Tax Administration:

Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments

GAO-05-747: Published: Sep 15, 2005. Publicly Released: Oct 18, 2005.

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Although some civil settlement payments are deductible, their deterrence factor could be lessened if companies can deduct certain settlement payments from their income taxes. GAO was asked to (1) identify federal agencies that negotiated some of the largest dollar civil settlements, (2) determine whether selected federal agencies take tax consequences into account when negotiating settlements and officials' views on whether they should address payment deductibility in settlement agreements, (3) determine whether companies with some of the largest civil settlement payments deducted any of the payments on their federal income taxes, and (4) determine what information the Internal Revenue Service (IRS) collects on civil settlements reached by federal agencies.

The Environmental Protection Agency (EPA), Securities and Exchange Commission (SEC), and Department of Justice (DOJ) negotiated civil settlements that were among the largest in the federal government in fiscal years 2001 and 2002. Also, the Department of Health and Human Services (HHS) was involved in negotiating some of the largest dollar False Claims Act (FCA) health-care civil settlements for which DOJ has primary responsibility. The largest civil settlements at these agencies ranged from about $870 thousand to over $1 billion. Officials in the four agencies we surveyed said that they do not negotiate with settling companies about whether settlement amounts are tax deductible. They said it was IRS's role to determine deductibility. In preparing to negotiate environmental settlements, EPA and DOJ may consider certain tax issues in calculating the amounts they propose to seek. This calculation estimates a company's economic benefit, that is, the financial gain from not complying with the law. Some DOJ environmental settlements with civil penalties have language stating that penalties are not deductible. DOJ officials said since the law is generally clear that civil penalties paid to a government are not deductible, stating so in the agreement was merely restating the law and is not necessary. The majority of companies responding to GAO's survey on how they treated civil settlement payments for federal income tax purposes deducted civil settlement payments when their settlement agreements did not label the payments as penalties. GAO received responses on 34 settlements totaling over $1 billion. For 20 settlements, companies reported deducting some portion or all of their settlement payments. IRS does not systematically receive civil settlement information from all four agencies. IRS officials said that a permanent system for agencies to provide information would be useful. IRS obtains information on a case-by-case basis from public sources and agencies. IRS also has two temporary compliance projects focusing on tax issues that affect settlement payment deductibility. In 2004, IRS introduced a tax schedule to provide information on a company's fines, penalties, and punitive damages.

Status Legend:

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  • Review Pending-GAO has not yet assessed implementation status.
  • Open-Actions to satisfy the intent of the recommendation have not been taken or are being planned, or actions that partially satisfy the intent of the recommendation have been taken.
  • Closed-implemented-Actions that satisfy the intent of the recommendation have been taken.
  • Closed-not implemented-While the intent of the recommendation has not been satisfied, time or circumstances have rendered the recommendation invalid.
    • Review Pending
    • Open
    • Closed - implemented
    • Closed - not implemented

    Recommendation for Executive Action

    Recommendation: The Commissioner of Internal Revenue should 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 Affected: Department of the Treasury: Internal Revenue Service

    Status: Closed - Implemented

    Comments: IRS held meetings with the four agencies with large civil settlements that we included in our report---Justice (DOJ), Health and Human Services (HHS), Environmental Protection Agency (EPA), and Securities and Exchange Commission (SEC)---to reach agreement on how to systematically provide IRS with information useful in ensuring the proper tax treatment on civil settlements. As of January 2008, arrangements were in place for SEC and EPA settlements. SEC's public Web site has all the information IRS needs. SEC settlements also include a signed taxpayer statement that they will not deduct or seek insurance reimbursements for penalties. IRS has tested this and determined that the penalty amounts were not deducted by taxpayers. EPA has agreed to provide IRS with certain information upon written request. EPA also now requires violators to certify that they will not deduct or depreciate expenses incurred in carrying out their settlements. This was done with coordination with IRS and DOJ. As a practical matter, DOJ handles certain EPA environmental settlements and all HHS settlement cases. DOJ agreed to share certain electronic information with IRS concerning cases with settlement amounts of at least $10 million, IRS's computer specialists are coordinating with DOJ to finalize the substance and format of information to be provided electronically by DOJ. Also, IRS issued additional guidance clarifying the deductibility of settlement payments on July 3, 2008 for environmental settlements and on September 5, 2008 for False Claim settlements.

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