US PIRG Education Fund
When large companies harm the public through fraud, financial scams, chemical spills, dangerous products or other misdeeds, they almost never just pay a fine or penalty, as ordinary people would. Instead, these companies negotiate out-of-court settlements that resolve the charges in return for stipulated payments or promised remedies. These agreements, made on behalf of the American people, are not subject to any transparency standards and companies often write them off as tax deductions claimed as necessary and ordinary costs of doing business.
Tax deductibility is a rarely discussed feature of many out-of-court settlements. According to the United States tax code, corporations are allowed to deduct from their taxable income all ordinary and necessary business expenses, though they are not allowed to deduct penalties or fines paid to a government. Corporate outlays to satisfy legal settlements with the government exist in a gray area of the tax code. These payments are often not specifically a penalty or fine, but are meant to resolve some liability in connection to alleged wrongdoing. 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
When corporations deduct settlements for wrongdoing, the public is doubly harmed. First, the deterrent value of those settlement payments is undermined. Instead of the message being that the payments atone for wrongdoing, the message is that the activity is acceptable business as usual. In cases like those involving fraud or financial scams or negligent chemical spills, that message is a dangerous one. Moreover, when corporations write off their settlement payments, the taxpaying public ultimately must shoulder the burden of the lost revenue in the form of higher tax rates for ordinary taxpayers, cuts to public programs, or more national debt.
Neither corporations nor government agencies are required to abide by any standards of transparency with regards to out of court settlements, leaving the public largely unaware of the tax deductibility of settlement agreements. Agencies like the Department of Justice can advertise the top-line numbers in their press releases rather than the actual net value of the settlements they sign. Ultimately, the American people don’t know the real public value of the deals signed on their behalf.
This report follows up on a 2005 study by the nonpartisan federal Government Accountability Office, which found that settlement agreements between corporations and government agencies rarely address tax deductibility, and that this practice overwhelmingly led corporations to claim the bulk of their settlement payments as tax deductions. Furthermore, the study found that neither the agencies nor the IRS took responsibility for designating the appropriate tax status for particular settlements. This lack of communication resulted in even some payments that were designated as “penalties” being construed by corporate tax attorneys as non-punitive and therefore tax deductible.
The present study examines all out-of-court settlements between 2012 and 2014 for which press releases were posted by the same agencies the GAO examined – the Department of Justice, Environmental Protection Agency, Securities and Exchange Commission, and Department of Health and Human Services – plus the Consumer Financial Protection Bureau, a new agency that negotiates some large settlements. For each agency we examine the extent to which announcements of settlements included a posting of the actual settlement language or whether the public and journalists were left to rely purely on the agency’s characterization of the deal they negotiated on the public’s behalf. For those settlements where it is possible to view the actual settlement language, we examine which portion of the settlement is designated as a penalty and whether any protections are included to ensure that the settlement won’t be written off as an ordinary tax deduction.
- Of the five agencies examined, none have a publicly announced policy for how to address the tax status of the settlements they sign.
- For the ten largest settlements announced by major agencies during the previous three years, companies were required to pay nearly $80 billion to resolve federal charges of wrongdoing, but can readily write off at least $48 billion of this amount as a tax deduction.
- Some agencies consistently act to limit tax deductibility for settlements they negotiate, while others rarely address the issue. Some agencies have stronger practices than others to clearly prevent settlements from being treated as tax deductions. The EPA and CFPB are most consistent in ensuring that at least portions of the settlements they sign are specifically non-deductible.
- Of all federal agencies, the DOJ signs most of the largest settlements. Based on the DOJ cases for which settlement text is available between 2012 and 2014, only 18.4 percent of settlement dollars were explicitly non-deductible. Similarly, only 15 percent of settlement dollars negotiated by the SEC included language to ensure against settlement deductions, at least for those settlements with publicly available language.
- The CFPB and the EPA had the strongest transparency practices, making the vast majority of settlements they sign publicly available online, while the SEC and the DOJ are less consistent about disclosing the text of their announced settlements. At the SEC the number of announced settlements where text was disclosed increased from 55 percent in 2012 to 87 percent in 2014. At the DOJ meanwhile, disclosure decreased from 35 percent to 25 percent of announced settlements during the period.
1. The federal tax code should explicitly deny tax deductions for all payments made to federal agencies in connection with corporate wrongdoing, unless otherwise specified in a settlement agreement. By requiring that agencies and corporations negotiate about tax deductibility rather than including it as a matter of course, many millions of dollars of unintended corporate tax write offs would be limited.
2. In lieu of changing the federal tax code, agencies can make it standard practice to specify settlements as non-deductible across the board. Agencies will have greater leverage in negotiating if they start with the default position of non-deductibility.
3. Regardless of their standard practice for deductibility, agencies should include language in all settlements specifying whether a settlement can be deducted as a business expense.
4. Agencies should only allow a settlement to be tax deductible if also accompanied with an explanation of why the conduct should be regarded as an ordinary and necessary business expense.
5. In cases where agencies do grant tax-deductibility, then agencies should make clear in their public statements about the settlement what the net value of the settlement would likely be once it has been applied against taxable income as an ordinary business expense.
6. Agencies should similarly be mandated to publicly post all settlement agreements online.
7. In rare cases when settlements require confidentiality, agencies and signing corporations should be required to publicly explain why a deal has been deemed confidential.