Whether from motor vehicle violations, environmental damages, OSHA compliance investigations, or other issues, taxpayers in business can find themselves in situations where laws are violated and fines, penalties and other payments are required.
Section 162(f)(1) denies a deduction for any amount paid or incurred to, or at the direction of, a government or governmental entity as a result of violating any law or the investigation or inquiry into the potential violation of any law (i.e., fines and penalties). The scope of nondeductible payments includes amounts paid to certain nongovernmental entities exercising certain self-regulatory powers.
The Tax Cuts and Jobs Act of 2017 amended section 162(f) to distinguish nondeductible payments of fines and penalties from deductible payments for restitution, remediation, and coming into compliance with the law. Section 162(f)(2) as amended, provides exceptions to the general disallowance to permit deductions for amounts that are established and expressly identified in the court order or settlement as paid for restitution or remediation of property, or paid to come into compliance with the law.
Additionally, Section 6050X was added to the Code to require governmental entities receiving these payments to report to the IRS the total amount received and how much may be deductible.
Earlier this year, the IRS released final regulations (T.D. 9946) for sections 162(f) and 6050X of the Internal Revenue Code. The final regulations for section 162(f) provide important definitions, examples, and practical implementation guidance. These regulations are effective for tax years beginning on or after January 19, 2021, for court orders and settlement agreements effective and binding on or after January 19, 2021.
Deducting Payments
The key to deducting payments under section 162(f)(2) is meeting both the identification and establishment requirements. The final regulations provide guidance and definitions to help taxpayers satisfy these tests.
The identification requirement can be met if the court order or settlement agreement:
- Specifically states (1) the amount of the payment and (2) that the payment constitutes restitution, remediation or is paid to come into compliance;
- Uses a different form of the required words and describes the purpose for which the amount is paid or the law the taxpayer will come into compliance with; or
- Describes the damage done, or harm caused, or the manner of noncompliance and the action the taxpayer is required to take for restitution, remediation or compliance.
If a court order or settlement involves unknown amounts or involves more than one taxpayer, the identification requirement can still be met under the regulations.
The establishment requirement is about documenting follow-through on the actions and payments called for in the court order or settlement agreement. The regulations provide an initial (but not exhaustive) list of documents that can satisfy the establishment requirement. Taxpayers gather documents to:
- Prove the legal obligation to pay an amount;
- Support the position that a payment is for restitution, remediation, or to come into compliance; and
- Confirm that the amount is actually paid or incurred and the date such payment occurred.
Annual Reporting to the IRS
Section 6050X requires government entities and agencies in the U.S. to annually report to the IRS receipt of taxpayer payments of more than $50,000. A new information reporting form, Form 1098-F, Fines Penalties, and Other Amounts, identifies both nondeductible and deductible payments made to the governmental authority. However, annual reporting is not required for court orders or settlement agreements entered into before January 1, 2022.
Penalties Assessed for Failure to Pay Taxes
The preamble to the final regulations addressed questions regarding how section 162(f) applies to penalties and interest assessed by tax authorities for failure to file or pay taxes. The final regulations do not disallow the deduction of an otherwise deductible tax when paid (e.g., federal payroll tax, state income tax, local property tax). However, any payment of federal income tax does not generate a deduction, because federal income taxes are not otherwise deductible. Payments of penalties assessed related to an unpaid tax and any interest on such penalties are not deductible.
Why These Regulations Matter
Business activities can intentionally or more often unintentionally run afoul of the law. When this happens, and penalties, fines and other actions or payments are prescribed by governing authorities, taxpayers have an opportunity to preserve tax deductions. It is important that in each such situation the taxpayer and the governing entity clarify the terms of any payments or actions required.
The identification and establishment requirements in the final regulations mean that taxpayers must have clear language in settlement agreements or court orders identifying whether payments are for violation of laws or for restitution, remediation or to come into compliance. For large payments, it is also important to clarify with the governing entity what amounts will be reported on Form 1098-F. An upfront agreement can eliminate requests for corrections to Form 1098-F once it’s been filed.
We recommend our business taxpayers with frequent interactions with government authorities, industry regulators, or other entities discuss these provisions with your in-house and outside counsel. If you have any questions about the final regulations, please reach out to your Cherry Bekaert tax advisors.
