THE SECURITIES INDUSTRY SETTLEMENT: SHOULD IT BE DECUTIBLE?

by Robert W. Wood

Lately, there has been a good deal of press over the supposed tax benefits to various securities houses arising out of the large settlements related to stock research abuses. I’d like to start with a brief overview of their complaints about the nature of the settlement, and tie this in (hopefully) to the landscape of what is deductible and what is not under traditional analysis. That traditional analysis has focused on the difference between nondeductible fines or penalties on the one hand and deductible remedial or compensatory payments (and even deductible punitive damages) on the other.

I’ll start by saying that I find the great hue and cry over this issue to be at least a little bit disingenuous, and perhaps a little naive.

The Complaints
As the securities industry reels in the wake of the approximately $1.5 billion global settlement to be paid by securities firms, The Wall Street Journal has stated that it looks as if only about $450 million of the $1.5 billion total would likely be characterized as fines for penalties. See Zuckerman, “Pain of Wall Street Settlement to be Eased by U.S. Taxpayers,” Wall Street Journal (Feb. 13, 2003). The bulk of the settlement, more than $1 billion, was slated to go toward investor restitution, education, and the dissemination of independent research. These kind of expenses, The Wall Street Journal corrected noted, would normally be tax deductible business expenses.

The $1.5 billion settlement, recall, was reached by twelve of the largest investment firms in dealing with state and federal regulators. Some commentators (and legislators) have criticized the $1.5 billion settlement as not enough to begin with. These criticisms become all the more vitriolic when the asserted tax benefits are taken into account. If the reports are correct that a $1.5 billion settlement becomes a $1.1 billion settlement on an after tax basis, then there is concern that the securities industry is getting off lightly.

Hot on the heels of the public outrage over this topic, Senators Grassley, McCain and Baucus wrote SEC Chairman William Donaldson on February 28, 2003. The gist of the letter was that the settlements were being structured to maximize the amount of the payments that are tax deductible, thereby forcing American taxpayers to “pick up much of the tab” for securities industry misdeeds. Must taxpayers first suffer with markets that were abused (taking money out of their pockets), and then have to sit as the same people who abused the markets try to structure the payments so that these brigands are not held accountable? Zounds!

The three senators note that the headlines stress the size of the settlement payments, but not the actual economic effect after taxes. The three senators go on to urge the SEC to take a more proactive stance when it comes to the tax treatment of the payments. “For the SEC to be oblivious to the tax treatment and the ultimate payor of a settlement is to have the SEC working contrary to other functions and goals of the U.S. government.” See Tax Analysts Doc. No. 2003-5497 (Feb. 28, 2003).

Senators Baucus, Grassley and McCain went to The Wall Street Journal on March 13, 2003 with a very public criticism entitled “A Second Betrayal,” Wall Street Journal (March 13, 2003). As the title of their piece suggests, the three senators argue that by structuring much of the settlement payment in a tax-deductible fashion, corporate America (and our whole system) has cheated taxpayers. The article asserts that by avoiding words like “fraud,” benefits from insurance or tax deductions may be available. (I won’t consider the insurance issues here.) As the senators flatly say, “To the extent that any portion of the settlement payments is paid by the firm’s insurance policies or deducted from their taxable income, insurers, other insureds, and taxpayers will be left picking up the tab for corporate wrongdoing.” Id.

Surveying the Landscape
What is all this about anyway? In contrast to the general rule that payments in a business context (either by way of settlement or judgment) will be deductible, the Internal Revenue Code states expressly that no deduction is allowed for “any fine or similar penalty paid to a government for the violation of any law.” I.R.C. §162(f). This provision denies a deduction for both criminal and civil penalties, as well as for sums paid in settlement of potential liability for a fine. Reg. §1.162-21(b). It is the latter element of the provision that often causes great controversy. It may (or may not) be clear that there is a likelihood of a fine being imposed when a “potential” liability is satisfied.

