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A 2010 court decision that favored the IRS over a corporate taxpayer provides useful insights for other companies making restitution payments to the government.
Robert Willens, CFO.com | US
July 19, 2010
On January 18, 2000, Fresenius Medical Care Holdings Inc. and the United States signed a "Global Agreement" resolving a series of suits against the company on claims of Medicare fraud. The agreement required Fresenius to pay the astonishing sum of $486,334,232 to the United States — $101,186,898 under the criminal agreements and $385,147,334 under the civil agreements. The civil agreements provided that "nothing in this Agreement constitutes an agreement by the United States concerning the characterization of the amounts paid...(for tax purposes)."
In its 2000 and 2001 tax returns, Fresenius claimed deductions for the entire civil payment. The IRS maintains that payments totaling $126,796,262 are not deductible. Fresenius moved for summary judgment but the court denied its motion. The issue, therefore, will have to be decided "on the merits" at trial.1
The Internal Revenue Code permits taxpayers to deduct all of the "ordinary and necessary" expenses paid or incurred during the taxable year in carrying on any trade or business.2 Amounts paid to settle litigation may constitute such an expense. However, "No deduction shall be allowed...for any fine or similar penalty paid to a government for the violation of any law."3
The regulations define a "fine or similar penalty" as a payment made under any one of the following circumstances:
• paid pursuant to conviction or plea of guilty or nolo contendere for a crime in a criminal proceeding;
• paid as a civil penalty imposed by federal, state, or local law; or
• paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (either civil or criminal). (See Regulation Section 1.162-21(b).)
However, compensatory damages paid to a government do not constitute a fine or penalty. For example, in Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497 (1980), the tax court addressed the applicability of the Internal Revenue Code, specifically Section 162(f), in terms of the purpose of civil settlement payments. The court characterized Southern Pacific payments as either "remedial" (in which event they are deductible) or "punitive" (in which instance the payments are not deductible).
Fresenius argues that the "plain language" of the civil agreements indicates the payments are nonpunitive, and therefore not a penalty. Fresenius's argument hinges on language in the civil agreements stating that "the FR entities agree that nothing in this Agreement is punitive in purpose or effect." The government responds that the language merely constitutes a concession by Fresenius that the civil payments are not punishment for purposes of the Double Jeopardy Clause and the Excessive Fines Clause of the Constitution.
Further, Fresenius insists "that the plain language in the civil settlements resolves the issue...because the parties agreed that the damages were not punitive." The court disagreed. It noted that the argument (advanced by Fresenius) "is not persuasive" because of the context of the language (cited by Fresenius). That is, the language appeared in the last sentence of a paragraph waiving Fresenius's rights under the aforementioned clauses.
The tax court noted that the Supreme Court has "long recognized that the Double Jeopardy Clause does not prohibit the imposition of all additional sanctions that could, in common parlance, be described as punishment."4 In short, whether a payment is deemed compensatory for Double Jeopardy purposes does not determine whether it is deductible for tax purposes.
Moreover, the court observed that only Fresenius, not the government, agreed that the purpose was not punitive. In addition, the agreement explicitly states that the United States does not release Fresenius from any claims arising out of the Internal Revenue Code and that the United States agrees to no characterization of the payments under the Code.
In the court's view, therefore, the contract embodying the global agreement was ambiguous, making the issue of the purpose of the payments wholly inappropriate for summary judgment.
Nevertheless, the case provides valuable insights for similarly situated taxpayers seeking to claim a tax deduction for payments made to a government in connection with the violation of any law. The portion of the payment that can be unequivocally classified as compensatory and remedial will be deductible, and only the portion that is punitive in nature will be regarded as a nondeductible fine or similar penalty within the meaning of Section 162(f).
Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.
1 See Fresenius Medical Care Holdings, Inc. v. United States, _F.Supp.2d_ (D.C. MA 2010).
2 See Section 162(a).
3 See Section 162(f).
4See Hudson v. United States, 522 US 93 (1997).