Tax Administration: Systematic Information Sharing Would Help IRS
Determine the Deductibility of Civil Settlement Payments
(15-SEP-05, GAO-05-747).
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.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-05-747
ACCNO: A36919
TITLE: Tax Administration: Systematic Information Sharing Would
Help IRS Determine the Deductibility of Civil Settlement Payments
DATE: 09/15/2005
SUBJECT: Claims settlement
Damages (legal)
Data collection
Federal taxes
Fines (penalties)
Income taxes
Surveys
Tax administration
Tax violations
Voluntary compliance
Tax deductions
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GAO-05-747
United States Government Accountability Office
GAO Report to the Committee on Finance, U.S. Senate
September 2005
TAX ADMINISTRATION
Systematic Information Sharing Would Help IRS Determine the Deductibility of
Civil Settlement Payments
a
GAO-05-747
[IMG]
September 2005
TAX ADMINISTRATION
Systematic Information Sharing Would Help IRS Determine the Deductibility of
Civil Settlement Payments
What GAO Found
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.
Approximate Ranges and Cumulative Values of the 20 Largest Civil
Settlement Agreements at the Four Agencies Contacted in Each Year for Both
Fiscal Years 2001 and 2002
Agency Smallest Largest Cumulative value
EPA $1 million $1 billion $4.1 billion
SEC $870 thousand $114 million $607 million
HHS $3 million $790 million $2 billion
DOJ $12 million $471 million $3.3 billion
Source: GAO analysis of EPA, SEC, HHS, and DOJ data.
Note: Settlement values include payments to the U.S. government. EPA
settlements also include estimated costs for any pollution controls, other
complying actions and Supplemental Environmental Projects. HHS settlements
are for FCA cases negotiated with DOJ. EPA settlements led by DOJ are
included in the EPA category.
United States Government Accountability Office
Contents
Letter
Results in Brief
Background
Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were
among the Largest in Fiscal Years 2001 and 2002
The Four Agencies Do Not Negotiate the Tax Deductibility of
Settlement Amounts, but Two Agencies Consider Aspects of
Taxes in Determining Amounts for Negotiations
A Majority of the Surveyed Companies Deducted Civil Settlement
Payments, Generally When Settlement Agreements Did Not
Label Payments as Civil Penalties
No Permanent System Is in Place for Agencies to Routinely Inform
IRS of Civil Settlements or Provide Other Settlement
Information That IRS Would Find Useful
Conclusions
Recommendation for Executive Action
Agency Comments and Our Evaluation
1
3 6
8
9
18
21 25 26 26
Appendix I Scope and Methodology
Appendix II Selected IRS Audit Results Information on Companies with Civil
Settlement Payments
Appendix III Comments from the Internal Revenue Service
Appendix IV Comments from the Environmental Protection Agency
Appendix V Comments from the Securities and Exchange
Commission 44
Appendix VI Comments from the Department of Health and Human Services 45
Appendix VII GAO Contact and Staff Acknowledgments
Tables
Table 1: Approximate Ranges and Cumulative Values of the 20
Largest Civil Settlement Agreements at the Four Agencies
Contacted in Each Year for Both Fiscal Years 2001 and
2002 8 Table 2: Practices of Four Federal Agencies regarding Tax Issues
They Consider during Settlement Negotiations and in Settlement Agreements
10
Table 3: Company Responses on Whether They Deducted Civil Settlement
Payments from Their Federal Income Taxes 18 Table 4: Company Responses on
Whether They Deducted Various Types of Civil Settlement Payments 19
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United States Government Accountability Office Washington, DC 20548
September 15, 2005
The Honorable Charles E. Grassley
Chairman
The Honorable Max Baucus
Ranking Minority Member
Committee on Finance
United States Senate
The value of civil settlements that federal regulatory agencies annually
reach with those who violate laws or regulations can exceed billions of
dollars. Civil settlements,1 which can be used to avoid litigation, are
one of
the enforcement tools some agencies can use to correct violations and
punish those who violate laws or regulations by imposing penalties or
other actions. Many civil settlements with federal agencies may require
that the entities settling with the agencies make monetary payments. When
negotiating settlements, agencies consider many factors, which may
include whether payments are sufficient in size to deter the violator or
others from violating applicable laws or regulations in the future and
mitigate any economic benefit that the violator gained from not complying.
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.
In general, payments that are intended to punish (punitive payments) a
violator are not deductible and payments made to compensate
(compensatory payments) those who were harmed by a violation are
deductible under federal law. Nevertheless, it may not always be clear
which payments are deductible, in part because the Internal Revenue Code
(IRC)2 does not address the deductibility of all types of payments that
may
be made pursuant to a civil settlement and the statutes imposing the
payments may be unclear regarding whether they are punitive,
compensatory, or both. Over the last several years, concerns that some
companies deducted, or planned to deduct, large civil settlement payments
1In this report, civil settlements are formal legal agreements between
agencies and alleged violators to resolve a lawsuit or potential lawsuit.
The terms agencies use to refer to civil settlement agreements may vary.
226 U.S.C. et seq.
from their federal income taxes have heightened Congress's interest in
this area.
Because of your interest in obtaining information on how agencies address
tax issues for civil settlements and how companies have treated civil
settlement payments on their federal income tax returns, you asked us to
review some of the largest settlement agreements and determine how some
companies have treated their civil settlement payments for federal tax
purposes. As agreed, the objectives of this report are to (1) identify
federal agencies that negotiated some of the largest dollar civil
settlements in recent years, (2) determine whether the selected federal
agencies having some of the largest civil settlements take tax
consequences into account when negotiating settlements and officials'
views on whether they should address the deductibility of payments in the
agreements, (3) determine whether the companies that paid some of the
largest civil settlement payments deducted any of the payments on their
federal income tax returns, and (4) determine what information the
Internal Revenue Service (IRS) collects on civil settlements reached by
federal agencies.
To identify federal agencies that negotiated the largest dollar civil
settlements in recent years, we analyzed information from various sources,
including agencies' Web sites, annual reports and enforcement reports, and
other available information. Based on our analysis of the information, we
concluded that the Environmental Protection Agency (EPA), the Securities
and Exchange Commission (SEC), and the Department of Justice (DOJ)
negotiated some of largest civil settlements in fiscal years 2001 and
2002. We also included the Department of Health and Human Services (HHS)
because HHS was involved in negotiating some of the largest dollar False
Claims Act (FCA) health care civil settlements that DOJ has primary
responsibility to negotiate.3 We selected this time frame since it would
allow the settling companies time to pay the settlements; determine the
applicable tax treatments, if any; and file federal income tax returns. We
interviewed officials in these agencies to identify and obtain copies of
their largest civil settlements.
To determine whether the four federal agencies having some of the largest
civil settlements take tax consequences into account when negotiating
3HHS's role in these negotiations includes recommending an appropriate
settlement amount to DOJ.
civil settlements, we determined whether the agencies negotiate with
companies about whether civil settlement amounts are tax deductible and
whether the agencies considered any aspects of taxes when internally
deciding on what settlement amounts they should present for the
negotiations. In making these determinations, we reviewed the underlying
agreements and obtained information on the agencies' civil settlement
policies and procedures, including whether they address tax issues, and
interviewed officials. We also obtained agency officials' views on whether
they should address the deductibility of payments in the agreements.
To determine whether the companies that paid some of the largest civil
settlement payments deducted any of the payments on their federal income
tax returns, we developed a questionnaire to survey the companies. We did
not independently verify the responses of the surveyed companies.
To determine what information IRS collects on civil settlements reached by
federal agencies, we interviewed knowledgeable officials from IRS and the
four agencies and reviewed supporting documentation about what
information, if any, IRS obtains from the four selected agencies regarding
their civil settlement agreements.
You also asked us to provide information on whether corporate taxpayers'
deductions for settlement payments were being examined in IRS audits and
the outcome of the audits. To obtain this information, we interviewed IRS
officials concerning our work and requested information on whether
corporate taxpayers' deductions for settlement payments were being
examined in audits and the outcome of the audits. Appendix II provides
this information.
We assessed the reliability of the lists of the largest settlement
agreements identified by the agencies and found them to be sufficiently
reliable for the purposes of our reporting objectives. Our work was
conducted from February 2004 through June 2005 in accordance with
generally accepted government auditing standards. (See app. I for a more
detailed description of our scope and methodology.)
Results in Brief Four agencies-EPA, SEC, HHS,4 and DOJ-negotiated civil
settlement agreements that were among the largest negotiated by the
federal
4HHS settlements were for FCA cases for which DOJ had primary
responsibility.
government in fiscal years 2001 and 2002. The cumulative value of their
160 largest settlements exceeded $9 billion. The settlements ranged in
size from just under $1 million to over $1 billion. For example, the
payments required under SEC's civil settlements ranged from about $870
thousand to about $114 million, and the estimated value of EPA's
settlements ranged from about $1 million to over $1 billion (see table 1
and the table notes).