Whether a fine or penalty may be imposed may in some cases depend upon the intent of the perpetrator. However, the denial of the deduction does not require that the violation of law have been intentional. No deduction will be permitted for the payment of a fine even if the violation is inadvertent, or if the taxpayer must violate the law in order to operate profitably. Tank Truck Rentals, Inc. v. Commissioner, 356 U.S. 30 (1958).

The significance of the rule that fines and penalties are nondeductible — and the considerable incentives that taxpayers have to avoid this rule — are well illustrated by the experience of Exxon with respect to its liability in the Exxon Valdez oil spill litigation. According to news reports, the U.S. government’s $1.1 billion Alaska oil spill settlement with Exxon actually cost Exxon a maximum of $524 million when Exxon’s tax deductions for the payments are taken into account. These findings were made by the Congressional Research Service, and announced by Representative Gerry E. Studds, Democrat from Massachusetts.

The study by the Congressional Research Service determined that more than half of the civil damages totaling $900 million could be deducted on Exxon’s federal income tax returns. The study also indicated that because the civil penalties would be paid out over ten years, the real return to the government will be significantly eroded by inflation. See “Tax Deductions Will Help Exxon Slip Away From Much Of Its Oil Spill Liability Says CRS,” Tax Analysts Highlights & Documents, March 21, 1991, p. 2853.

One of the more important cases to define the line between nondeductible fines or penalties and deductible compensatory damage payments is Allied-Signal, Inc. v. Commissioner, 54 F.3d 767 (3rd Cir. 1995). In this case, the Third Circuit affirmed the Tax Court’s denial of any deduction for an $8 million payment Allied-Signal paid into a trust to eradicate a toxic chemical pesticide from the environment. The court found that the payment was made with the virtual guarantee that the district court would reduce the criminal fine by at least the amount previously levied against Allied-Signal. The issues surrounding these fine vs. compensatory line drawings have been discussed with increasing frequency by commentators. See Raby, “When Will Public Policy Bar Tax Deductions for Payments to Government?” Tax Notes, March 27, 1995, p. 1995. See also Manns, “Internal Revenue Code Section 162(f): When Does the Payment of Damages to a Government Punish the Payor?” Vol. 13, No. 2, Virginia Tax Review (Fall 1993), p. 271.

There seems more and more litigation over the question of what constitutes a fine or penalty. For example, in S. Clark Jenkins, et ux. v. Commissioner, T.C. Memo. 1996-539, T.C.M. (1996), the Tax Court held that a shareholder of a fertilizer manufacturer was entitled to deduct, through his S corporation, amounts he paid to two states as “penalties” for deficiencies in the fertilizer produced by his company. The IRS had disallowed the deduction (passed through from his S corporation), arguing that the payments represented nondeductible penalties. The Tax Court, however, looked to the purpose of the state legislation, finding that it was to compensate the consumer, not to punish the manufacturer.

Indeed, the Tax Court noted that the penalty was calculated by determining the value of the deficient ingredient that the consumer paid for but never received, plus an additional amount that was to compensate for additional crop yield. In this case, the Tax Court found for the taxpayer because it was a remedial statute, not a punitive one. Jenkins demonstrates that it is important to look beyond the mere “fine or penalty” language to discover the purpose of the statute pursuant to which the fine or penalty is levied. For additional discussion, see Schnee, “Some Fines and Penalties Can Be Deducted,” Vol. 58, No. 1, Tax’n for Accountants, January 1997, p. 20.

Merely concludin that a penalty is civil rather than criminal, of course, does not get the taxpayer out of the woods. For example, in Hawronsky v. Commissioner, 105 T.C. 94 (1995), the Tax Court held that Section 162(f) prohibited a man from deducting treble damages he was required to pay when he breached a scholarship program contract. Finding that the payment was a civil penalty, the Tax Court concluded that Section 162(f) applies both to criminal fines and to certain civil penalties.

Difference Between Fines and Late Fees
Although Section 162(f) bars a deduction for any fine or similar penalty paid to a government for a violation of law, many payments have been ruled not to constitute fines for this purpose. Thus, a late filing fee, which is really designed to encourage prompt compliance with the law, has not been treated as a fine for this purpose. Reg. §1.162-21(b)(2). See also Southern Pacific Transportation Co. v. Commissioner, 75 T.C. 497 (1980); supplemental op., 82 T.C. 122 (1984).

