Risk & Compliance

GAO Eyes Settlement Write-offs

''Letting companies deduct settlement payments from their income taxes takes away the sting,'' says the chairman of the Senate Finance Committee.
Stephen TaubOctober 20, 2005

The Internal Revenue Service and agencies that reach civil settlements with businesses should work more closely to ensure that companies give the proper tax treatment to their payouts, maintains a report from the Government Accountability Office.

Earlier this year, for example, Marsh & McLennan Cos. agreed to pay $850 million to settle charges of fraud and anti-competitive practices stemming from an investigation by New York State Attorney General Eliot Spitzer. Published accounts later suggested that as much as the entire settlement may be tax deductible, precisely because the payment is restitution to the company’s clients rather than a fine or penalty.

The GAO report examined only the period from 2001 to 2002, and only the records of the four federal agencies that negotiated the largest settlements during that time. According to the congressional watchdog, officials at the four agencies — the Environmental Protection Agency, the Securities and Exchange Commission, the Department of Justice, and the Department of Health and Human Services — said that they do not negotiate with settling companies about whether settlement amounts are tax deductible. It is the IRS’s role to determine deductibility, the officials added.

The GAO also received responses from companies that negotiated 34 civil settlements, totaling more than $1 billion, with one of the four agencies during that period. In 20 cases, companies reported deducting some portion or all of their payment from their federal income taxes.

The report conceded that it may not always be clear which payments are deductible, in part because the Internal Revenue Code does not address the deductibility of all types of payments that may be made pursuant to a civil settlement. Further, the statutes that impose the payments may be unclear regarding whether they are punitive, compensatory, or both.

Even so, the GAO observed that “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.”

The Associated Press pointed out that the Senate Finance Committee intends to clarify the law and to require businesses to report settlement information to the IRS.

“Letting companies deduct settlement payments from their income taxes takes away the sting,” said committee chairman Sen. Charles Grassley (R-Iowa), reported the AP. “It is galling that artfully crafted settlement agreements create loopholes that allow wrongdoers to escape the full impact of fines and water down any deterrent effect,” said Sen. Max Baucus D-Mont.), according to the wire service.