Officials in the four agencies we surveyed said that they do not negotiate
with settling companies about whether settlement amounts are tax
deductible. Some officials said it was IRS's role to determine
deductibility. Before entering into a settlement with the settling
companies for environmental settlements, EPA and DOJ officials consider
tax issues in determining the economic benefit a settling company gained
from noncompliance. This takes into account whether a company would have
incurred tax deductible costs if it had complied with the law, such as a
one-time nondepreciable expenditure and applies the violator's appropriate
year-specific combined state and federal marginal tax rates to the costs.
Other than some settlements with civil penalties containing language
stating that the penalties are not deductible, the settlement agreements
we reviewed generally did not specify the deductibility of settlement
amounts, which was consistent with what the agency officials told us. As
an example of the exceptions, we found that some DOJ environmental
settlements with civil penalties did include language in the agreement
between DOJ and the settling company that the penalties would not be
deducted for federal income tax purposes. DOJ officials said that
including such language is not standard practice and emphasized that since
the law is generally clear that civil penalties paid to a government are
not deductible, stating so in the settlement agreement is merely restating
the law.
The majority of the companies responding to our survey on how companies
treated civil settlement payments for federal income tax purposes deducted
settlement payments when their settlement agreements did not label the
payments as penalties. We received responses on the companies' tax
treatment of 34 civil settlements with total amounts exceeding $1 billion.
The companies reported deducting some or their entire civil settlement
amount for 20 of the 34 settlements. In 2 of these settlements, company
representatives said they erred in deducting the civil penalty payments
totaling about $1.9 million and told us they would file amended tax
returns. For 3 of the 15 settlements for which companies deducted some or
all of their DOJ FCA settlement payments, companies reported that language
in their settlement agreements was a rationale for the deductions,
although DOJ told us that
language did not pertain to tax deductibility. The total amount of
deductions taken by these 5 companies exceeded $100 million. DOJ changed
the language for future FCA settlements based on our findings.
Furthermore, three companies that deducted FCA settlement payments
reported that they did so in whole or in part because their settlement
agreements contained language stating that the company denied wrongdoing.
Their deductions totaled about $15.5 million.
IRS does not generally receive civil settlement information in a
systematic manner from the four agencies we surveyed, although IRS obtains
some settlement information from those agencies on a case-by-case basis to
use in determining whether companies properly treated settlement amounts
for tax purposes. IRS officials told us that a permanent system for
agencies to provide IRS with timely civil settlement information could
help, for instance, in selecting firms to audit. Officials of the four
agencies in our review expressed willingness to work with IRS to provide
settlement information. IRS has two temporary compliance projects that
collect information on tax issues that affect the deductibility of
settlement amounts made pursuant to FCA and environmental settlement
agreements in part to help IRS address improper deductions during
examinations. In association with one of the compliance projects, DOJ
recently agreed to provide information about large FCA settlements shortly
after they are closed and information on all FCA cases annually for the
duration of the project. In addition, in 2004, IRS introduced Schedule
M-3, which could also help IRS in identifying companies with civil
settlements because it captures some information on fines, penalties, and
punitive damages from companies with total assets of $10 million or more.
We are recommending that the Commissioner of Internal Revenue direct the
appropriate officials to work with federal agencies that reach large civil
settlements to develop a cost effective means of obtaining information on
settlement agreements that would be beneficial to IRS in ensuring the
correct tax treatment of the settlement amounts.
In commenting on a draft of this report (see app. III), the Commissioner
of Internal Revenue agreed with our recommendation and will form an
executive-led team to implement it. EPA also provided comments and said
they generally supported our recommendation (see app. IV). SEC provided
written comments but did not address our recommendation (see app. V). HHS
sent a letter stating they had no comments but provided technical comments
(see app. VI). DOJ also provided technical comments. We made changes to
our report to incorporate the agencies' comments as appropriate.
Background
Civil settlements are one of several enforcement tools used by some
federal agencies to help ensure that individuals and companies comply with
the laws and regulations they enforce. For purposes of this report, civil
settlements involve negotiations by federal agencies with companies to
resolve issues about their compliance with laws and regulations. The
negotiation process can involve discussions between agency officials and a
company about each party's proposals to address the compliance problem and
can end with a written agreement that reflects the terms reached by the
settling parties. In such cases, the civil settlements generally require a
company to agree to perform certain activities or stop engaging in certain
activities. Some settlements also require that monetary payments be made
to the government and to others. When determining settlement amounts,
agencies consider various factors, including thresholds for fines and
penalties set by federal statutes for violations and the severity of the
violation.
While some agencies have administrative authority to enter into civil
settlements, some cases are required to be referred to DOJ for resolution.
For these cases, DOJ may settle with the defendant or take the defendant
to court. Of the four agencies we contacted, DOJ is responsible for
certain environmental settlements on behalf of EPA and certain civil
health care fraud cases on behalf of HHS.
Section 162 of the IRC provides a deduction for all ordinary and necessary
business expenses, including settlements and similar payments. This
provision is subject to an exception in IRC S: 162(f) that denies a
deduction for any fine or similar penalty paid to the government for the
violation of any law.5 The definition of "fine or similar" penalty
includes an amount paid in the settlement of the taxpayer's actual or
potential liability for a fine or penalty (civil or criminal).6
Furthermore, Treasury regulations provide that payments made as
compensatory damages paid to a
5Recently, several legislative proposals have been introduced, but not
enacted, to modify the rules for deducting fines or similar penalties paid
to the government for the violation of any law. Currently, a proposed
provision in S. 1565, 109th Cong. S: 207 (2005), would provide that
amounts paid or incurred (whether by suit, agreement, or otherwise) to or
at the direction of a government in relation to the violation of any law
or the investigation or inquiry into the potential violation of any law
are nondeductible. The bill contains an exception for restitution. Amounts
paid to certain self-regulatory entities that impose sanctions, such as
the National Association of Securities Dealers, are treated similarly for
purposes of the proposal.
6Treas. Reg. S: 1.162-21(b)(1)(iii).
government do not constitute a fine or penalty.7 In general, IRS views
punitive payments as being nondeductible and compensatory payments as
being deductible.
Although the terms used to describe a payment required as part of a civil
settlement may provide an indication of whether the amount is deductible
or not, according to IRS, often it is necessary to look to the intent of
the law requiring the payment or the facts and circumstances of the
settlement to determine whether a payment is deductible. Civil settlement
agreements we reviewed use terms other than "compensatory" or "punitive"
to describe settlement payments. For instance, some agencies use terms
like restitution or disgorgement for payments that are intended to
compensate the government or others.8 Even when a term used to describe a
payment may seem to indicate that a payment is not deductible, in fact,
the opposite may be the case. For example, a payment labeled as a civil
penalty9 and that seems not deductible may be deductible if it is imposed
as a remedial measure to compensate the government or other party. Or,
payments that will be used for remedial or compensatory purposes and seem
deductible may not be so if the law requiring the payment indicates the
payment is to have a punitive or deterrent effect. IRS and courts look to
the purpose of the statute, including the legislative history and
administrative and judicial interpretation, to determine whether a payment
serves a punitive or compensatory purpose. If the law is unclear, or if
the statute serves both punitive and compensatory purposes, the facts and
circumstances of the specific settlement payment, including the terms of
the settlement agreement, often need to be examined to determine the
purpose the parties intended the payment to serve.
Until recently, IRS did not have a tax form that could be used to identify
whether a fine or penalty had been deducted for tax purposes. Effective
for any tax year ending on or after December 31, 2004, corporations with
consolidated assets of $10 million or more that are required to file IRS
Form 1120, the corporate income tax return, must also file Schedule M-3.
Schedule M-3 requires companies to reconcile financial accounting net
income (or loss) with taxable net income and expense and deduction
7Treas. Reg. S: 1.162-21(b)(2).
8Restitution is the return or restoration of some specific thing to its
rightful owner or status. Disgorgement is the act of giving up something
(such as profits illegally obtained) on demand or by legal compulsion.
9A civil penalty is a fine assessed for violation of a statute or
regulation.
Civil Settlements Negotiated by EPA, SEC, HHS, and DOJ Were among the Largest
in Fiscal Years 2001 and 2002
items. The 2004 Schedule M-3 line items for reconciliation include fines,
penalties, and punitive damages.
