Keywords: burden of proof, deductions, government settlements
On May 9, 2013, the US District Court of Massachusetts issued a Memorandum and Order in Fresenius Medical Care Holding, Inc. v. United States,1 involving federal income tax deductions related to the settlement of several government Federal False Claims Act (FCA) claims. The court's Memorandum addresses one of the government's principal arguments used to disallow taxpayers' deductions for FCA settlements.
Three important observations about the court's findings can be made. First, if the taxpayer can show that the settlement was for singles damages, i.e., actual losses, the settlement is deductible. Second, by contrast, when multiple damages are included in the settlement amount, the taxpayer should be prepared for the IRS to focus on its burden of proof when examining the deduction. Third, the government will rely on the US Department of Justice's policy of not characterizing a settlement for tax purposes to argue that the taxpayer failed to meet its burden.
In light of these points, taxpayers should consider laying the groundwork during settlement negotiations regarding which portions of a settlement are compensatory or otherwise not punitive and preserving documents and testimony to support their position. On the latter point, because memories fade and papers can become lost, evidence preservation may be critical to surviving an IRS challenge.
In addition, taxpayers may consider various alternatives for resolving a potential tax dispute. One alternative some taxpayers should consider is requesting a Pre-Filing Agreement with the IRS to resolve the issue before they file their tax returns.2
The procedural background explains why the court issued its Memorandum.
- Before Fresenius commenced litigation, the IRS permitted it to deduct approximately $258 million, including $66 million paid to the whistleblower, on four civil settlements.
- Fresenius's suit sought a refund of an additional $127 million, the remaining amount it paid under the civil settlements.
- Last fall, a jury returned a verdict in favor of Fresenius, allowing it to deduct $95 million of the disputed amount.
- On March 29, 2013, the district court denied the parties' pending motions for judgment as a matter of law. The court explained that it issued the May 9th Memorandum to clarify why it had "view[ed] the jury's fact finding—rather than some legal determination by the court—to be determinative."3
The Memorandum set forth the tax principles at issue. Section 162(a) provides a deduction for payments that are ordinary and necessary expenses. Section 162(f), however, precludes deductions under section 162(a) for any payment that constitutes a "fine or similar penalty paid to a government for the violation of any law."
To determine whether a payment is a fine or similar penalty, a trier of fact first determines whether "payment on a civil liability is deductible based on the purpose indicated by the statute that is the source of liability."4 A statute's legislative history and judicial and administrative interpretations may be helpful in this endeavor. The FCA imposes a "civil penalty of not less than $5,000 and not more than $10,000," which is adjusted for inflation, "plus 3 times the amount of damages which the Government sustains ...."5
Relying on judicial interpretations, the court made it clear that, although civil penalties are "plainly punitive," singles damages—i.e., actual losses—are "plainly compensatory."6 It further stated that multiple damages—i.e., trebling—require a "fact-dependent inquiry" to determine their characterization as remedial or punitive.7 The court observed that the "tipping point between payback and punishment defies general formulation."8 Thus, the facts of "any particular litigation" dictate the characterization of all or a portion of multiple damages as remedial.9
The government argued that Fresenius failed to meet its burden of proof with respect to the deduction. It read, albeit incorrectly, Talley Indus., Inc. v. Comm'r,10 to have held that "parties must agree on the purpose of a settlement payment in order to characterize the payment as compensatory for tax purposes."11 The court recognized that this argument had the ability to put a taxpayer between a rock and a hard place because the DOJ has a policy of not involving itself in the characterization of the settlement for tax purposes, virtually assuring that a taxpayer would not meet its burden of proof. The court rejected this argument: "a manifest agreement is not necessary ... to establish that all or some portion of the payments ... [were] non-punitive."12
Next, the court stated that where the purpose of the statute is unclear (e.g., the FCA), other evidence must be considered to determine the purpose of the settlement. Consistent with prior tax authorities, because the settlement agreement did not characterize the payment, the court considered non-contractual evidence; here, the parties' settlement negotiations.
The government again relied on the taxpayer's burden of proof to support its non-deduction argument. According to the government, Fresenius should have proposed to the DOJ to characterize the payment during settlement negotiations as compensatory.13 The court even noted that the parties paid little attention to the nature of the settlement during negotiations resulting in Fresenius "fac[ing] an uphill battle" to show it was compensatory.14
Ultimately, however, the court rejected the government's argument. The court found that Fresenius could not have identified the portion of the payment that covered the expenses that the government incurred to investigate the dispute or the interest rate that represented "lost opportunity cost to the government from the delayed payments."15 These were facts the government had not shared with Fresenius. More importantly, the evidence the government relied upon did not establish how it was recompensed for its losses.16 In fact, other evidence presented by Fresenius was sufficient to allow a trier of fact to infer that the multiple damages portion of the settlement was to recompense the government.17
Originally published May 21, 2013
1 No. 08-12118 (D. Mass. May 9, 2013).
2 See Rev. Proc. 2009-14, 2009-3 I.R.B. 324.
3 Fresenius, slip op. at 8.
4 Id. at 9.
5 31 U.S.C. sec. 3729(a)(1).
6 Fresenius, slip op. at 10.
7 Id. at 12.
8 Id. (quoting Cook County v. United States ex rel. Chandler, 538 U.S. 119, 130 (2003)).
10 T.C. Memo. 1999-200.
11 Fresenius, slip op. at 13.
12 Id. at 14.
13 Id. at 24.
14 Id. at 28.
15 Id. at 25.
17 Id. at 25-27.
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