Subsidizing Bad Behavior

How Corporate Legal Settlements for Harming the Public Become Lucrative Tax Write Offs, with Recommendations for Reform


Georgia PIRG Education Fund

BP’s recent $4.5 billion legal settlement with the Justice Department for its misdeeds in the Gulf oil spill was historic for being the largest ever criminal settlement. But it was historic for another reason as well—none of it is allowed to be tax deductible. Unfortunately, too many settlements for wrongdoing end up as tax deductions.

Corporations accused of wrongdoing commonly settle legal disputes with government regulators out of court. Doing so allows both the company and the government to avoid going to trial and the agency gets to appear as if it is teaching the company a lesson for its misdeeds. However, very often the corporations deduct the costs of the settlement on their taxes as an ordinary business expense, shifting a significant portion of the burden onto ordinary taxpayers to pick up the tab. Especially when Congress is struggling to reduce budget shortfalls, every dollar that corporate wrongdoers avoid paying by deducting a settlement must be made up for through higher tax rates for others, cuts to public programs, or an increase in the national debt.

Taxpayers should not subsidize BP’s recklessness and deception in the Gulf, big banks’ costly tampering with interest rates in the Libor scandal, or other wrongdoing.

The law clearly states that punitive penalties and fines issued by government agencies are not tax-deductible, but agencies that negotiate settlements all too rarely make clear what portion of a settlement should be regarded as punitive. Corporate tax lawyers can take advantage of this ambiguity by acting as if none of the settlement was meant to be punishment for misdeeds. The Internal Revenue Service is ill prepared to challenge these claims, and taxpayers end up holding the bag.

To help ensure that corporate wrongdoing is not publicly subsidized and that taxpayers are not saddled with the burden, U.S. PIRG offers the following policy recommendations that could save billions of dollars each year:

  • The President should instruct federal regulatory bodies to assume full responsibility for determining the extent to which settlement payments are punitive and therefore nondeductible.
  • Congress should clarify ambiguities in law and require settlement payments to be designated in ways that will have clear consequences for whether those payments are deductible or non-deductible.
  • Agencies should disallow tax deductibility of settlement payments when companies wrongly treat public harm as an acceptable business risk. In cases where company costs truly are incurred from normal business activities, regulators should clearly define and distinguish, in the settlements, between the agreed-upon punitive payments which will not be tax deductible and normal costs of doing business.
  • Agencies should be instructed to publicize the expected after-tax amounts of settlements, which would more accurately report the net penalty that will be paid by the corporation. This is a matter of truth in advertising. Likewise, any company’s public statements about the settlement should list how much of the settlement the company would likely pay after taxes.
  • Any publicly traded corporations that deduct part or whole of a settlement with federal agencies should be required to provide brief justification for deducting such expenses on their annual filings with the Securities and Exchange Commission (SEC).
  • The Internal Revenue Service should continue its progress towards comprehensive information sharing with federal agencies to help agencies designate what can be tax deductible and to establish standard procedures to determine the tax treatment of settlements. The IRS should likewise develop a system of communicating with state and local governments to ensure that settlements negotiated by these entities receive proper federal tax treatment.
  • Following the recommendations of the past three administrations, Congress should prohibit the tax deduction of punitive settlement payments to private parties. At present, this prohibition is only for settlement costs paid to the government.