The Deductibility of FCA Payments in Light of <b><i>Kokesh</i></b>

The U.S. Court of Appeals for the Ninth Circuit was the first circuit court to squarely address the tax treatment of payments made to settle claims under the FCA when, in Talley Industries Inc. v. C.I.R., 116 F.3d 382 (9th Cir. 1997), it found that the tax treatment depended on the payment's “characterization and … purpose.” Id. at 387. Because the settlement agreement did not clarify either, the Ninth Circuit remanded the case to the Tax Court to determine “whether the parties intended the payment to compensate the government for its losses (deductible) or to punish or deter [the taxpayer] (nondeductible).” Id. The Ninth Circuit also concluded that because the taxpayer bore the burden of proving deductibility, if “evidence to establish such a deduction is lacking, the taxpayer, not the government, suffers the consequence.” Id. at 387-88. While it included payment “purpose” as part of the tax treatment analysis, Talley would be used by the government to argue for a heightened emphasis on how the payment is characterized in the settlement agreement.

In Fresenius Medical Care Holdings Inc. v. U.S., 763 F.3d 64 (1st Cir. 2014), the U.S. Court of Appeals for the First Circuit rejected the government's argument, based on Talley, that an FCA settlement payment cannot be deducted absent a tax characterization agreement affirming deductibility. Id. at 69-72. The First Circuit found that “[i]f the government and a defendant settle an FCA claim and specifically agree as to how the settlement will be treated for tax purposes, it is hard to envision any reason why a reviewing court should not honor that agreement.” Id. at 70. Nonetheless, in determining deductibility, “a court may consider factors beyond the mere presence or absence of a tax characterization agreement” regarding “the economic realities of the transaction.” Id. at 70-72. In other words, “[s]ubstance matters.” Id. at 70.

In January 2016, although concluding that an SEC disgorgement payment was a nondeductible penalty, the IRS issued a Chief Counsel Advice that analyzed the deductibility question largely as the First Circuit had in Fresenius. In this instance, the taxpayer contended that a payment made to the SEC to disgorge profits resulting from illegal conduct was deductible. In response, the IRS observed that “disgorgement in federal securities law cases can be primarily compensatory or primarily punitive for federal tax law purposes depending on the facts and circumstances of a particular case.” Id. at 8. For example, “the SEC may be using disgorgement as a means to obtain compensation for harmed investors,” while in other instances disgorgement “serves primarily to prevent wrongdoers from profiting from their illegal conduct and deters subsequent illegal conduct.” Id. at 8-9.

Concluding that there was no evidence that the disgorgement payment was compensatory, the IRS concluded that it was “primarily punitive” and therefore not deductible. Id. at 10. The IRS gave no weight to the fact that neither the consent agreement nor the resulting final judgment contained language prohibiting deductibility, noting that “the absence of a provision prohibiting a deduction for disgorgement does not create a negative implication.” Id.

Contrary to the IRS's “facts and circumstances” approach to individual disgorgements, the SEC historically took the categorical view that disgorgement is always nonpunitive. SEC enforcement actions seeking fines, penalties and/or forfeiture are subject to a five-year statute of limitations. 28 U.S.C. § 2462. If disgorgement is punitive (i.e., a penalty, fine and/or forfeiture), enforcement actions seeking disgorgement would be subject to this statute of limitations. Perhaps with an eye toward enhancing its enforcement powers, the SEC viewed disgorgement as remedial rather than punitive, and thus not subject to § 2462. See SEC Enforcement Manual § 3.1.2 (Oct. 28, 2016).

After Kokesh

While traditionally, courts generally agreed with the SEC that its use of the disgorgement remedy was not punitive and therefore not subject to § 2462, in recent years some courts disagreed, concluding that disgorgement was properly analogized to forfeiture. Earlier this year, the U.S. Supreme Court resolved the circuit split in Kokesh v. SEC, 137 S. Ct. 1635 (2017), reversing a U.S. Court of Appeals for the Tenth Circuit decision, and rejecting the SEC's interpretation in unanimously concluding that disgorgement operates as a penalty and thus is subject to § 2462. The Supreme Court found that “SEC disgorgement … bears all the hallmarks of a penalty.” Id. at 1644.

First, “SEC disgorgement is imposed by the courts as a consequence for violating public laws … . [W]hen the SEC seeks disgorgement, it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.” Id. at 1643 (internal quotation marks omitted).

Second, it “has become clear that deterrence is not simply an incidental effect of disgorgement” and “[s]anctions imposed for the purpose of deterring infractions of public laws are inherently punitive.” Id.

Third, “in many cases, SEC disgorgement is not compensatory. As courts and the Government have employed the remedy, disgorged profits are paid to the district court, and it is within the court's discretion to determine how and to whom the money will be distributed.” Id. at 1644 (internal quotation marks omitted).

Finally, the Supreme Court rejected the SEC's argument that “disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.” Id. (brackets and internal quotation marks omitted). The Court noted that “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and “sometimes is ordered without consideration of a defendant's expenses that reduced the amount of illegal profit.” Id.

