Challenges To Deducting Settlement Payments Under The False Claims Act: Fresenius Sheds Light On The Burden

Whether a business may deduct litigation settlement payments can have a substantial real dollar impact on the business. In the midst of combating potential litigation, companies rarely first focus on the potential tax impact of settlement payments. Some businesses mistakenly assume that the Internal Revenue Service (IRS) will not challenge a deduction of settlement payments, and later find themselves in a dispute with the IRS over the characterization. The recent case of Fresenius Medical Care Holdings Inc. v. United States, involving payments under the False Claims Act (FCA), underlines that tax planning can reduce surprises in the tax treatment of such payments. 1

Deductible Expenses

Ordinary and necessary business expenses are deductible under Section 162 of the Internal Revenue Code of 1986, as amended (the Code). Although settlement payments made by a business are generally deductible expenses, a business must look to the origin and character of the claim with respect to which the expense is incurred to make the determination. 2 Amounts paid to settle a legal action may be deductible as ordinary and necessary expenses if the acts that gave rise to the litigation were performed in the ordinary course of the taxpayer's business, provided that the amounts were not fines or similar penalties paid to a government for the violation of any law. Settlement payments to the government may be compensatory or punitive. When a business pays the government to compensate the government for losses as a result of violations of the law, a business is allowed to deduct such payments as ordinary and necessary business expenses. Conversely, settlement payments that are not directly related to the losses sustained by the government are usually for the purpose of punishing the lawbreaker and deterring similar violations. These payments are nondeductible. Allocating settlement payments between deductible compensatory payments and nondeductible fines and penalties can be a difficult exercise without an express agreement between the parties regarding the intent of the settlement payments. A hurdle for taxpayers is that the taxpayer bears the burden of proving that it is entitled to any deduction claimed.

The government normally does not agree to an allocation for tax purposes of settlement payments under the FCA. Although allocations agreed to in a settlement agreement are generally respected, the IRS is not bound by allocations set forth by a taxpayer or in a...