Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments
Released: 2005-10-18T00:00:00

Letter

Background

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.

Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were among the Largest in Fiscal Years 2001 and 2002

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.

The Four Agencies Do Not Negotiate the Tax Deductibility of Settlement Amounts, but Two Agencies Consider Aspects of Taxes in Determining Amounts for Negotiations

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.

A Majority of the Surveyed Companies Deducted Civil Settlement Payments, Generally When Settlement Agreements Did Not Label Payments as Civil Penalties

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.

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

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.

Settlement Information from Agencies Could Help IRS with Its Audit Strategy and Facilitate Pre-filing Agreements

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.

DOJ and EPA Are Providing IRS Settlement Information as Part of IRS’s Temporary Compliance Research Projects

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.

Schedule M-3 Provides IRS with Some Settlement Information from Companies

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.

Conclusions

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.

Recommendation for Executive Action

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.

Agency Comments and Our Evaluation

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.

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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.

Appendix I: Scope and Methodology

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.

Appendix II: Selected IRS Audit Results Information on Companies with Civil Settlement Payments

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.

Appendix III: Comments from the Internal Revenue Service

Appendix IV: Comments from the Environmental Protection Agency

GAO Comments

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.

Appendix V: Comments from the Securities and Exchange Commission

Appendix VI: Comments from the Department of Health and Human Services

Appendix VII: GAO Contact and Staff Acknowledgments

GAO Contact

Acknowledgments

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.