The Court concluded that while “disgorgement serves compensatory goals in some cases … we have emphasized the fact that sanctions frequently serve more than one purpose,” and that “[b]ecause disgorgement orders go beyond compensation, are intended to punish, and label defendants wrongdoers as a consequence of violating public laws, they represent a penalty.” Id. at 1645 (citations and internal quotation marks omitted).

Conclusion

As the Supreme Court emphasized, the only question before it in Kokesh was whether SEC enforcement actions seeking disgorgement were subject to § 2462's statute of limitations. Id. at 1642 n.3. Thus, while the IRS in the context of assessing deductibility had not adopted the SEC's categorical conclusion that all SEC disgorgement is nonpunitive because it could have compensatory aspects, it will presumably not feel bound to conclude, as the Supreme Court did, that disgorgement payments are categorically punitive because the payments may not be 100% compensatory.

However, the factors that the Supreme Court applied to analyze the disgorgement remedy ought to be useful to courts and federal agencies in considering the deductibility of FCA and other settlement payments, and for those negotiating such resolutions, as they provide a road map for assessing the relevant facts and circumstance to get to the true economic reality. Indeed, if the First Circuit's observation that “substance matters” remains correct, the Supreme Court's Kokesh factors provide a framework for evaluating that substance.

Accordingly, when negotiating a settlement, a taxpayer would be well advised to have in mind whether the payment is extracted for a deterrent purpose pursuant to the government's general enforcement of laws on behalf of the public or whether the payment is to the government as a victim; whether the payment exceeds the taxpayer's corresponding profit; whether the payment accounts for the taxpayer's corresponding expenses; and whether the payment is made to alleged victims. The record the parties create during settlement negotiations may now be explicitly analyzed in light of the Kokesh factors as the IRS, and ultimately the courts, determine deductibility.

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Joseph F. Savage, Jr. ([email protected]), a member of Business Crimes Bulletin's Board of Editors, is a partner in the Boston office of Goodwin Procter LLP and a former federal prosecutor. Timothy H. Kistner ([email protected]) and Ezekiel L. Hill ([email protected]) are associates in the same office.

In negotiating False Claims Act (FCA) or similar settlements with the government, one key consideration is the tax treatment of any payment. While business expenses (including compensatory damages) may be deducted, deductions may not be taken for fines or penalties paid to the government for a legal violation or for payments made to the government to settle such potential liability. See 26 U.S.C. § 162(a), (f); 26 C.F.R. § 1.162-21. Taxpayers and the Internal Revenue Service (IRS) have litigated the deductibility of settlement payments, with courts adopting differing approaches to determine if a payment is punitive and thus a nondeductible penalty.

While not in the context of deductibility, the Supreme Court this year, in Kokesh v. SEC, analyzed whether disgorgement in an SEC enforcement action was punitive or compensatory. The Court's approach in Kokesh may provide a template for tax cases for analyzing if a settlement payment is deductible.

Disgorgement: Punitive or Not?

The U.S. Court of Appeals for the Ninth Circuit was the first circuit court to squarely address the tax treatment of payments made to settle claims under the FCA when, in Talley Industries Inc. v. C.I.R. , 116 F.3d 382 (9th Cir. 1997), it found that the tax treatment depended on the payment's “characterization and … purpose.” Id . at 387. Because the settlement agreement did not clarify either, the Ninth Circuit remanded the case to the Tax Court to determine “whether the parties intended the payment to compensate the government for its losses (deductible) or to punish or deter [the taxpayer] (nondeductible).” Id. The Ninth Circuit also concluded that because the taxpayer bore the burden of proving deductibility, if “evidence to establish such a deduction is lacking, the taxpayer, not the government, suffers the consequence.” Id. at 387-88. While it included payment “purpose” as part of the tax treatment analysis, Talley would be used by the government to argue for a heightened emphasis on how the payment is characterized in the settlement agreement.

In Fresenius Medical Care Holdings Inc. v. U.S. , 763 F.3d 64 (1st Cir. 2014), the U.S. Court of Appeals for the First Circuit rejected the government's argument, based on Talley, that an FCA settlement payment cannot be deducted absent a tax characterization agreement affirming deductibility. Id. at 69-72. The First Circuit found that “[i]f the government and a defendant settle an FCA claim and specifically agree as to how the settlement will be treated for tax purposes, it is hard to envision any reason why a reviewing court should not honor that agreement.” Id. at 70. Nonetheless, in determining deductibility, “a court may consider factors beyond the mere presence or absence of a tax characterization agreement” regarding “the economic realities of the transaction.” Id. at 70-72. In other words, “[s]ubstance matters.” Id. at 70.

In January 2016, although concluding that an SEC disgorgement payment was a nondeductible penalty, the IRS issued a Chief Counsel Advice that analyzed the deductibility question largely as the First Circuit had in Fresenius. In this instance, the taxpayer contended that a payment made to the SEC to disgorge profits resulting from illegal conduct was deductible. In response, the IRS observed that “disgorgement in federal securities law cases can be primarily compensatory or primarily punitive for federal tax law purposes depending on the facts and circumstances of a particular case.” Id. at 8. For example, “the SEC may be using disgorgement as a means to obtain compensation for harmed investors,” while in other instances disgorgement “serves primarily to prevent wrongdoers from profiting from their illegal conduct and deters subsequent illegal conduct.” Id. at 8-9.