In fiscal years 2001 and 2002, EPA, SEC, HHS, and DOJ negotiated some of
the largest civil settlements in the federal government. The civil
settlements we examined ranged in size from about $870 thousand to over $1
billion. (See table 1.) For example, a 2001 EPA judicial settlement
related to the Clean Air Act required a utility company to significantly
reduce harmful air pollution from its power plants at an estimated cost of
over $1 billion and pay a $3.5 million fine. The cumulative value for the
20 largest settlements for fiscal year 2001 and the 20 largest settlements
for fiscal year 2002 at the four agencies-a total of 160
settlements-exceeded $9 billion.10
Table 1: Approximate Ranges and Cumulative Values of the 20 Largest Civil
Settlement Agreements at the Four Agencies Contacted in Each Year for Both
Fiscal Years 2001 and 2002
Agency Smallest Largest Cumulative value
EPAa $1 million $1 billion $4.1 billion
SEC $870 thousand $114 million $607 million
HHSb $3 million $790 million $2 billion
DOJc $12 million $471 million $3.3 billion
Source: GAO analysis of EPA, SEC, HHS, and DOJ data.
Notes: For settlements identified by SEC, HHS, and DOJ, the total value of
settlements reflects payments payable to the U.S. government and other
recipients such as the relator, also known as the whistleblower. For
settlements identified by EPA, the total value of settlements included
payments payable to the U.S. government; the estimated cost of any
Supplemental Environmental Projects; and the estimated costs of pollution
controls, monitoring equipment, or other complying actions that companies
are required to take to come into compliance with environmental laws. The
penalty portion ranged from approximately $500,000 to almost $10 million,
and the cumulative value of the penalty amount for these settlements was
about $124.3 million.
aEPA settlements, including those for which DOJ led the negotiations, are
included under the EPA category.
bThe settlements identified by HHS include only FCA settlements. HHS
officials told us FCA settlements, which DOJ negotiates, are the largest
of the agency's civil settlements.
cThe list of settlements obtained from DOJ was of cases closed in fiscal
years 2001 and 2002. The dollar values of settlements provided were net of
relators' fees.
10This total differs from the sum of the agency cumulative value in table
1 because we excluded 7 of the FCA settlements identified by HHS that were
also included in DOJ's list of the 20 largest civil settlements for fiscal
year 2001 and the 20 largest civil settlements for fiscal year 2002.
The Four Agencies Do Not Negotiate the Tax Deductibility of Settlement
Amounts, but Two Agencies Consider Aspects of Taxes in Determining Amounts for
Negotiations
Officials in the four agencies said that they do not take tax consequences
into account during negotiations with settling parties, that is, they do
not negotiate with companies about the deductibility of settlement
amounts.11 They said they generally do not have tax expertise and that
determining deductibility of settlement amounts is IRS's role. When
negotiating, officials said they look to the relevant laws and regulations
and the facts and circumstances of the case, including the severity of the
violation and the strength of the evidence against the violator to
determine the settlement amount to seek. In preparing for negotiations,
two agencies- EPA and DOJ-consider certain tax issues in calculating the
amounts they propose to seek in negotiating environmental settlements.
This calculation estimates a company's financial gain from not complying
with the law, that is, their economic benefit. The agencies factor in
whether the company would have incurred tax deductible expenses to stay in
compliance and apply the violator's year-specific combined state and
federal marginal tax rates to the costs of complying on time and complying
late. Except for some settlement agreements stating that civil penalties
are not deductible, the agencies' written civil settlement agreements we
reviewed generally did not specify the deductibility of settlement
amounts. As an exception to this general practice, we found that some DOJ
environmental settlements with civil penalties included language
indicating that the penalties would not be deducted for federal income tax
purposes. DOJ Environmental and Natural Resources (ENR) Division officials
explained that when a settlement agreement includes civil penalties, their
attorneys have discretion about whether to include such language in an
agreement. The officials emphasized that the law is generally clear that
civil penalties paid to a government are not deductible and stating so in
the agreement is essentially restating the law and is not necessary. In
addition, in 2003, subsequent to the time frame of the settlements we
reviewed, SEC adopted a policy of requiring settlement agreements with
civil penalties to include language stating that the settling parties
would not deduct civil penalties for tax purposes.
Table 2 describes the four agencies' practices regarding how they consider
tax issues during their settlement negotiation processes, including
drafting the terms of their settlement agreements. The settlement
agreements we reviewed were consistent with the practices described to us
by the agencies' officials. These practices are current as of June 2005.
Because
11Although DOJ has lead responsibility for negotiating FCA cases on behalf
of HHS, HHS is involved in the negotiations process, including
recommending settlement amounts to DOJ.
each settlement agreement is unique, settlements negotiated by these agencies
can have some exceptions to the practices listed in the table.
Table 2: Practices of Four Federal Agencies regarding Tax Issues They
Consider during Settlement Negotiations and in Settlement Agreements
Does the agency
negotiate with Does the agency consider
settling
parties about any aspects of taxes when Does the
whether written settlement agreement
settlement amounts calculating its proposed include
are specific information about the
Agency tax deductible? settlement amount? deductibility of
the settlement amount?
EPA No. Yes, if applicable to determine Yes,
when settlements include civil
the economic benefit portion of
penalties, some agreements state that
civil a civil penalty and if
Administrative applicable penalties are not
environmental deductible. Also when a as part of
settlements valuing company has said it will not
deduct the Supplemental Environmental
cost of a SEP, the government takes
this
Projects (SEP) a company into account
when determining the value of
agrees to undertake as part of the
SEP, and the agreement will specify
a settlement. that the company will
not deduct the costs
of the SEP.
SEC settlementsa No. No. Yes, since 2003, settlements that
include
civil penalties are to state that the
civil
penalties are not deductible.
HHS settlementsb No. No. No.
DOJ
FCA settlements No. No. No.
Judicial environmental No. Yes, if applicable to determine Yes, when
settlements include civil
settlements the economic benefit portion of penalties, some
agreements state that civil
a civil penalty and if applicable penalties are
not deductible. Also when a
as part of valuing SEPs a company has said it
will not deduct the
company agrees to undertake cost of a SEP, the
government takes this
as part of a settlement. into account when
determining the value of
the SEP, and the agreement will specify
that the company will not deduct the costs
of the SEP.
Source: GAO analysis.
aIn 2003, SEC implemented a policy that settlements with civil penalties
are to include language stating that the civil penalties would not be
deducted. Agreements negotiated before SEC implemented this policy do not
include such language.
bThe HHS settlements we reviewed were FCA civil health care fraud cases
negotiated by DOJ.
As table 2 shows, the selected agencies do not negotiate with companies
about whether they can deduct any portion of their settlement from their
income taxes. In determining their negotiating position and any changes to
agree to during negotiations, officials generally look to factors such as
the relevant laws and regulations and the facts and circumstances of the
case, including the severity of the violation and the strength of evidence
against
the violator. Officials in the four agencies said that determining
deductibility is IRS's role, and they generally do not have the expertise
to address the deductibility of payments during negotiations or to specify
the tax consequences of amounts in the settlements. IRS staff agreed and
said that if agencies were to specify whether a settlement amount is
deductible, there could be a risk that the agencies might concede tax
consequences in order to reach a settlement.
The following information summarizes the policies, procedures, and views
of the agencies on taking taxes into account during negotiations and
specifying the tax deductibility of settlement payments in the agreements.
EPA
EPA's mission is to protect the environment and address related human
health impacts. EPA can reach civil administrative and judicial
enforcement settlements against violators of environmental laws, and its
priorities in negotiating settlements are to ensure that violators come
into compliance with the law, punish past violations and deter future
violations, obtain restoration of environmental damage resulting from
violations, and impose civil penalties sufficient to recover any economic
benefit gained as a result of the violator's noncompliance and deter
future violations. EPA negotiated the civil administrative settlements
under its own authority without a judicial process. Cases that are brought
and settled by DOJ on behalf of EPA are referred to as civil judicial
enforcement settlements. DOJ's policies, procedures, and officials' views
for these cases are discussed in the DOJ section of this report.
All EPA civil settlements we reviewed included payments labeled as civil
penalties for violations of environmental laws or regulations. In
addition, the value of the settlements sometimes included estimated
amounts a company may incur to achieve and maintain compliance with the
environmental laws and regulations, such as installing a new pollution
control device to reduce air pollution or prevent emissions of a
pollutant. Also, some settlements included SEPs, which are projects a
company agrees to undertake in addition to complying actions. IRS is
currently reviewing the deductibility of SEPs.
Civil penalties in EPA settlements are generally composed of two parts:
economic benefit and gravity. Economic benefit represents the financial
gains that a violator accrues by delaying expenditures necessary to comply
with environmental regulations, avoiding them, or both. Under EPA's civil
penalty policy, the goal of recovering the economic benefit of
noncompliance is to place the violator in the same position as if
compliance had been achieved from the start. The amount EPA includes in a
civil penalty to account for the seriousness of the violation is referred
to as the gravity portion of the penalty. EPA includes the gravity portion
of the penalty to provide deterrence against future noncompliance. When
calculating the gravity portion of the initial civil penalty amount, EPA
adjusts the gravity-based penalty on various case-specific factors,
including the strength of evidence against the company and the company's
degree of cooperation and history of noncompliance.
