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Settlements Are Big Tax Write-Offs for Companies

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Jan 11th 2016
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As mere mortals begin preparing for tax season, a recent study by the US Public Interest Research Group (PIRG) Education Fund reveals how corporate giants take advantage of a gray area in the tax code to write off billions of dollars in out-of-court settlements as business costs.

Settling for a Lack of Accountability? states that the tax code allows corporations to deduct ordinary and necessary business expenses but not penalties or fines paid to the government. But the settlements often aren't a penalty or fine. They're intended to address liability in connection with alleged wrongdoing, the study states.

“When the tax status of these required payments is not addressed by the government agency that is signing a settlement, then the corporation typi­cally can claim the vast majority of those payments made to address allegations of wrongdoing as an ‘ordinary and necessary cost of doing business,' and, thus, as a tax deduction,” according to the study.

“The human cost of corporate misconduct is very real – from damaged ecosystems to devastated economies,” Michelle Surka, program associate with the US PIRG Education Fund and co-author of the study, said in a prepared statement. “When corporations and federal agencies settle out of court, the impact of the settlement should be real, too. Federal agencies must ensure that tax deductions don't undercut the purpose of such deals and that the public knows their true after-tax value.”

The US PIRG Education Fund study follows up on a 2005 study by the US Government Accountability Office (GAO). The GAO found that settlement agreements with government agencies rarely address tax deductibility. As a result, corporations take most of their settlement pay­ments as tax deductions. The GAO also revealed that neither the agencies nor the IRS claimed responsibility for what the correct tax status was for settlements. And that meant that some settlement payments that actually were designated as penalties were considered nonpunitive by corporations' tax attorneys – and, thus, deductible.

The message that conveys outside of the C-suite is that settlements aren't really a punishment for wrongdoing, and “the activity is acceptable as business as usual,” the study states. â€œThe taxpaying public ultimately must shoulder the burden of the lost revenue in the form of higher taxes for other ordinary taxpay­ers, cuts to public programs, or more na­tional debt.”

So when public agencies announce these settlement agreements, they publicize the gross value – not the net value after tax deductions.

For the US PIRG Education Fund study released last month, researchers examined out-of-court settlements from 2012 to 2014 that involved press releases from the US Department of Justice (DOJ), US Environmental Protection Agency (EPA), US Securities and Exchange Com­mission (SEC), US Department of Health and Human Services, and the Consumer Fi­nancial Protection Bureau (CFPB).

Here are the study's five key findings:

  • None of the government agencies has indicated how they will address the settlements' tax status.
  • In the 10 largest settlements during the study period, companies paid almost $80 billion in settlements but can take at least $48 billion as a tax deduction.
  • Some federal agencies' practices are stronger than others in preventing tax deductions on settlements. The EPA and the CFPB are the most consistent in making sure that a portion of the settlements are nondeductible.
  • DOJ settlements generally are the largest, but during the three-year study period in which settlement information was available, only 18.4 percent of the settlement payment was nondeductible. At the SEC, 15 percent of settlements included language banning deductions (for those settlements made public).
  • The CFPB and the EPA were the most transparent about their settlements, and most were posted online. The SEC's disclosure of settlement content rose from 55 percent in 2012 to 87 percent in 2014. DOJ disclosure dropped from 35 percent to 25 percent.

The study recommends seven “common-sense measures” to correct the settlement tax-deduction and transparency issues.

  1. The tax code should deny tax deductions for payments made for alleged cor­porate wrongdoing unless the settlement specifies otherwise.
  2. In lieu of that, federal agencies can flatly make settlements nondeductible. That will provide them more leverage in negotiations.
  3. Settlements should indicate whether they can be deducted as a business expense.
  4. Settlement tax deductions should be allowed only if they explain why the conduct is a necessary business expense.
  5. If tax deductions are allowed, settlements should make clear what the net value is.
  6. Federal agencies should be mandated to post the full text of settlements online.
  7. If settlements require confidentiality, it should be explained why.
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