sites. In  addition, we also performed more general searches of commercially  available databases that contain archived content from newspapers,  magazines, legal documents, and other printed sources and other federal  Web sites that provided information about corporate civil settlements to  help us gauge whether the settlements we were identifying at these  agencies were among the largest being reported from various publication  sources.
As part of our analysis of this information, we comparatively assessed, to  the extent possible, whether agencies tended to have relatively fewer  individual settlements with typically large-dollar assessments (millions of  dollars per individual settlement) or more numerous individual  settlements of relatively low-dollar amounts. We chose those agencies that  appeared to have a larger settlement amount per case.
We did not include IRS in the agencies we analyzed since tax settlements  are not tax deductible. We also excluded the Federal Reserve System from  consideration because its reported total settlement amounts could  incorporate settlements by multiple agencies.
By comparing and analyzing such information across the leading agencies  for overall civil assessments in 1997, we selected the Environmental  Protection Agency (EPA), the Securities and Exchange Commission  (SEC), and the Department of Justice (DOJ) for further review after  concluding that they were among those agencies responsible for  negotiating the largest individual civil settlements in fiscal years 2001 and  2002 that we could identify. Also, during these 2 fiscal years, we  determined that the Department of Health and Human Services (HHS) was  involved in negotiating some of the largest dollar False Claims Act health- care-related civil settlements that DOJ has primary responsibility for  negotiating.
We contacted each of the four agencies and requested information on its  largest civil settlements, that is, cases in which the largest dollar amounts  were to be paid to the federal government or others. In discussing our  request for lists of settlements, agency officials advised that lists of cases  based on largest settlements would likely include cases of entities not  required to file IRS Form 1120. (See table 1 in the body of this report for  information received from the four agencies on their 20 largest civil  settlements for fiscal years 2001 and 2002, which includes settlements with  some entities not required to file IRS Form 1120.)
We took several steps to assess the reliability of the agencies’ automated  systems that provided the lists of settlement agreements. We interviewed  agency officials who were knowledgeable about compiling, entering, and  checking the data in the databases used to provide the lists; reviewed  related documentation about the quality and accuracy of the data and the  systems that produced them; and to the extent possible, cross-checked the  lists with other sources. For example, we compared selected information,  such as settlement amount from copies of the actual settlement  agreements with the amount shown on the list obtained from the agencies.  We also asked the companies to confirm this information. Likewise, the  companies confirmed whether they had paid the settlement. We  determined that the lists of largest settlements and associated settlement  amount information were sufficiently reliable for the purposes of this  report.
To determine whether the federal agencies take the tax consequences of  the companies into account when negotiating civil settlements and their  views on whether they should address the deductibility of payments in  settlement agreements, we interviewed officials in each of the four  agencies about their settlement policies and negotiation processes. We  obtained and reviewed the underlying agreements and documentation on  the agencies’ policies, procedures, and processes for negotiating and  structuring civil settlements with monetary payments.
We also interviewed officials in the four agencies to determine if their  settlement policies and procedures were different now than they were  during fiscal years 2001 and 2002. We obtained documentation supporting  any major policy or procedural changes that addressed how settlement  payments are treated for tax purposes.
To determine whether the companies that paid some of the largest civil  settlement payments deducted any of their payments on their federal  income tax returns, we developed a data collection instrument (DCI) to  collect the information. We collected information from the four agencies  on their largest dollar civil settlements, that is, cases that included  payments to the federal government or others. Agency officials advised us  that the lists of the largest settlements would likely include some  settlements with entities that were not required to file IRS Form 1120.  When such a settlement was among the 20 largest, we selected additional  settlements that otherwise met our criteria. In contrast to SEC, HHS, and  DOJ, from which we obtained information on the largest civil settlements  payable to the federal government and other parties such as relators, EPA  settlement amounts included costs incurred for companies to comply with  environmental laws and regulations. We selected the largest EPA  settlements that had a civil penalty because our focus was on how  payments were treated for tax purposes. We requested copies of  settlement agreements for the cases appearing on the lists from the  agencies.
We sent the DCI we developed to 44 companies for which we were able to  obtain copies of the settlement agreements and find cognizant  representatives who were familiar with the settlements and the tax  treatment of the settlement payments and who agreed to participate in our  survey. These 44 companies were required to file IRS Form 1120. In the  end, we received DCI responses from 31 companies concerning 34 of the  settlements. We told companies that we would only report information we  collected in summary form so company names are not specifically  identified.
