Category: Deductions & Credits
Subject: Fines and Penalties
Title: Non-Deductible vs. Potentially Deductible Components
IRC Sections: 162(f)
Filename: 1159.html
Date Produced: 7/96

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Background
Taxpayer inadvertently released asbestos in connection with repair of a rental building. The local fire department and hazardous materials team was called out to clean up the situation and protect the surrounding inhabitants and property. Ultimately, the taxpayer agreed to pay the following amounts in connection with the incident:

$15,000 as a penalty for simply breaking the law.

$20,000 to reimburse the local government for the cost of the hazardous materials response; and

$15,000 as a donation to an environmental cause.

Tax Treatment of the Components of the Settlement
In general, IRC Section 162(f) denies the deductibility of fines, penalties, and similar payments.

A. Pure Fines and Penalties
Obviously, the amount designated simply as a penalty for breaking the law is not deductible under this principle.

Do we have any flexibility at this point as to how the entire $50,000 is allocated? If so we could potentially gain an advantage by allocating amounts away from pure penalties and towards something that is potentially deductible such as compensatory damages.

Is the $15,000 penalty the full measure of penalties that could apply in this case?

I would like to see language to the effect that the $15,000 penalty is in full settlement of all penalties that could potentially be asserted. In essence, it should be made explicit that none of the other payments under the agreement represent some kind of quid pro quo payments to avoid other penalties, whether criminal or civil. See further discussion under Item C., below. I suspect such language is already in place. Obviously, we should discuss this with the attorney.

B. Reimbursement for HAZ-MAT Response
Under Regulation Section 1.62-21(b)(2), compensatory damages paid to a government do not constitute a fine or penalty. I assume that the amounts paid to reimburse the local government for the cost of the hazardous materials response would be viewed from a legal standpoint as compensatory damages. Even if this is something that is obvious to a good attorney, I would like to see the amounts paid to the fire department (or whatever agency is involved) explicitly referred to in the agreement as compensatory damages. Clearly, that which might be obvious to a competent attorney might be considerably less obvious to an examining agent from the IRS.

Open issue: even if the amounts in question are not restricted under Section 162(f), is there some other obstacle to deductibility, e.g., not an "ordinary" expense, or capitalizable under the INDOPCO doctrine? I suspect that at worst, the taxpayer would be required to capitalize this amount under INDOPCO. This must be researched further when time permits. In any event, it is absolutely clear that the taxpayer's position would not be worse from a characterization of settlement amounts as compensatory damages than he would be if the same amounts were characterized as pure penalties or charitable contributions in lieu thereof.

C. Contribution to Environmental Fund
Revenue Ruling 79-148, 1979-1 CB 93, held nondeductible a payment to a charity equal to the maximum fine that could have been imposed upon the taxpayer and as a condition of probation. The rationale behind this ruling is the payment to the charity is in lieu of (or as a substitution for) payment to a governmental entity.

In Allied Signal, Inc. v. Comr., T.C. Memo 1992-204, aff'd in unpub. opin., 95-1 USTC Para.50,151 (3d Cir. 1995), the court held nondeductible a payment made to an environmental endowment fund pursuant to an agreement in connection with a plea of nolo contendere in a case in which the taxpayer was accused of unlawful discharge of manufacturing wastes. The theoretical underpinning of this case is the "contribution" is a substitute for a criminal or civil fine.

GCM 39465 suggests that if a contribution to a charity is in lieu of payment of further compensatory damages (instead of other fines and penalties), the amounts might be deductible. GCM 39465 applies an "origin-of-the-claim" analysis to discover what is behind the various amounts paid by the taxpayer.

It seems to me there may be some flexibility with respect to this issue.

We must have the language referred to above to the effect that the penalties in the amount of $15,000 represent full settlement of all potential penalties in this matter.

Could we characterize the amount paid to the environmental fund as amounts paid in lieu of further compensatory damages with respect to this incident?

If the two conditions set forth above could be satisfied, it seems possible to take a position the "donation" should be treated the same as compensatory damages under the so-called origin-of-the-claim doctrine of U.S. v. Gilmore, 372 U.S. 39, 63-1 USTC ¶9285, (1963).

Obviously, this conclusion is subject to a great deal of doubt and potential second guessing by the IRS; however, the alternative is to allow the "contribution" to be characterized as a substitute for further penalties which are nondeductible without any doubt whatsoever.