IRS Releases Final Regulations on Nondeductibility of Penalties

Thoughtware Article Published: Feb 03, 2021
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The IRS recently issued final regulations to provide guidance on Internal Revenue Code (IRC) Sections 162(f) and 6050X.  

IRC §162(f) was amended in 2017 by the Tax Cuts and Jobs Act (TCJA). The amendments expanded the prohibition on deductibility from just fines and penalties to also include amounts paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or government entity in relation to the violation of any law or the investigation or inquiry by such government or governmental entity into the potential violation of any law. The amendments also included certain nongovernmental entities with self-regulatory powers within the definition of governmental entities. Note, the final regulations revise this definition to clarify that self-regulatory powers include enforcing rules, not laws. 

An exception to the prohibition on deductibility also was inserted into §162(f) by the TCJA. Amounts paid or incurred for restitution, remediation, or to come into compliance with a law are deductible if the taxpayer can show they meet the identification and establishment requirements of §162(f). The identification requirement is met by a court order or settlement identifying the amounts paid or incurred as restitution, remediation, or to come into compliance with a law. However, the establishment clause is a higher hurdle. Here, the taxpayer must establish with underlying facts that amounts paid or incurred were restitution, remediation, or to come into compliance with a law.  

In addition, the TCJA added §6050X. This new section establishes reporting requirements for the appropriate official of any government or governmental entity involved in a suit or agreement with respect to a violation of any law or investigation into the violation of any law over which the government or entity has authority. Essentially, this new section requires reporting of amounts that may be disallowed under §162(f) to the IRS by the government or governmental entity bringing the suit or action.

On May 13, 2020, the IRS published proposed regulations to provide guidance on §162(f) and §6050X. In response to the proposed regulations, members of the public provided written comments to the IRS. These comments were considered by the IRS, and several changes were made to the final regulations. Highlights of the changes from the proposed to the final regulations include:

  • Additional language was added to clarify that an investigation or inquiry into the potential violation of any law doesn’t include routine investigations or inquiries of regulated businesses, such as audits or inspections, if the payment is otherwise deductible as an ordinary and necessary business expense.
  • Under the proposed regulations, the identification requirement is met when an order or agreement specifically states a payment is for restitution, remediation, or to come into compliance with a law. If the order uses a different form of these words, the identification requirement also would be met. The final regulations further add that the identification requirement will be met where the order specifically describes the damage done, harm suffered, or manner of noncompliance with a law and describes the action required of the taxpayer to provide restitution, remediation, or to come into compliance with any law. 
  • The proposed regulations excluded disgorgement or forfeiture from the definition of restitution, remediation, or amounts paid to come into compliance with a law, making disgorgement or forfeiture nondeductible. However, the final regulations don’t treat disgorgement or forfeiture as per se nondeductible. Instead, under the final regulations, restitution may include disgorgement or forfeiture where the identification and establishment requirements are met, and the payments aren’t in excess of the taxpayer’s net profits or paid to the general account of the government or government entity.   
  • The final regulations revised the definition of “restitution, remediation of property, and amounts paid to come into compliance with a law” to include environment, wildlife, or natural resource restitution or remediation. To fall within the definition, amounts paid or incurred must be for the purpose of conserving soil, air, or water resources, protecting or restoring the environment or an ecosystem, improving forests, or providing a habitat for fish, wildlife, or plants. In addition, there must be a strong nexus or connection between the purpose of the payment and the harm to the environment, natural resources, or wildlife the taxpayer has caused or is alleged to have caused.

The final regulations maintain the $50,000 threshold for reporting. However, for purposes of the information reporting requirements in §6050X, a nongovernmental entity treated as a governmental entity doesn’t include a nongovernmental entity of a territory of the U.S., including American Samoa, Guam, the Northern Mariana Islands, Puerto Rico, or the U.S. Virgin Islands, a foreign country, or an Indian tribe. 

The final §162(f) regulations apply to taxable years beginning on or after the date of publication in the Federal Register, except that such rules don’t apply to amounts paid or incurred under any order or agreement pursuant to a suit, agreement, or otherwise, which became binding under applicable law before such date, determined without regard to whether all appeals have been exhausted or the time for filing appeals has expired. The final regulations under §6050X apply only to orders and agreements that become binding under applicable law on or after January 1, 2022.

The above changes between the proposed and final regulations are only a summary. Other changes were made that may affect your fact pattern. Please reach out to your BKD Trusted Advisor™ to discuss the effect of these final regulations on your organization or submit the Contact Us form below.

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