When calculating the economic benefit portion of civil penalties, EPA uses
an economic computer model to estimate any financial advantage a company
gained from not complying with environmental laws. EPA's economic computer
model takes into account whether a company would have incurred tax
deductible costs if it had complied with the law, such as a one-time
nondepreciable expenditure, in estimating the economic benefit a company
gained by not complying with environmental laws or regulations. The
computer model applies the appropriate year-specific combined state and
federal marginal tax rates of the violator in calculating economic benefit
along with standard financial cash flow and net present value analysis
techniques to calculate the costs of complying on time and of complying
late.
When calculating the gravity portion of civil penalties, EPA officials
consider the facts surrounding each violation, including factors such as
the actual or possible harm caused by the violation, the size of the
violation, and the goals of the specific environmental program. EPA
officials acknowledged that they negotiate with violators about the size
of the gravity portion of the penalty, but said in doing so they consider
factors such as the strength of their position and not whether the
violator may be able to claim a tax deduction.
When EPA settlements include civil penalty payments,12 EPA's practice is
to explicitly label these payments as civil penalties. In some settlements
with civil penalties, the settlement agreements also reference IRC S:
162(f), which states that penalties payable to a government are
nondeductible. Officials noted that including language referencing IRC S:
162(f) is not EPA's usual practice. EPA officials said that they believe
the law is clear that civil penalties payable to a government are
generally nondeductible,
12In some cases, such as when the settlement only requires a company to
come into compliance, a settlement does not include a civil penalty
payment.
so they do not see inclusion of such language in settlement agreements as
necessary.
As part of some settlements, companies perform SEPs, which are projects
not required by law, that are voluntarily undertaken by a respondent in
exchange for possible penalty mitigation.13 EPA may mitigate the civil
penalty ultimately assessed as part of the settlement, when a respondent
agrees to undertake a SEP. EPA still collects a civil penalty as part of
the settlement in accordance with its 1998 SEP policy, which calls for
collecting the greater of 25 percent of the gravity component of the
penalty, or 10 percent of the gravity, plus economic benefit. To determine
the value of SEPs, EPA uses an economic computer model, and if a company
tells EPA that it plans to deduct the SEP costs, EPA factors the company's
decision into valuing the SEP through the model. EPA officials said that
they are not involved in a violator's decision to deduct the SEP costs and
that they take the violator's decision at face value.
SEC
SEC is responsible for administering and enforcing federal securities laws
and regulations and fostering fair and efficient markets for the trading
of securities. SEC enforcement officials told us that in enforcing the
securities laws, they aim to protect investors and punish violators. In
performing its enforcement role, SEC may, among other actions, negotiate
civil settlements with those who violate securities laws. When
appropriate, SEC provides that violators make monetary payments that
generally include amounts for civil penalties and disgorgement. The SEC
settlement agreements we reviewed included penalties for violations of the
securities laws. These settlements also included disgorgement, in which
SEC attempts to ensure that violators of securities laws or regulations do
not profit from their illegal activity, and when appropriate, these
disgorged profits are returned to investors.
The IRC does not specifically address the deductibility of disgorgement.
Although IRS looks at the individual facts and circumstances of a case to
13In B-247155 (July 7, 1992) we concluded that EPA lacked authority to
settle certain EPA actions by entering into SEPs. Further, in B-247155.2
(Mar. 1, 1993) we concluded that the Miscellaneous Receipts Act, 21 U.S.C.
S: 3302, which requires all federal agencies to remit all penalties to the
U.S. Treasury, was circumvented when alleged violators were allowed to
make payments to an institution other than the federal government.
According to EPA officials, subsequent to our decisions, EPA made
substantial changes to its SEP policy to address our concerns. We did not
assess the changes to EPA's SEP policy.
determine deductibility, it has generally regarded disgorgement payments
as compensatory, and therefore tax deductible. As previously discussed,
Treasury regulations provide that in civil actions, compensatory damages
paid to a government do not constitute a fine or a penalty.14
SEC's Chief Counsel for Enforcement emphasized that SEC's decision on how
much of a settlement payment is penalty versus disgorgement is based
solely on the facts and circumstances of the case, including the law
violated, the degree of harm, and the seriousness of the violation.
However, the official further said that although SEC does not negotiate
with settling parties about the deductibility of settlement payments,
settling parties may initiate negotiations with SEC about how the
settlement payment is to be allocated between penalty and disgorgement.
Although settling parties may seek a larger disgorgement amount because it
is generally tax deductible, SEC staff make recommendations for
disgorgement and penalties based on their analysis.
In 2003, SEC implemented a policy requiring all civil settlement
agreements with penalties to include language that expressly prohibits the
settling party from taking a tax deduction or seeking to recover from an
insurance carrier the penalty portions of the settlement payment. SEC
adopted standardized language prohibiting deductions as a result of the
Global Research settlement, in which 10 Wall Street companies settled for
a combined $875 million in civil penalties and disgorgement. There were
reports that some of the settling companies were planning to take
deductions for the civil penalty portion of the settlement payments that
would be placed into funds for investors who were harmed by the companies'
violations. The Sarbanes-Oxley Act of 2002 allows SEC, in appropriate
cases, to add penalties to the disgorgement fund for the benefit of harmed
investors, pursuant to the "fair fund" provisions of the act.15 SEC
provides in its standardized settlement language that such amounts are to
be treated as penalties for tax purposes. SEC's settlement agreements are
silent on the tax deductibility of disgorgement. Senior SEC officials
noted that in their view, decisions about the deductibility of
disgorgement should be left to IRS.
14Treas. Reg. S: 1.162-21(b)(2).
15Pub. L. No. 107-204, S: 308, 116 Stat. 745 (2002).
HHS
HHS is the principal federal agency responsible for protecting the health
of American citizens and providing essential human services. HHS's largest
civil settlements are generally FCA cases relating to civil health care
fraud. FCA generally provides that anyone who knowingly submits false
claims to the government is liable for damages up to three times the
amount of the damages sustained by the government plus penalties from
$5,500 to $11,000 for each false claim submitted. Although many FCA cases
involve civil health care fraud against the Medicare and Medicaid programs
that HHS administers, the act is also used in settling other types of
fraud perpetrated against the federal government, such as defense
contractor fraud. A civil health care FCA case, for example, could involve
a health care provider who grossly overcharged for medical services
rendered and then filed claims for reimbursement at the overcharged rates.
Usually, civil health care fraud cases are based on referrals from federal
and state investigative agencies and private persons.16
DOJ is responsible for representing the United States in FCA cases and
therefore negotiates the FCA settlements. DOJ's Civil Division carries out
those responsibilities along with U.S. Attorneys' Offices located across
the country. Accordingly, DOJ sets the overall policy for civil health
care fraud FCA settlements. For health care settlements, HHS's Office of
Inspector General (OIG) provides DOJ assistance in several ways, including
investigating individuals and companies that may have abused the HHS
health care programs, and sometimes works with DOJ to determine the amount
of single damages, that is, the amount of loss sustained by the government
due to the violator's actions.
DOJ
DOJ negotiates settlement agreements on behalf of other federal agencies,
including some cases involving HHS and EPA. The DOJ settlement agreements
we reviewed were limited to FCA settlements negotiated by DOJ's Civil
Division and judicial environmental settlements negotiated by DOJ's ENR
Division. The FCA cases negotiated by DOJ that we reviewed contained a
single payment labeled as a settlement amount, which does not characterize
the extent to which payments are for single or multiple damages or civil
penalties. All of the DOJ-led environmental settlement agreements that we
reviewed included amounts labeled as penalties and some included SEPs.
16Private persons, known as relators, can bring actions for violations of
FCA. 31 U.S.C. S: 3730.
In negotiating FCA civil settlement agreements, DOJ Civil Division
officials said that they do not consider or discuss any aspects of taxes.
In calculating the settlement amount for FCA cases, DOJ first assesses the
amount of damages the violation cost the government and seeks to recover
the full amount. It also considers the severity of the violation in
determining whether the settling company should pay a multiple of the
assessed damages and civil penalties.
DOJ Civil Division officials stated that they do not include language on
the deductibility of payments in their written FCA settlement agreements.
In fact, according to the officials, all FCA settlements contain DOJ's
standard settlement agreement language, which states that nothing in the
agreement characterizes the payments for federal income tax purposes. DOJ
Civil Division officials said that this language supports the agency's
policy of not addressing the tax treatment of settlement payments in
settlements agreements.
DOJ Civil Division and IRS officials told us that the agencies came to a
mutual agreement that DOJ's tax-neutral practices on the deductibility of
civil settlement payments are appropriate. Furthermore, officials added
that the settlement agreements refer to the payments as a settlement
amount because the negotiations with the settling party usually involved
agreeing on a lump sum amount without characterizing the payment into
categories such as single, double, or treble damages and civil penalties.