Compensatory Payments Distinguished From Fines
Another exception from the scope of Section 162(f) and its denial of deductions for the payment of fines relates to so-called “compensatory” fines. Even a fine (as distinguished from a late fee), can be deducted if it is compensatory. If a fine is imposed only to compensate a governmental entity for harm it has suffered, as distinguished from a fine having a punitive motivation, a deduction will be allowed.

Thus, a fine that is essentially a reimbursement to the government for the amount of lost custom taxes has been held deductible. Middle Atlantic Distributors, Inc. v. Commissioner, 72 T.C. 1136 (1979), acq., 1980-2 C.B. 2. Similarly, a payment to the Clean Water Fund in order to avoid prosecution for water pollution was held deductible in S&B Restaurant, Inc. v. Commissioner, 73 T.C. 1226 (1980).

Even fines that may appear to be punitive on the surface may be held to be deductible as long as the requisite compensatory character of the payment can be proven. Thus, in Mason-Dixon Lines, Inc. v. U.S., 708 F.2d 1043 (6th Cir. 1983), statutory “liquidated damages” imposed for the violation of truck weight limitations were held to be deductible. The theory of this case was that the statutory liquidated damages compensated the state for damage to the highways caused by overweight vehicles. Liquidated damages imposed by contracts, even where denominated as “fines,” have been viewed as compensatory, even by the IRS, on the same theory. Rev Rul 69-214, 1969-1 C.B. 52 (1969).

Admittedly, the line between compensatory fines and noncompensatory ones is sometimes difficult to discern. The regulations, for example, take the position that civil environmental fines are nondeductible. Reg. §1.162-21(c), Examples (2) and (7). Moreover, it may be difficult for the taxpayer to show that a fine is imposed with a compensatory motive. How high the stakes are, of course, depends on the size of the fine and the degree to which it is likely to be recurrent. This brings us to two important cases.

Talley and Allied Signal
In Talley Industries, Inc., et al v. Commissioner, T.C. Memo. 1994-608 (1994); rev’d, remanded, 116 F.3d 382 (9th Cir. 1997), a company and several of its executives were indicted for filing false claims for payment with the federal government. The Navy contracts in question allegedly resulted in a loss to the Navy of approximately $1.56 million. However, because of various potential liabilities, the settlement that was ultimately agreed to between the company and the Justice Department was $2.5 million. The company deducted this amount on its tax return, and the IRS asserted that essentially the settlement amounted to a fine or penalty that could not be deducted.

The Tax Court granted summary judgment for the taxpayer, holding that the settlement payment was not a fine or penalty, except for a very small amount ($1,885) that was explicitly for restitution. The Tax Court found that the government had never suggested that it was attempting to exact a civil penalty from the company. Noting that $2.5 million was less than double the alleged $1.56 million loss, the court inferred that the settlement was not intended to be penal or punitive, but rather to be compensatory. Unfortunately for the taxpayer, the Ninth Circuit then reversed and remanded the case, concluding that there was a material issue of fact and that the matter was not ripe for summary judgment.

In Allied-Signal, Inc. v. Commissioner, T.C. Memo 1992-204 (1992), aff’d, 54 F.3d 767 (3rd Cir. 1995), the Tax Court considered a deduction claimed by Allied-Signal for payments made pursuant to the resolution of a suit involving environmental violations. In addition to other payments, the company made an $8 million payment into a nonprofit environmental fund. The Tax Court determined that the entire payment to the endowment fund was nondeductible because the payment was made with the virtual guarantee that the sentencing judge would reduce the criminal fine to which the company was subject by at least that amount.

The Tax Court rejected the company’s argument that the payment was not a fine or penalty because it did not serve to punish or deter, concluding that the payment served a law enforcement, not a compensatory purpose. In a widely noted decision, the Third Circuit Court of Appeals affirmed the Tax Court. In the environmental area in particular, taxpayers should make every attempt to avoid penalty characterization and to emphasize the remedial effects (or intent) of the payments. See Raby, “Two Wrongs Make a Right: The IRS View of Environmental Cleanup Costs,” Tax Notes, May 24, 1993, p. 1091; and Raby, “When Will Public Policy Bar Tax Deductions for Payments to Government?” Tax Notes, March 27, 1995, p. 1995..

