Companies that agree to pay millions of dollars to settle civil charges brought by the federal agencies often turn around and deduct the payments on their tax returns, reducing the pain and potentially costing the government billions of dollars in revenue, a study by the Government Accountability Office has found.
The GAO, in a study expected to be released today, also found that while such deductions could be challenged by the Internal Revenue Service, there is no requirement that agencies notify the IRS of settlements, and they do not routinely do so. The agencies do sometimes alert the IRS, but the GAO found that the tax agency often learns of settlements from press releases and by searching other agencies' Web sites.
The deductibility of fines and penalties became an issue in the wake of the corporate scandals of a few years ago, but the GAO found that the law remains unclear in many cases. Several companies interviewed by the congressional watchdog agency said that unless the settlement agreement specified that the payment was not deductible, they deducted it.
After reviewing the GAO's findings, IRS Commissioner Mark W. Everson told the agency: "It is often necessary to look at the pertinent statute that underlies the settlement payment and the facts and circumstances of the settlement to determine deductibility."
Everson called doing this on a case-by-case basis "the IRS's most difficult obstacle in this area," and said the tax agency will "continue to explore options for making penalty determinations more readily ascertainable." In the meantime, the IRS is working with other agencies to try to get information about settlements systematically and promptly, he said.
The GAO questioned 44 companies that entered into large settlement agreements in fiscal 2001 and 2002. Of those, 34 responded. The GAO did not identify the companies it surveyed, but it noted that two said "they had erred" in deducting civil penalties and told the GAO they would file amended returns.
Chairman Charles E. Grassley (R-Iowa) and ranking Democrat Max Baucus (Mont.) of the Senate Finance Committee are planning to introduce legislation, perhaps as early as today, to clarify not only that fines are not deductible, but that neither are most other payments made to settle civil cases. The bill would allow an exception for restitution payments made to victims and costs incurred by companies to come into compliance, such as installation of pollution-control equipment.
"A civil settlement is supposed to sting like a bee, not annoy like a gnat. Letting companies deduct settlement payments from their income taxes takes away the sting," Grassley said.
Baucus called the GAO findings "galling," adding that "companies punished for wrongdoing should not be able to subsidize their government settlements through a tax deduction that effectively passes on the costs" to taxpayers.
The issue attracted attention two years ago when 10 Wall Street firms reached a $1.4 billion "global settlement" with the Securities and Exchange Commission over allegations of conflicts of interest in securities research.
Grassley complained at the time that while the settlement specified that $487 million in civil penalties was not to be deducted, he understood that the rest of the settlement, which was to go for such things as investor education, independent research for investors, and other items, could be deducted.
Sen. Charles E. Grassley (R-Iowa) plans to introduce a bill that would clarify that such settlements are not tax-deductible.
Sen. Max Baucus (D-Mont.) says companies being punished should not be able to subsidize settlements through tax deductions.