Officials said they do not categorize the payments more specifically
because doing so would add complexity to the negotiation process by adding
additional factors on which to obtain agreement between the parties. Thus,
the agreement does not characterize the extent to which the settlement
payment is punitive or compensatory. According to IRS staff, single
damages are generally considered compensatory and therefore tax
deductible, and any multiple damages and civil penalties are generally
considered punitive and therefore nondeductible.
Officials in DOJ's Civil Division and HHS's OIG said that even though FCA
allows for the assessment of penalties in addition to multiple damages,
penalties are not always sought. The HHS officials said that penalties are
not generally sought in FCA settlements because collecting a multiplier of
damages is sufficient to compensate the government and provide a
deterrence.
DOJ also negotiates environmental cases on behalf of EPA. EPA refers to
cases it sends to DOJ to settle as judicial cases since they are not
resolved under EPA's administrative authority. EPA staff assist DOJ staff
in
building these cases and EPA's civil penalty policies generally apply to
DOJ environmental settlements. However, DOJ-not EPA-has primary settlement
authority for these cases, and DOJ is not bound by EPA's penalty policies.
Like EPA, in preparing for negotiations and determining the amount to seek
at settlement, DOJ considers aspects of taxes in calculating the economic
benefit a violator received from not complying with environmental laws.
However, DOJ ENR Division officials told us that their position is to be
neutral on tax issues. DOJ sometimes uses the EPA economic benefit
computer model to calculate economic benefit amounts but may also obtain
outside experts. Similar to EPA's administrative settlements, some
DOJ-negotiated environmental settlements may involve SEPs, which can be
used to offset a portion of the civil penalty that DOJ would otherwise
seek. The officials reiterated that they do not negotiate with the
violator about the deductibility of the SEP costs, but would factor in the
violator's stated intentions about deducting the SEP costs in establishing
its value as part of the settlement.
As with EPA civil administrative settlements, when DOJ-negotiated
environmental settlements include civil penalties, the practice is to
explicitly label these payments as civil penalties. Also, in some
settlements with civil penalties, DOJ-negotiated environmental settlement
agreements reference IRC S: 162(f), which states that fines or similar
penalties payable to a government are nondeductible. DOJ ENR Division
officials said that having settlement agreements reference IRC S: 162(f)
is not standard practice and would be at the discretion of officials
involved in the settlement negotiations. According to these officials, the
law is generally clear that civil penalties payable to the government are
nondeductible and stating so in agreements is merely restating the law.
The officials said they do not negotiate with the settling companies about
whether the amounts are deductible.
We observed that one large settlement agreement negotiated by DOJ's ENR
Division contained language stating that the settling company was not
allowed to take a deduction for funding of remediation work and that its
chief financial officer must submit a certification that deductions were
not taken. DOJ's ENR Division officials told us that a case such as this
one likely involved particular negotiating circumstances and strategies.
They emphasized that this was an exception rather than their usual
practice of not specifying the tax treatment of settlement amounts in the
settlement agreement.
A Majority of the Surveyed Companies Deducted Civil Settlement Payments,
Generally When Settlement Agreements Did Not Label Payments as Civil Penalties
In responding to our survey,17 companies that paid some of the largest
civil settlement payments at the four agencies we reviewed generally
reported that they deducted civil settlement payments when the settlement
agreements did not label the payments as penalties. Conversely, when the
settlement agreements labeled the payments as penalties, the companies
generally reported that they did not deduct the payments. Overall, for 20
of the 34 settlements for which we received survey responses, companies
stated that they deducted some or all of their civil settlement
payments.18 The total value of settlement amounts of the 34 settlements
for which we received responses was over $1 billion. Table 3 summarizes
the overall responses from the companies, and table 4 provides survey
results on deductions categorized according to how the settlement
agreements labeled the settlement payments.
Table 3: Company Responses on Whether They Deducted Civil Settlement
Payments from Their Federal Income Taxes
Company deducted Company deducted
Agency some or all none a
SEC settlements 1
bDOJ environmental settlements 4
DOJ FCA settlements 15
Total 20
Source: GAO.
Note: We did not verify the companies' responses with IRS.
aBecause some companies with SEPs did not report whether they deducted the
SEPs, the number of settlements listed for which companies did not make
any deduction may be overstated.
bIn table 1, environmental cases handled by DOJ are reported under EPA
cases. In this table, they are reported as "DOJ environmental
settlements." To the extent that any of these settlements contained
estimates of compliance costs, those were not among the costs included in
our survey.
17We sent surveys on 47 civil settlements to companies in which we
identified a representative who could address our survey questions. Our
results are limited to the 34 settlements for which we received responses.
Three of the companies we surveyed responded for 2 settlements each. See
app. I for more details on our methodology.
18One surveyed company stated that it planned to take a deduction for the
SEP portion of its civil settlement payment, but had not yet done so at
the time of our survey. For purposes of this report, we categorized this
company's response as deducted.
Table 4: Company Responses on Whether They Deducted Various Types of Civil
Settlement Payments
Classifications of settlement payments in settlement agreements
Civil Settlement SEPb Disgorgement
penalty amounta
Not Not Not Not
Agency Deducted Deducted Deducted Deducted
deducted deducted deducted deducted
SEC 1 2 N/A N/A N/A N/A 1
DOJ environmentalc 2 13 N/A N/A 2 2 N/A N/A
DOJ FCA 0 0 15 1 N/A N/A N/A N/A
Total 3 15 15 1 2 2 1
Source: GAO.
Note: Totals in this table do not add up to 34 because the following
settlement agreements contain more than one classification of settlement
payment: one SEC settlement contains both a civil penalty and disgorgement
and 10 DOJ-led EPA settlements contain both civil penalties and SEPs.
aSettlement amount includes only those settlements in which the entire
settlement payment was labeled as a settlement amount and was the only
payment in the settlement.
bFor six of the survey responses for settlements with SEPs, the companies
did not respond as to whether they had deducted SEPs associated with the
settlement.
cIn table 1, environmental cases handled by DOJ are reported under EPA
cases. In this table, they are reported as "DOJ environmental." To the
extent that any of these settlements contained estimates of compliance
costs, those were not among the costs included in our survey.
As shown in table 4, for 15 of the 16 DOJ FCA settlements, companies
reported deducting their payments. Of these 15 settlements, 12 survey
responses showed that companies deducted the full amount of the payment,
while 3 responses showed they deducted a percentage of the full
amount-ranging from 43 to 89 percent. Consistent with DOJ's usual practice
for FCA civil settlements, these FCA settlement agreements referred to the
settlement payment as the settlement amount, which does not characterize
whether the settlement amount included a penalty or was punitive or
compensatory in nature.
In addition, of the 15 settlements for which companies settled DOJ FCA
cases and deducted payments, companies in 7 settlements told us that they
deducted payments because, in their view, the settlement amounts were
restitution or compensatory in nature. However, minutes of a healthcare
fraud settlements meeting between IRS and DOJ show that IRS believes FCA
settlement payments usually include a punitive portion to punish violators
and to deter future violations. Also, according to DOJ's technical
comments on the draft of this report, in most FCA settlements (apart from
those that recover strictly penalties), some of the amounts paid are in
the nature of compensatory reimbursement and may be deductible.19
Five companies we surveyed reported that a sentence in their FCA
settlement agreements indicating that the settlement was not punitive in
purpose or effect was a basis for them taking deductions. The settlement
amounts deducted by these five companies totaled over $100 million.
According to a director in DOJ's Civil Division, DOJ does not intend for
the language in FCA settlement agreements that the companies mentioned to
refer to tax treatment. The DOJ official said that this sentence is not
intended to imply that the settlement amounts are compensatory for tax
purposes, but rather to ensure that the amounts are not punitive for
double jeopardy purposes or prohibitions on excessive fines.20 The DOJ
official added that a subsequent statement that is standard in all FCA
settlement agreements articulates DOJ's position on deductibility, that
is, that the agreement does not characterize the payment for federal
income tax purposes. Based on our discussions with DOJ and our survey
evidence showing that some companies cited this sentence in support of
their tax deductions, DOJ revised the relevant portions of the FCA
settlement agreement model language. Effective June 2005, the new language
removes references to the settlement not being punitive in purpose or
effect.
Furthermore, three companies that deducted FCA settlement payments
reported that they did so in whole or in part because their settlement
agreements contained language stating that the company denied wrongdoing.
Their deductions totaled about $15.5 million. Two of these three companies
also cited the sentence discussed in the prior paragraph as another reason
for deducting the amounts.
Also, as shown in table 4, three other companies reported deducting
settlement payments even though they were labeled as civil penalties. Two
of these companies reported that our survey made them aware that their
deductions were improperly taken, and they plan to file amended tax
returns. These deductions totaled about $1.9 million. The other company
19DOJ cited Cook County, Illinois v. U.S. ex rel. Chandler, 538 U.S. 119
(2003).
