Subject to the origin of the claim test, most judgments or settlements paid by a business are fully deductible as ordinary and necessary business expenses under Section 162(a). However, one exception is in Section 162(f), which provides “no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.” This fine or penalty exception is defined broadly to include almost any payment made to a governmental plaintiff. It prevents a subsidy in the form of tax deductions for payments to governmental entities for violations of law.

There is an important exception to fine and penalty nondeductibility in Section 162(f)(2)(A), which allows deductions of amounts that might otherwise be disallowed under Section 162(f)(1) if they are restitution. As stated in the Code: “(i) the taxpayer establishes [such payment (I) constitutes restitution (including remediation of property) for damage or harm which was or may be caused by the violation of any law or the potential violation of any law, or (II) is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry described in [Section 162(f)(1)], (ii) is identified as restitution or as an amount paid to come into compliance with such law, as the case may be, in the court order or settlement agreements, and (iii) in the case of any amount of restitution for failure to pay any tax imposed under this title in the same manner as if such amount were such tax, would have been allowed as a deduction under this chapter if it had been timely paid.” The Code states “[t]he identification under clause (ii) alone shall not be sufficient to make the establishment required under clause (i).” Section 162(f)(2)(B) provides the exception for qualifying restitution “shall not apply to any amount paid or incurred as reimbursement to the government entity for the costs of any investigation or litigation.”

Congress’s reasoning is where the payment is to make the damaged parties whole and is merely enforced by a governmental entity, it is appropriate for the business to deduct the payment. The restitution exception, however, is narrow. It requires the parties to agree to specific restitution language in the court order or settlement agreement, and the funds to fulfill their purpose as restitution rather than a fine or penalty.

John G. Hodnette is an attorney with Fox Rothschild, LLP in Charlotte.

January 17, 2025/by TAX