Robert W. Wood (Wood & Porter, San Francisco) has published Cleaning Up: Tax Deductions for Restitution, Fines, and Penalties,122 Tax Notes 489 (Jan. 26, 2009). Here is the Conclusion:
Restitution payments, compensatory fines, and remedial penalties all seem to be fair game for tax deductions, though the facts and the law are all important. It is awfully hard to summarize this area. It is no wonder that taxpayers negotiating with plaintiffs or regulatory bodies seek tax deductions for their payments. …
In fact, because of the difficulty in harmonizing the case law, many taxpayers can perhaps be forgiven for believing that virtually all of their payments should be in the deductible category. This is a fact-intensive area. One has to consider the facts about particular conduct, and related criminal or other civil proceedings, real or perceived quid pro quos, the purpose and scope of a particular fine or penalty, the statutory or regulatory scheme under which the fine or penalty is awarded, and the particular nature and intent of any restitution. That multiplicity of factors makes this a tough area.
Yet engaging in bargaining over tax-driven language in settlement agreements may be somewhat one-sided. Interestingly, a GAO study [Tax Administration: Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments (GAO-05-747) (Sept. 2005)] found that four large federal agencies (including the Justice Department) do not negotiate with companies over whether settlement payments are tax deductible. Instead, the GAO says, the agencies leave the IRS to handle that. Indeed, the Justice Department has said that as a matter of policy, its agreements are "tax neutral," leaving the difficult issues of deductibility to the expertise of IRS tax lawyers.
Without legislative action, which seems unlikely, a major shift in the focus of settlement discussions and the tax treatment of payments is probably not in the offing. Taxpayers can and should consider tax issues when they are resolving matters. Absent cross-pollenization from differing governmental entities (including the IRS), it is probably unreasonable to expect that the government as a whole will be as sensitive as taxpayers to these tax issues.
Moreover, the endemically amorphous restriction on the deductibility of fines and penalties — with "compensatory fines" and "nonpunitive penalties" being deductible — inevitably leads to line-drawing that probably must be done on a case-by-case basis. There is probably a better system for this. But until we have one, we've got to apply what we have.