20The Double Jeopardy Clause in the U.S. Constitution prohibits anyone
from being prosecuted twice for substantially the same crime. U.S. Const.
amend. V. The Excessive Fines Clause of the U.S. Constitution prohibits
the imposition of excessive fines. U.S. Const. amend. VIII.
reported that it deducted the civil penalty because it was paid to a
selfregulatory organization, which the company believed was not a
government agency. This settlement agreement contained language indicating
that the self-regulatory organization settled with the company on behalf
of a federal agency.
Ten companies that responded to our survey had environmental settlement
agreements negotiated by DOJ that contained SEPs.21 Our analysis of the
settlement agreements for the 10 companies showed that four agreements
contained language stating that the SEP costs are not deductible. Two
companies with settlements that contained this language reported to us
that they did not deduct the costs, and the other 2 companies did not
respond to the survey question. Of the 6 companies with SEPs for which the
settlement agreements did not state whether the costs were deductible, 2
companies reported deducting the SEP costs and the other 4 companies did
not indicate whether they deducted SEP costs.
Some of the companies that reported not deducting any settlement payments
gave us varying reasons for not taking deductions. The reasons included
references to IRC S: 162(f), which states, in part, that penalties paid to
a government are not deductible, and provisions in their settlement
agreements specifying that they would not deduct the settlement payments.
No Permanent System Is in Place for Agencies to Routinely Inform IRS of Civil
Settlements or Provide Other Settlement Information That IRS Would Find Useful
The four federal agencies do not systematically provide IRS with civil
settlement information that would be useful to IRS for compliance
purposes, although the agencies do provide such information on a
case-bycase basis at IRS's request, such as for audits of companies with
settlement agreements. The agencies told us they were willing to work with
IRS to develop a permanent system for routinely providing appropriate
information. DOJ Civil Division and EPA have established means for
providing IRS with information on civil settlement agreements as part of
IRS's temporary compliance research projects. In 2004, IRS introduced
Schedule M-3, which could potentially help IRS identify corporations with
some settlements because it captures information on fines, penalties, and
punitive damages from companies with assets of $10 million or more.
21In settlement agreements for the surveyed companies, some SEPs are
referred to as Beneficial Environmental Projects or Environmental
Beneficial Projects.
Settlement Information from Agencies Could Help IRS with Its Audit Strategy
and Facilitate Pre-filing Agreements
In general, the four federal agencies do not routinely notify IRS when a
civil settlement has been reached or provide other settlement-related
information that IRS would find useful, although they provide IRS with
settlement information on a case-by-case basis. To identify settlements
that have been reached, IRS officials search agency Web sites and press
releases. DOJ ENR Division, EPA, and SEC officials said that their Web
sites generally post most of their civil settlement agreements. IRS
usually contacts the agencies on a case-by-case basis to obtain
information to use during audits in assessing whether companies properly
treated their settlement payments on their income tax returns. For
example, to determine the facts and circumstances of a settlement, IRS
contacts DOJ officials to obtain information on FCA settlements, including
written exchanges between the agency and the company and the tracking
forms that are used by DOJ to allocate settlement amounts to various
government accounts. According to IRS staff, the tracking form and the
other information it obtains from DOJ about a settlement can provide leads
for determining nondeductible punitive damages in FCA cases.22
The agencies have expressed willingness to notify IRS when a settlement
has been reached and to work with IRS on providing other appropriate
information. Some steps in this direction have already been taken. For
example, EPA has designated staff to work with IRS to provide specific
settlement information.
IRS officials said that it would help IRS's compliance efforts if agencies
systematically notified IRS that a settlement has been reached and
provided additional information, such as their intent regarding the
breakdown of the settlement payment by category (i.e., punitive versus
compensatory). According to an IRS Director in the Large and Mid-Size
Business Division, such information could play a role in determining which
firms to audit and, when an audit occurs, whether a settlement should be
covered. Further, the IRS Director said that in some cases IRS
22IRS recently issued a technical advice memorandum, TAM 200502041 (Jan.
14, 2005), that concluded that the tracking form was not relevant "since
the proper allocation [between punitive and compensatory aspects of a FCA
recovery] depends on intent at the time the settlement was reached, not on
events occurring after that time." A TAM is a written response to a
technical or procedural question on the interpretation and proper
application of tax authority to a specific set of facts. A taxpayer may
not rely on a TAM issued to another taxpayer.
would like to offer pre-filing agreements to settling companies,23 which
would resolve the tax treatment of settlement payments before tax returns
are filed. The Director focused on large settlements for which IRS
enforcement action was more likely than on smaller settlements.
DOJ and EPA Are Providing IRS Settlement Information as Part of IRS's
Temporary Compliance Research Projects
IRS is collecting information on certain settlements through two
compliance projects. IRS uses compliance projects to collect information
and conduct research in order to target audits in particular issue areas.
It intends to use the project results on the degree to which companies
incorrectly deduct civil settlement payments to make data-driven business
decisions on how to correct the noncompliance.
In 2003, IRS initiated a fraud settlements compliance project focusing on
the deductibility of payments made in the settlements involving fraud,
primarily FCA settlements. The fraud settlements compliance project
targets multimillion-dollar settlements where at least part of the
settlement payment may be punitive although the agreements may not specify
punitive damages. During February 2005 discussions between IRS and DOJ,
DOJ officials agreed to notify IRS promptly of FCA settlements they reach
of $10 million and more and provide a list of smaller dollar FCA
settlement agreements annually for the duration of the project. DOJ
officials told us they would be willing to continue providing IRS with
this information after the completion of this compliance project. IRS
officials said that this information would be useful to them in targeting
and conducting audits. According to the compliance project description,
IRS staff have found that for settlements involving Medicare fraud,
companies are claiming deductions for the full amount of the settlement.
However, IRS staff told us that these settlement payments generally
contain a punitive portion. This compliance project is scheduled to be
completed in 2006.
In 2004, IRS initiated an environmental settlements compliance project,
which focuses on four components of environmental settlements that may
result in an income tax issue-civil penalties; SEP costs; complying
actions; and other payments and requirements, which may include
23IRS's Pre-filing Agreement Program encourages taxpayers to request
consideration of an issue before the tax return is filed and thus resolve
potential disputes and controversy earlier in the examination process. IRS
intends such agreements to reduce the cost and burden associated with
post-filing examinations, to provide companies a level of certainty
regarding a transaction, and to make better use of taxpayer and IRS
resources.
punitive sanctions. For the project, IRS says it needs access to
negotiating files, court documents, settlement documents, databases,
personnel, and attorneys at the relevant settling agencies. EPA has agreed
to provide IRS with certain case-specific information. To obtain an
initial sample of approximately 30 recently negotiated significant
environmental settlements, IRS staff searched agency press releases and
Web sites and contacted EPA and DOJ staff for settlement information on a
case-by-case basis. The initial review of this sample suggests that
companies may be noncompliant when deducting, capitalizing, amortizing, or
depreciating SEP costs. The compliance initiative description also said
that some IRS staff have questioned the appropriateness of deducting SEP
costs if SEP costs are payments in lieu of a penalty because it appears
that such costs are not deductible under IRC S: 162(f).24 IRS officials
said that IRS's National Office plans to issue a technical advice
memorandum (TAM) that will address SEP deductibility and capitalization
issues. The compliance project staff told us that this compliance project
is scheduled to be completed in late 2005, although it may be extended.
According to IRS's fraud settlements compliance project description, the
compliance projects also provide IRS with the necessary information to
evaluate the potential for negotiating pre-filing agreements with settling
companies. Under pre-filing agreements, IRS and companies resolve whether
all or a portion of a settlement payment can be deducted before the
companies file their tax returns. The project description says that for
those cases for which a pre-filing agreement is not executed, IRS
examiners can more timely develop the facts and reach a position on
deductibility, which can reduce examination time on this issue while
enhancing IRS compliance results. IRS officials told us they are in
discussions with one company that reached a civil settlement regarding a
pre-filing agreement and are offering pre-filing agreements to other
settling companies.
24According to EPA, SEPs are projects, not already required by law,
undertaken voluntarily by a respondent/defendant in an enforcement action.
A respondent/defendant's agreement to perform a SEP may be taken into
account as a mitigating factor in assessing the ultimate civil penalty in
a particular case. To calculate the value of an SEP, EPA's economic model
considers, among other things, the entity's tax status, the penalty
payment date, the estimated project costs, the project's operation date,
the combined state and federal tax rate, and the tax deductibility of
onetime nondepreciable expenditures.
Schedule M-3 Provides IRS with Some Settlement Information from Companies
Conclusions
IRS has a new source of information that could help it identify companies
with settlements. In 2004, IRS introduced Schedule M-3, which is designed
to reconcile differences in financial accounting and taxable income (or
loss). The schedule is being used by corporations with assets of $10
million or more and is to be phased in for use by other corporations in
2005 and 2006. Because Schedule M-3 collects information on fines,
penalties, and punitive damages, it may help IRS identify settlements that
should be considered if a company is audited. Schedule M-3 as currently
designed may not capture settlement payments that were not labeled as
fines, penalties, or punitive damages in the written settlement agreement.