Concluding that there was no evidence that the disgorgement payment was compensatory, the IRS concluded that it was “primarily punitive” and therefore not deductible. Id. at 10. The IRS gave no weight to the fact that neither the consent agreement nor the resulting final judgment contained language prohibiting deductibility, noting that “the absence of a provision prohibiting a deduction for disgorgement does not create a negative implication.” Id.

Contrary to the IRS's “facts and circumstances” approach to individual disgorgements, the SEC historically took the categorical view that disgorgement is always nonpunitive. SEC enforcement actions seeking fines, penalties and/or forfeiture are subject to a five-year statute of limitations. 28 U.S.C. § 2462. If disgorgement is punitive (i.e., a penalty, fine and/or forfeiture), enforcement actions seeking disgorgement would be subject to this statute of limitations. Perhaps with an eye toward enhancing its enforcement powers, the SEC viewed disgorgement as remedial rather than punitive, and thus not subject to § 2462. See SEC Enforcement Manual § 3.1.2 (Oct. 28, 2016).

After Kokesh

While traditionally, courts generally agreed with the SEC that its use of the disgorgement remedy was not punitive and therefore not subject to § 2462, in recent years some courts disagreed, concluding that disgorgement was properly analogized to forfeiture. Earlier this year, the U.S. Supreme Court resolved the circuit split in Kokesh v. SEC , 137 S. Ct. 1635 (2017), reversing a U.S. Court of Appeals for the Tenth Circuit decision, and rejecting the SEC's interpretation in unanimously concluding that disgorgement operates as a penalty and thus is subject to § 2462. The Supreme Court found that “SEC disgorgement … bears all the hallmarks of a penalty.” Id. at 1644.

First, “SEC disgorgement is imposed by the courts as a consequence for violating public laws … . [W]hen the SEC seeks disgorgement, it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.” Id. at 1643 (internal quotation marks omitted).

Second, it “has become clear that deterrence is not simply an incidental effect of disgorgement” and “[s]anctions imposed for the purpose of deterring infractions of public laws are inherently punitive.” Id.

Third, “in many cases, SEC disgorgement is not compensatory. As courts and the Government have employed the remedy, disgorged profits are paid to the district court, and it is within the court's discretion to determine how and to whom the money will be distributed.” Id. at 1644 (internal quotation marks omitted).

Finally, the Supreme Court rejected the SEC's argument that “disgorgement is not punitive but remedial in that it lessens the effects of a violation by restoring the status quo.” Id. (brackets and internal quotation marks omitted). The Court noted that “SEC disgorgement sometimes exceeds the profits gained as a result of the violation” and “sometimes is ordered without consideration of a defendant's expenses that reduced the amount of illegal profit.” Id.

The Court concluded that while “disgorgement serves compensatory goals in some cases … we have emphasized the fact that sanctions frequently serve more than one purpose,” and that “[b]ecause disgorgement orders go beyond compensation, are intended to punish, and label defendants wrongdoers as a consequence of violating public laws, they represent a penalty.” Id. at 1645 (citations and internal quotation marks omitted).

Conclusion

As the Supreme Court emphasized, the only question before it in Kokesh was whether SEC enforcement actions seeking disgorgement were subject to § 2462's statute of limitations. Id. at 1642 n.3. Thus, while the IRS in the context of assessing deductibility had not adopted the SEC's categorical conclusion that all SEC disgorgement is nonpunitive because it could have compensatory aspects, it will presumably not feel bound to conclude, as the Supreme Court did, that disgorgement payments are categorically punitive because the payments may not be 100% compensatory.

However, the factors that the Supreme Court applied to analyze the disgorgement remedy ought to be useful to courts and federal agencies in considering the deductibility of FCA and other settlement payments, and for those negotiating such resolutions, as they provide a road map for assessing the relevant facts and circumstance to get to the true economic reality. Indeed, if the First Circuit's observation that “substance matters” remains correct, the Supreme Court's Kokesh factors provide a framework for evaluating that substance.

Accordingly, when negotiating a settlement, a taxpayer would be well advised to have in mind whether the payment is extracted for a deterrent purpose pursuant to the government's general enforcement of laws on behalf of the public or whether the payment is to the government as a victim; whether the payment exceeds the taxpayer's corresponding profit; whether the payment accounts for the taxpayer's corresponding expenses; and whether the payment is made to alleged victims. The record the parties create during settlement negotiations may now be explicitly analyzed in light of the Kokesh factors as the IRS, and ultimately the courts, determine deductibility.

*****
Joseph F. Savage, Jr. ([email protected]), a member of Business Crimes Bulletin's Board of Editors, is a partner in the Boston office of Goodwin Procter LLP and a former federal prosecutor. Timothy H. Kistner ([email protected]) and Ezekiel L. Hill ([email protected]) are associates in the same office.