Restitution
The deductibility of restitution payments has been discussed in a number of cases. For example, in Jess Kraft, et ux. v. U.S., 991 F.2d 292 (6th Cir. Mich. 1993); cert. denied, 510 U.S. 976 (1993), the Sixth Circuit held that payments of restitution to Blue Cross/Blue Shield arising out of a criminal action for fraud were nondeductible. Although the restitution was paid to a private party and not to the government, the court held the payments nondeductible. The cases dealing with restitution have become more common. Although traditionally such restitution payments have been analogized by the IRS to penalties, a number of courts have disagreed and found restitution payments to be deductible. See Jon T. Stephens v. Commissioner, 93 T.C. 108, rev’d, 905 F.2d 667 (2d Cir. 1990). For a helpful collection of such cases, see Raby and Raby, “Restitution Payments May Produce a Tax Deduction,” Tax Notes, Oct. 21, 1996, p. 335. See also Schnee, “Some Fines and Penalties Can Be Deducted,” Vol. 58, No. 1, Tax’n for Accountants, January 1997, p. 20; and Raby, “Deductibility of Restitution Payments,” Tax Notes, May 31, 1993, p. 1221.

Public Policy Restrictions?
Public policy and taxes? Boy, that gets sticky. Occasionally, the IRS has objected to the deductibility of a payment where allowing the payment as a deduction raises public policy issues. The IRS as policy wonk? Again, that is disturbing.

No Internal Revenue Code provision specifically authorizes the IRS to disallow deductions based upon this doctrine. Nevertheless, the government has occasionally raised the issue where a legal action involves penalties or punitive provisions, and the settlement or judgment payment could therefore be seen to acquire a similar taint. Fortunately, the Supreme Court determined in 1963 that the IRS could not disallow deductions under a general public policy theory. Commissioner v. Tellier, 383 U.S. 687 (1966).

Although the deductibility of expenses may be restricted under Section 162(a), the IRS cannot generally disallow deductions based upon public policy. Id. Indeed, the fact that a liability is based upon the taxpayer’s fraud, breach of fiduciary duty or mismanagement is generally not enough to prevent the payment from being deductible, as long as the liability arose out of the taxpayer’s trade or business. Examples of this rule in operation are illustrated below:

• Damages caused by a taxpayer’s fraud in negotiating a lease were held deductible. Helvering v. Hampton, 79 F.2d 358 (9th Cir. 1935).

• Damages paid by a stockbroker for improperly churning a client’s account were held deductible. Ditmars v. Commissioner, 302 F.2d 481 (2d Cir. 1962).

• Damages paid by a director for breach of fiduciary duty to a corporation were held deductible. Graham v. Commissioner, 326 F.2d 878 (4th Cir. 1964).

• Damages paid by an executive for mismanagement and misuse of corporate assets were held deductible. Great Island Holding Corp., 5 T.C. 150, acq., 1945 C.B. 3 (1945); and acq. sub nom., 1945 C.B. 7.

• Punitive damages paid by a corporation to a victim of a fraudulent scheme in settlement of a breach of contract and fraud action were held deductible. Rev Rul 80-211, 1980-2 C.B. 57 (1980).

Is there a common thread here? The question of when a payment may not be deductible based on public policy restrictions is closely tied to the restriction on the deductibility on fines or penalties. Indeed, it has been argued that the public policy doctrine and Section 162(f) are interrelated. One article notes that the nondeductibility of fines or penalties under Section 162(f) was designed to replace the old restriction on public policy grounds. See Raby, “When Will Public Policy Bar Tax Deductions for Payments to Government?” Tax Notes, March 27, 1995, p. 1995.