Based on our discussions, IRS officials responsible for Schedule M-3 said
that they were considering options to address this situation.
When settlement agreements specify civil penalties, the law is generally
clear that they are nondeductible. However, when the settlements do not
contain penalties, deductibility may be less clear because the IRC and the
statutes imposing the payments may be silent regarding whether the
payments are punitive or compensatory in nature. Moreover, many settlement
agreements do not contain language addressing the tax deductibility of
settlement payments. To determine the deductibility of settlement payments
during audits or in reaching pre-filing agreements, IRS examines
settlement information that would provide the relevant facts and
circumstances in a particular case.
Given this situation, one way to help IRS better ensure that companies are
properly treating settlement payments for tax purposes is to have agencies
systematically notify IRS when they have reached a settlement that
requires significant dollar payments and provide information that IRS may
find useful. With such information, IRS can better determine which
companies to examine and whether settlement payments should be part of the
examination. In addition, with a regular flow of information on
settlements as they are reached, IRS would be able to contact companies
when appropriate to obtain pre-filing agreements on how the settlement
payments should be treated on their tax returns. This may be especially
useful in cases such as the DOJ FCA settlement agreements, which may not
contain useful information for the settling company and IRS to determine
the tax treatment of the settlement amounts.
Recommendation for Executive Action
Agency Comments and Our Evaluation
We recommend that the Commissioner of Internal Revenue 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.
We sent a draft of this report to IRS, EPA, SEC, HHS, and DOJ for comment.
We received written comments from IRS, EPA, SEC, and HHS. DOJ provided
written technical comments.
In his August 26, 2005, letter, the Commissioner of Internal Revenue (see
app. III) said that he agreed with our recommendation and said that it
would be beneficial for IRS to work with federal agencies to develop a
systematic method for obtaining information on civil settlements
contemporaneous with those settlements. He said that IRS will form an
executive led team to work with each agency with significant civil
settlements to reach agreement on what information will be provided, the
format of the information, and the frequency of delivery. IRS also
provided technical comments which we incorporated in our report.
EPA's Assistant Administrator, Office of Enforcement and Compliance
Assurance stated in an August 26, 2005, letter (see app. IV) that EPA
generally supports our recommendation and believes that EPA already has
mechanisms to provide IRS with settlement information useful in
determining the proper tax treatment of settlement amounts. The Assistant
Administrator said that EPA's publicly available Web site contains 3 years
of information on concluded enforcement settlements and other EPA online
enforcement databases with settlement information could be made available
to IRS. EPA believes that these mechanisms are more cost effective than
developing a specific notification process for IRS. While we agree that
EPA has mechanisms in place to provide IRS a means to access its
settlement information, we believe that it would be useful if EPA notified
IRS directly of its significant settlements contemporaneously so IRS could
ensure that it is aware of all significant settlements and be better
positioned to contact companies sooner to initiate pre-filing agreements
with them. Regarding our reference to IRS officials needing access to
information such as negotiating files and documents to help determine the
proper tax treatment of settlement payments, the Assistant Administrator
expressed concern that making such information available to IRS could
result in a waiver of any protective privilege associated with such
information and might jeopardize pending settlements and ongoing
enforcement actions. This issue was not within the scope of our study and
in our view is among the type of issues that can be addressed as IRS and
agency officials work together to establish information sharing
arrangements regarding significant settlement agreements.
The Assistant Administrator also commented on how we characterized the
value of EPA settlements and, in particular, stated that our comparison of
EPA settlement values to those of the other agencies we surveyed is
dissimilar. The Assistant Administrator said that we should only include
monetary payments for EPA civil penalties in valuing EPA settlements to
make them comparable to the value of settlements in the other agencies. In
our view, and as consistently reflected in our report, the value of an
agency's settlements includes all components that are reflected in
settlement agreements. This was also consistent with how the agencies we
surveyed valued their settlements. We believe it would be misleading to
show the value of settlements based on civil penalties alone when the
negotiated settlement agreement clearly included other components.
Further, some settlements we reviewed, such as DOJ FCA settlements, did
not contain penalties. EPA also made some technical comments which we have
incorporated into the report to clarify and more fully present certain
information.
In a letter dated September 1, 2005, an SEC Enforcement Division director
did not specifically comment on our recommendation but said that the
Commission takes seriously the importance of meaningful sanctions in its
enforcement program (see app. V). HHS provided a letter stating they had
no comment on the draft but sent technical comments which we incorporated
into our report (see app. VI). DOJ provided some technical comments which
we included in our report to more accurately reflect information about
their settlements.
As agreed with your offices, unless you publicly release its contents
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its date. At that time, we will send copies to interested congressional
committees, the Secretary of the Treasury, the Commissioner of Internal
Revenue, and other interested parties. We will also make copies available
to others on request. In addition, the report will be available at no
charge on the GAO Web site at http://www.gao.gov.
If you or your staff have any questions about this report, please contact
me at (202) 512-9110 or [email protected]. Contact points for our Offices
of Congressional Relations and Public Affairs may be found on the last
page
of this report. GAO staff who made major contributions to this report are
listed in appendix VII.
Michael Brostek Director, Tax Issues Strategic Issues
Appendix I: Scope and Methodology
The objectives of this report were to (1) identify federal agencies that
negotiated some of the largest dollar civil settlements in recent years,
(2) determine whether the selected federal agencies having some of the
largest civil settlements take the tax consequences of the companies into
account when negotiating civil settlements and officials' views on whether
they should address the deductibility of payments in the agreements, (3)
determine whether the companies that paid some of the largest civil
settlement payments deducted any of the payments on their federal income
tax returns, and (4) determine what information the Internal Revenue
Service (IRS) collects on companies with civil settlements reached by
federal agencies. In addition, we sought to identify whether companies'
deductions for settlement payments were being examined in audits and the
outcome of the audits.
To identify federal agencies that negotiated civil settlements involving
companies with some of the largest civil settlement payments, we analyzed
information on settlements reached by various federal agencies because we
were unable to identify any single, reliably searchable, comprehensive
source or database that was known to contain such information
governmentwide. We limited our scope to settlements that were negotiated
in fiscal years 2001 and 2002 involving companies that file IRS Form 1120,
U.S. Federal Corporate Tax Return.1 We selected this time frame since it
would allow the settling companies time to pay the settlements; determine
applicable tax treatments, if any; and file federal income tax returns.
As a starting point to identify agencies with large settlements in those
years, we used information in the 1998 Federal Financial Management Status
Report and Five-Year Plan that summarized assessments and collections of
civil monetary penalties by federal agencies for fiscal year 1997.2 The
information in the report was based on data compiled from 76 federal
agencies and showed which of those agencies were responsible for the
majority of the civil monetary penalty assessments and collections in
fiscal year 1997. Consolidated information on federal agency assessments
of civil penalties was not available for subsequent years because the
1We excluded flow-through entities, such as partnerships that do not file
IRS Form 1120. We also excluded individuals, governments, and
not-for-profit entities.
2This document was jointly written by the Chief Financial Officers Council
and the Office of Management and Budget.
Appendix I: Scope and Methodology
Federal Reports Elimination Act of 19983 eliminated the annual
requirements for federal agencies to report this information.
Generally, we then sought to determine if the same agencies that were
responsible for the majority of the civil monetary assessments and
collections in fiscal year 1997 were likely to have some of the largest
settlement amounts in fiscal years 2001 and 2002. We did this by reviewing
such material as agency press releases on settlement agreements, annual
reports, enforcement reports, and other data on agency Web sites. In
addition, we also performed more general searches of commercially
available databases that contain archived content from newspapers,
magazines, legal documents, and other printed sources and other federal
Web sites that provided information about corporate civil settlements to
help us gauge whether the settlements we were identifying at these
agencies were among the largest being reported from various publication
sources.
As part of our analysis of this information, we comparatively assessed, to
the extent possible, whether agencies tended to have relatively fewer
individual settlements with typically large-dollar assessments (millions
of dollars per individual settlement) or more numerous individual
settlements of relatively low-dollar amounts. We chose those agencies that
appeared to have a larger settlement amount per case.
We did not include IRS in the agencies we analyzed since tax settlements
are not tax deductible. We also excluded the Federal Reserve System from
consideration because its reported total settlement amounts could
incorporate settlements by multiple agencies.
By comparing and analyzing such information across the leading agencies
for overall civil assessments in 1997, we selected the Environmental
Protection Agency (EPA), the Securities and Exchange Commission (SEC), and
the Department of Justice (DOJ) for further review after concluding that
they were among those agencies responsible for negotiating the largest
individual civil settlements in fiscal years 2001 and 2002 that we could
identify. Also, during these 2 fiscal years, we determined that the
Department of Health and Human Services (HHS) was involved in negotiating
some of the largest dollar False Claims Act health
3Pub. L. No. 105-362, S: 1301(a), 112 Stat. 3280 (1998).
