As part of the 2017 Tax Cuts and Jobs Act (TCJA), Congress modified the rules governing the deductibility of certain government settlement-related expenses under the Internal Revenue Code (IRC). Effective January 1, 2022, governmental agencies are now required to report certain settlement payments made by employers where those payments equal or exceed $50,000. The IRS created the Form 1098-F to report these payments, and if you reached a settlement with a government agency in 2022, you may have been asked for input on the Form 1098-F in 2023. It is important for employers not to ignore these requests, as they may be able to deduct portions of those payments for tax purposes.
The TCJA established what can and cannot be used as a tax deduction when settling with a government agency. IRC § 162(f) was amended to establish that employers cannot deduct amounts paid for penalties. However, payments made toward “restitution, remediation, or to come into compliance with a law,” where those amounts were paid or incurred as part of an agreement with the government, are deductible. The amount must be specifically identified in the settlement agreement or court order as being made for restitution, remediation, or compliance, but this identification alone is not enough to satisfy the deduction requirement — the employer must also be able to establish that the payment or payments were made for the purpose identified. In other words, the employer must be able to 1) identify the amount paid as restitution, remediation, or compliance and 2) establish with appropriate records and documentation that the deductible amount was actually paid or incurred for the purpose identified.
Congress also enacted IRC § 6050X, which requires the governmental parties involved in those suits or agreements to report the amounts paid to the IRS. In the original law, the reporting threshold was set at $600, but the IRS raised this amount to $50,000 for settlements reached in 2022. Of particular importance, the $50,000 threshold applies only to that portion of the settlement that relates to fines or penalties and not to other amounts paid as part of the settlement.
If your business was involved in a settlement, lawsuit, or investigation into a potential violation with a governmental agency that became binding after January 1, 2022, and you paid or incurred $50,000 or more in the aggregate in connection with the settlement or investigation, you may have received a request to provide input on a Form 1098-F from the government agency involved.
Because many settlements do not clearly distinguish between the amounts that are deductible and those that are not deductible, it is in the employer’s best interests to cooperate with the government to provide information that may accurately reflect its ability to claim its deductions for restitution (box 3) and compliance (box 4) on the Form 1098-F. Ultimately, it’s the employer’s responsibility to be able to substantiate the deductions for expenses occurred.
There is no bright-line rule on the deductibility of payments for restitution, remediation, or compliance, so a careful analysis will be required in each case. For example, compensatory fines intended to compensate a governmental entity for harm that it suffered as a result of a violation are deductible, whereas fines imposed as punitive measures are not.
Employers should consider adding language to settlement agreements involving governmental agencies that specifically delineates which parts of the payments are for restitution, remediation, or compliance with a law. Employers should also cooperate with governmental agencies in providing the information necessary to complete Form 1098-F accurately so that they can properly deduct amounts under IRC § 162(f)(2). Both measures will assist employers in ensuring that they have proper substantiation for their settlement payment deductions.
Ensuring that the information on the Form 1098-F is accurate is essential to your company’s ability to make its IRC § 162(f)(2) deduction. Because the deduction is only allowable for restitution, remediation, or compliance, ensuring that those amounts are properly delineated on the Form 1098-F may determine your ability to deduct those amounts for tax purposes.
For assistance or questions about this alert, please contact the authors or any member of the Steptoe & Johnson Taxation and Nonprofit Law Team or Labor & Employment Team.
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