Indeed, despite the enactment of Section 162(f), it can be argued that when a payment is made to a private party that will definitely reduce the amount of a government-imposed fine, allowing a deduction for the payment could subvert the purposes of Section 162(f). That was essentially the position taken in Allied-Signal, Inc. v. Commissioner, 54 F.3d 767 (3rd Cir. 1995). The court in Allied-Signal denied the taxpayer any deduction for the $8 million it paid to a trust established to eradicate a highly toxic chemical pesticide from the environment. The court denied the deduction (affirming the Tax Court) because it found that the $8 million was paid with the virtual guarantee that the district court would reduce the criminal fine by at least that amount.

What is troubling about cases such as Allied-Signal is that it would seem difficult to control the circumstances in which the Section 162(f) type of restriction would apply. The factual determinations that must be made, and that were made in the Allied-Signal case, are still important. Negotiated settlements for a variety of types of legal violations occur with great frequency. Surely Congress did not intend that all of these negotiated settlements would be brought within the ambit of Section 162(f). Did it?

If one reviews some of the case law with this public policy view in mind, it is possible to discern disturbing trends even where the “public policy” moniker is not used. In Oden v. Commissioner, T.C. Memo. 1988-567 (1988), the Tax Court disallowed a sole proprietor’s deduction of a judgment for compensatory damages obtained against her in a defamation suit brought by an ex-employee. Noting that there was malice in the defamation, the Tax Court found that there are some actions so extreme that a deduction should not be available. Given the elimination of the public policy grounds for denying a deduction (and the explicit limitation in Section 162(f) to fines and penalties), this decision seems wrong. Regarding the deduction of Michael Milken’s settlement, see Sheppard, “Milken’s Deduction for His Settlement,” Tax Notes, March 9, 1992, p. 1189.

Some taxpayers have expressed concern whether exemplary or punitive damages will give rise to normal business expense deductions notwithstanding the fact that they may be incurred in the course of an activity that arguably violates public policy. For example, an employer may incur liability for exemplary damages under the Age Discrimination in Employment Act or the Fair Labor Standards Act. The Treasury Regulations flatly state that an amount that is otherwise deductible under Section 162 of the Code will not be made nondeductible by reason of the fact that allowing the deduction would frustrate public policy. Reg. §1.162-1(a). See also Rev Rul 80-211, 1980-2 C.B. 57 (1980). But as with so many flat statements, even that does not obviate all of the line drawing.

In a blow to the traditional notion that virtually any legal expense (of a non-capital and nonpersonal nature) is deductible, in Daniel Frances Kelly, Jr. v. Commissioner, T.C. Memo 1999-69 (1999), Tax Analysts Doc. No. 1999-9190, the Tax Court held that the legal costs of defending against a sexual assault charge are nondeductible. The taxpayer had been charged with criminal sexual assault, and sought to deduct the legal fees as a business expense. The Tax Court found that the sexual harassment charges arose out of the individual’s personal activities, and not out of any profit seeking activities. The court distinguished Clark v. Commissioner, 30 T.C. 1330 (1958), because of the personal nature of this claim.

Clark seems inconsistent with Kelly, because the court in Clark found the expenses deductible. However, in that case there was a finding that Clark had been working within the course and scope of his employment, and he had not committed the rape. The Tax Court in Kelly stated that, unlike the Clark case, sexual assault activity was not within the course and scope of the defendant’s employment, nor was it conducted for a legitimate business purpose. In Clark, the taxpayer had been wrongfully accused of assault with intent to rape during the course of his employment activities. In Kelly, on the other hand, the Tax Court found that Kelly was pursuing a purely personal desire.

Most tax advisors have assumed that sexual harassment, gender or race discrimination, wrongful termination, and a variety of other claims made against an officer of a company would be deductible by the company. The specific facts and the conclusion may turn on whether there is an express indemnity obligation either under law or in the employment contract or other governing documents (including bylaws). Reading Kelly, it may be disturbing to think that virtually all harassment or discrimination cases arguably arise out of some personal activity that could, at least under one reading of the facts, be considered outside the course and scope of employment. It remains to be seen exactly how far this particular notion will go.