Appendix I: Scope and Methodology
care-related civil settlements that DOJ has primary responsibility for
negotiating.
We contacted each of the four agencies and requested information on its
largest civil settlements, that is, cases in which the largest dollar
amounts were to be paid to the federal government or others. In discussing
our request for lists of settlements, agency officials advised that lists
of cases based on largest settlements would likely include cases of
entities not required to file IRS Form 1120. (See table 1 in the body of
this report for information received from the four agencies on their 20
largest civil settlements for fiscal years 2001 and 2002, which includes
settlements with some entities not required to file IRS Form 1120.)
We took several steps to assess the reliability of the agencies' automated
systems that provided the lists of settlement agreements. We interviewed
agency officials who were knowledgeable about compiling, entering, and
checking the data in the databases used to provide the lists; reviewed
related documentation about the quality and accuracy of the data and the
systems that produced them; and to the extent possible, cross-checked the
lists with other sources. For example, we compared selected information,
such as settlement amount from copies of the actual settlement agreements
with the amount shown on the list obtained from the agencies. We also
asked the companies to confirm this information. Likewise, the companies
confirmed whether they had paid the settlement. We determined that the
lists of largest settlements and associated settlement amount information
were sufficiently reliable for the purposes of this report.
To determine whether the federal agencies take the tax consequences of the
companies into account when negotiating civil settlements and their views
on whether they should address the deductibility of payments in settlement
agreements, we interviewed officials in each of the four agencies about
their settlement policies and negotiation processes. We obtained and
reviewed the underlying agreements and documentation on the agencies'
policies, procedures, and processes for negotiating and structuring civil
settlements with monetary payments.
We also interviewed officials in the four agencies to determine if their
settlement policies and procedures were different now than they were
during fiscal years 2001 and 2002. We obtained documentation supporting
any major policy or procedural changes that addressed how settlement
payments are treated for tax purposes.
Appendix I: Scope and Methodology
To determine whether the companies that paid some of the largest civil
settlement payments deducted any of their payments on their federal income
tax returns, we developed a data collection instrument (DCI) to collect
the information. We collected information from the four agencies on their
largest dollar civil settlements, that is, cases that included payments to
the federal government or others. Agency officials advised us that the
lists of the largest settlements would likely include some settlements
with entities that were not required to file IRS Form 1120. When such a
settlement was among the 20 largest, we selected additional settlements
that otherwise met our criteria.4 In contrast to SEC, HHS, and DOJ, from
which we obtained information on the largest civil settlements payable to
the federal government and other parties such as relators, EPA settlement
amounts included costs incurred for companies to comply with environmental
laws and regulations. We selected the largest EPA settlements that had a
civil penalty because our focus was on how payments were treated for tax
purposes. We requested copies of settlement agreements for the cases
appearing on the lists from the agencies.5
We sent the DCI we developed to 44 companies for which we were able to
obtain copies of the settlement agreements and find cognizant
representatives who were familiar with the settlements and the tax
treatment of the settlement payments and who agreed to participate in our
survey. These 44 companies were required to file IRS Form 1120. In the
end, we received DCI responses from 31 companies concerning 34 of the
settlements. We told companies that we would only report information we
collected in summary form so company names are not specifically
identified.
We examined the settlement agreements for the 34 settlements reached by
companies that responded to our DCI to determine if they contained
specific language that addressed how civil settlement payments are to be
4We selected to survey companies on 5 settlements outside of the 20
largest for 4 DOJ-led HHS False Claims Act settlements and 1 DOJ-led EPA
settlement -for reasons including the following: we were not always able
to identify a cognizant representative or obtain a settlement agreement
for each of the 20 largest for each fiscal year.
5In some instances, we did not need to request copies of the EPA
settlement agreements because EPA posted the agreements on its Web site.
Appendix I: Scope and Methodology
treated for federal income tax purposes.6 In those instances where we
found specific language that addressed how civil settlement payments are
to be treated for federal income tax purposes, we followed up with agency
officials to corroborate how this treatment related to the specific
agencies' policies and procedures.
The settlement agreements we examined are not a representative sample of
settlements for these agencies in these fiscal years, and the results of
our examination cannot be generalized to other settlement agreements.
Likewise, the information we obtained through our DCI represents the
responses of each company that voluntarily completed the instrument with
regard to a specific settlement. Their responses cannot be generalized to
any other population of settlements. Other than verifying the settlement
amount and that the amount was paid by the companies when possible, we did
not verify the other company responses to our survey questions.
To determine what information IRS collects on companies with civil
settlements reached by federal agencies, we interviewed knowledgeable
officials from IRS and the four agencies and reviewed supporting
documentation about what information, if any, IRS obtains from the four
selected agencies regarding their civil settlement agreements.
To determine the results of IRS's audits of companies concerning the tax
treatment of settlement payments, we obtained information from
knowledgeable IRS auditing staff.7 An IRS technical advisor (TA) manager
provided us readily available information on IRS's industry groups in its
Large and Mid-Size Business Division on the results of corporate audits
where the deductibility of civil settlement payments was an issue.8
6We did not examine SEC settlement agreements to determine if they
contained specific language addressing federal tax treatment of payments
because SEC officials told us that the agency did not include language
addressing tax consequences in settlement agreements prior to 2003.
7Because IRS databases do not have indicators to track audit cases with
settlements, a systematically identified set of cases involving
settlements was not available for us to examine.
8According to an IRS TA Manager, IRS examiners are likely to consult TAs
and TA managers in examining such issues as deduction of settlement
amounts. TAs are nationwide experts who ensure consistent treatment of all
taxpayers' issues within their specific industries or issue areas.
Appendix I: Scope and Methodology
We conducted our work at EPA, SEC, HHS, DOJ, and IRS regional and
headquarters offices, from February 2004 through June 2005 in accordance
with generally accepted government auditing standards.
Appendix II: Selected IRS Audit Results Information on Companies with Civil
Settlement Payments
According to selected information IRS provided on 46 companies that
claimed settlement payment deductions on their income tax returns, IRS
adjusted or proposed adjustments for approximately half of these
companies. The 46 companies settled with varying agencies, including EPA,
HHS, and DOJ. In the 24 cases for which IRS adjusted or proposed
adjustments to the amount deducted as settlement payments on the tax
return, the adjustments ranged from "not substantial" to 100 percent,
according to the IRS examiners' notes for the cases.
According to IRS staff, only a portion of the amount listed as a
settlement payment would be nondeductible. Because these portions would be
deemed to be penalties, the balance would be a deductible compensatory
expense. IRS collected this information under compliance research projects
and from additional information from staff familiar with audits of
companies in which the deductibility of settlement payments was an issue.
This information, which covers multiple years, is limited to these
particular companies. As IRS staff selected the 46 companies for audit or
research because of potential noncompliance, these audit results cannot be
projected to other companies with civil settlements.
Appendix III: Comments from the Internal Revenue Service
Appendix III: Comments from the Internal Revenue Service
Appendix IV: Comments from the
Environmental Protection Agency
Note: GAO comments supplementing those in the report text appear at the
end of this appendix.
Appendix IV: Comments from the Environmental Protection Agency Appendix IV:
Comments from the Environmental Protection Agency
See comment 1.
Appendix IV: Comments from the Environmental Protection Agency
See comment 2.
Appendix IV: Comments from the Environmental Protection Agency Appendix IV:
Comments from the Environmental Protection Agency
GAO Comments
1. We reviewed the text in our draft report and believe that it
adequately distinguishes between monetary payments made directly to a
governmental entity and costs to be incurred by a defendant as a
consequence of performing actions required under a civil settlement
agreement. To illustrate, a note to table 1 in our draft report stated
that "For settlements identified by EPA, the total value of settlements
included payments payable to the U.S. government; the estimated cost of
any Supplemental Environmental Projects; and the estimated costs of
pollution controls, monitoring equipment, or other complying actions that
companies are required to take to come into compliance with environmental
laws."
2. As the Assistant Administrator suggested, we have revised our report
to show that a proposed legislative provision mentioned in a footnote to
disallow tax deductions for amounts paid to or at the direction of a
government in relation to a violation was not included in the bill signed
into law. However, our report shows that a new provision has since been
introduced.
Page 44 GAO-05-747 Civil Settlement Payments
Appendix VI: Comments from the Department of Health and Human Services Appendix
VII: GAO Contact and Staff Acknowledgments
GAO Contact Acknowledgments
(450296)
Michael Brostek (202) 512-9110
In addition to the contact named above, Thomas Beall, Danielle Bosquet,
Charlie Daniel, Keira Dembowski, Jeanine Lavender, Cheryl Peterson,
Michael Rose, Amy Rosewarne, and Jennifer Wong made key contributions to
this report.
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