We examined the settlement agreements for the 34 settlements reached by  companies that responded to our DCI to determine if they contained  specific language that addressed how civil settlement payments are to be  treated for federal income tax purposes. In those instances where we  found specific language that addressed how civil settlement payments are  to be treated for federal income tax purposes, we followed up with agency  officials to corroborate how this treatment related to the specific agencies’  policies and procedures.
The settlement agreements we examined are not a representative sample  of settlements for these agencies in these fiscal years, and the results of  our examination cannot be generalized to other settlement agreements.  Likewise, the information we obtained through our DCI represents the  responses of each company that voluntarily completed the instrument  with regard to a specific settlement. Their responses cannot be generalized  to any other population of settlements. Other than verifying the settlement  amount and that the amount was paid by the companies when possible, we  did not verify the other company responses to our survey questions.
To determine what information IRS collects on companies with civil  settlements reached by federal agencies, we interviewed knowledgeable  officials from IRS and the four agencies and reviewed supporting  documentation about what information, if any, IRS obtains from the four  selected agencies regarding their civil settlement agreements.
To determine the results of IRS’s audits of companies concerning the tax  treatment of settlement payments, we obtained information from  knowledgeable IRS auditing staff. An IRS technical advisor (TA) manager  provided us readily available information on IRS’s industry groups in its  Large and Mid-Size Business Division on the results of corporate audits  where the deductibility of civil settlement payments was an issue.
We conducted our work at EPA, SEC, HHS, DOJ, and IRS regional and  headquarters offices, from February 2004 through June 2005 in accordance  with generally accepted government auditing standards.
section_title: Appendix II: Selected IRS Audit Results Information on Companies with Civil Settlement Payments
paragraphs: According to selected information IRS provided on 46 companies that  claimed settlement payment deductions on their income tax returns, IRS  adjusted or proposed adjustments for approximately half of these  companies. The 46 companies settled with varying agencies, including  EPA, HHS, and DOJ. In the 24 cases for which IRS adjusted or proposed  adjustments to the amount deducted as settlement payments on the tax  return, the adjustments ranged from “not substantial” to 100 percent,  according to the IRS examiners’ notes for the cases.
According to IRS staff, only a portion of the amount listed as a settlement  payment would be nondeductible. Because these portions would be  deemed to be penalties, the balance would be a deductible compensatory  expense. IRS collected this information under compliance research  projects and from additional information from staff familiar with audits of  companies in which the deductibility of settlement payments was an issue.
This information, which covers multiple years, is limited to these  particular companies. As IRS staff selected the 46 companies for audit or  research because of potential noncompliance, these audit results cannot  be projected to other companies with civil settlements.
section_title: Appendix III: Comments from the Internal Revenue Service
section_title: Appendix IV: Comments from the Environmental Protection Agency
subsections: section_title: GAO Comments
paragraphs: 1.  We reviewed the text in our draft report and believe that it adequately  distinguishes between monetary payments made directly to a  governmental entity and costs to be incurred by a defendant as a  consequence of performing actions required under a civil settlement  agreement.  To illustrate, a note to table 1 in our draft report stated  that “For settlements identified by EPA, the total value of settlements  included payments payable to the U.S. government; the estimated cost  of any Supplemental Environmental Projects; and the estimated costs  of pollution controls, monitoring equipment, or other complying  actions that companies are required to take to come into compliance  with environmental laws.”  2.  As the Assistant Administrator suggested, we have revised our report  to show that a proposed legislative provision mentioned in a footnote  to disallow tax deductions for amounts paid to or at the direction of a  government in relation to a violation was not included in the bill   signed into law.  However, our report shows that a new provision has  since been introduced.
section_title: Appendix V: Comments from the Securities and Exchange Commission
section_title: Appendix VI: Comments from the Department of Health and Human Services
section_title: Appendix VII: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Acknowledgments
paragraphs: In addition to the contact named above, Thomas Beall, Danielle Bosquet,  Charlie Daniel, Keira Dembowski, Jeanine Lavender, Cheryl Peterson,  Michael Rose, Amy Rosewarne, and Jennifer Wong made key  contributions to this report.