Indeed, the kind of line drawing that is done in Kelly reminds me a little bit of the origin of the claims test. That, of course, is the overarching rule for determining the tax treatment of a settlement or judgment payment (to a payor or payee). Although I think it is possible to make sense of the origin of the claims test, I find that it is also often possible to come out with quite different results depending on how one chooses to view the course of conduct that led up to the litigation. Some of the seminal cases in this area, such as U.S. v. Gilmore, 372 U.S. 39 (1963), involve precisely this line drawing. While it is understandable that the authorities would seek to make sense of what may be perceived as tax advantages arising from abhorrent conduct, there should probably be a more systematic and reasoned approach for this than there is.

Punitive Damages Confusion
I cannot leave this topic without at least mentioning punitive damages. Punitive damages paid to private parties are deductible. Nonetheless, there seems to be no end of confusion about this topic, with many business people and even with tax practitioners. The IRS ruled that liquidated damages paid under the Fair Labor Standards Act are deductible as business expenses. Rev. Rul. 69-581, 1969-2 C.B. 25. The Tax Court held that liquidated damages paid under the Age Discrimination in Employment Act and the Fair Labor Standards Act are also deductible. See Downey v. Commissioner, 97 T.C. 150 (1991), on reconsideration, 100 T.C. 634 (1993), rev’d and remanded, 33 F.3d 836 (7th Cir. 1994), cert. denied, 550 U.S. 1141. As long as punitive damages are paid or incurred by a taxpayer in the ordinary conduct of its business, they will be deductible. Rev. Rul. 80-211, 1980-2 C.B. 57.

Of course, a controversy raged for years about the tax treatment of punitive damages in the hands of the recipient. With O’Gilvie v. U.S., 519 U.S. 79 (1996) and the parallel changes in the 1996 tax legislation, it is now clear that punitive damages are always taxable to the recipient. Still, there remains a difficult determination of precisely when “punitive damages” have been paid, since neither the Code nor the regulations define this term. Often, a liability that might be viewed as partially punitive in nature is settled on appeal or in some other consensual way.

I suspect the controversy about the treatment of punitive damages to the recipient has not helped the confusion over the treatment of punitive damages to the payor. Then, there was President Clinton’ 1999 budget proposal to deny deductions on punitive damages paid to plaintiffs in civil lawsuits. The proposal would have denied a deduction to any party paying punitive damages. Furthermore, President Clinton’s proposal would have required a company with insurance for punitive damages to recognize income in the amount that the insurance company actually paid for the punitives. The proposal did not meet with approval from the business community, which was hardly a surprise. See Schlesinger and Hitt, “Clinton Wants to Tax Civil Damages,” Wall Street Journal (Feb. 1, 1999), p. A3.

So Should the Securities Settlement be Deductible?
I suppose this is the question that the SEC and other concerned parties should be raising. Much of it comes down to expectations, though I fear that the popular press tends to gloss over the landscape of these rules. The headlines have suggested that something nefarious is afoot, with the powers that be giving “tax breaks” to the securities industries, so that their $1.5 billion settlement is winnowed down to a more reasonable size.

Whether that’s appropriate or not, I frankly don’t know. It certainly doesn’t surprise me that those negotiating on behalf of the various securities firms would attempt in settlement documents to characterize as much as possible as remedial in nature. Characterization is one thing, of course, but reality can sometimes be another. From what little I know about this settlement (only what I’ve read), a good deal of the money is actually being set aside for education, research, etc. — the very things that one would think of as remedial in nature.

Ultimately, it is understandable that legislators would want to point out the bad conduct that gave rise to this large securities industry settlement in the first place. It is also understandable that these legislators would want to suggest that the securities firms will get a tax benefit for part of the payments, though to me the recognition of these tax benefits seem both belated and unexceptional. Indeed, this whole issue strikes me as something that cuts to the very essence of our tax system. Every time one reads about a big business paying a huge settlement amount, it is deductible, unless it falls within what is a fairly narrow exception (fine or penalty). There is probably some legislative line drawing that can be done here, but I don’t predict it will be easy.

Should the Securities Industry Settlement Be Deductible?, Vol. 99, No. 1, Tax Notes (April 7, 2003), p. 101.