Settling for a Lack of Accountability?

Phineas Baxandall and Michelle Sukra

The United States Public Interest Research Group Education Fund released a report that examines which federal agencies allow companies to write off out-of-court settlements as tax deductions, and which are transparent about it. Here’s the Executive Summary.

When large companies harm the public through fraud, financial scams, chemical spills, dangerous products or other misdeeds, they almost never just pay a fine or penalty, as ordinary people would. Instead, these companies negotiate out-of-court settlements that resolve the charges in return for stipulat­ed payments or promised remedies. These agreements, made on behalf of the Ameri­can people, are not subject to any trans­parency standards and companies often write them off as tax deductions claimed as necessary and ordinary costs of doing business.

Tax deductibility is a rarely discussed feature of many out-of-court settlements. According to the United States tax code, corporations are allowed to deduct from their taxable income all ordinary and nec­essary business expenses, though they are not allowed to deduct penalties or fines paid to a government. Corporate outlays to satisfy legal settlements with the gov­ernment exist in a gray area of the tax code. These payments are often not spe­cifically a penalty or fine, but are meant to address some liability in connection to al­leged wrongdoing. When the tax status of these required payments is not addressed by the government agency that is signing a settlement, then the corporation typi­cally can claim the vast majority of those payments made to address allegations of wrongdoing as an “ordinary and necessary cost of doing business,” and thus as a tax deduction.

When corporations deduct settlements for wrongdoing, the public is doubly harmed. First, the deterrent value of those settlement payments is undermined. In­stead of the message being that the pay­ments are atoning for wrongdoing, the message is that the activity is acceptable business as usual. In cases like those in­volving fraud or financial scams or negli­gent chemical spills, that message is a dan­gerous one. Moreover, when corporations write off their settlement payments, the taxpaying public ultimately must shoulder the burden of the lost revenue in the form of higher taxes for other ordinary taxpay­ers, cuts to public programs, or more na­tional debt.

Because neither corporations nor gov­ernment agencies have to abide by any standards of transparency with regards to out of court settlements, the public re­mains largely unaware of the tax deduct­ibility of settlement agreements. Agencies like the Department of Justice can adver­tise the top-line numbers rather than the net value of the settlements they sign. Ul­timately, the American people don’t know the real public value of the deals signed on their behalf.

This report follows up on a 2005 study by the nonpartisan federal Government Accountability Office, which found that settlement agreements between corpo­rations and government agencies rarely address tax deductibility, and this prac­tice overwhelmingly led corporations to claim the bulk of their settlement pay­ments as tax deductions. Furthermore, the study found that neither the agen­cies nor the IRS took responsibility for designating the appropriate tax status for particular settlements. This lack of communication resulted in even some payments that were designated as “pen­alties” being construed by corporate tax attorneys as non-punitive and therefore tax deductible.

The present study examines all out-of-court settlements between 2012 and 2014 for which press releases were posted by the same agencies – the Department of Justice, Environmental Protection Agency, Securities and Exchange Com­mission, and Department of Health and Human Services – plus the Consumer Fi­nancial Protection Bureau, a new agency that negotiates some large settlements. For each agency we examine whether the announcements of settlements include a posting of the actual settlement language or whether people must rely purely on the agency’s characterization of the deal they negotiated on the public’s behalf. For those settlements where it is possible to view the actual settlement language, we examine which portion of the settlement is designated as a penalty and whether any protections are included to ensure that the settlement won’t be written off as an ordi­nary tax deduction.

Key Findings:

Of the five agencies examined, none have publicly announced a policy for how to address the tax status of the settlements they sign.

For the ten largest settlements an­nounced by these major agencies dur­ing the three year period, companies were required to pay nearly $80 billion to resolve federal charges of wrongdo­ing, but companies can readily write off at least $48 billion of this amount as a tax deduction.

Some agencies consistently act to limit tax deductibility for settlements they negotiate, while others rarely address the issue. Some agencies have stron­ger practices than others in prevent­ing settlements from being treated as tax deductions. The EPA and CFPB in particular are most consistent in ensur­ing that at least portions of the settle­ments they sign are specifically non-deductible.

The DOJ signs most of the largest settlement agreements of all federal agencies. Based on the cases with avail­able settlement text, between 2012 and 2014, only 18.4 percent of settlement dollars were explicitly non-deductible. Only 15 percent of settlement dol­lars negotiated by the SEC included language to ensure against settlement deductions, at least for those with pub­licly available settlement language.

The CFPB and the EPA had the stron­gest transparency practices, making the vast majority of settlements they sign publicly available online. These agen­cies have continued to improve their practices. The SEC and the DOJ are less consistent about disclosing the text of their announced settlements. At the SEC the number of announced settlements where text was disclosed increased from 55 percent in 2012 to 87 percent in 2014. At the DOJ, dis­closure decreased from 35 percent to 25 percent of announced settlements during the period.

Recommendations

Some common sense measures would make the use of out-of-court settlements as tax deductions less common and more transparent.

1. The federal tax code should explicitly deny tax deductions for all payments made in connection with alleged cor­porate wrongdoing, unless otherwise specified in a settlement agreement. By requiring that agencies and corpo­rations negotiate in tax deductibility, even for payments that qualify as com­pensation or restitution and are not necessarily going to the federal gov­ernment, rather than including it as a matter of course, millions of dollars of unintended corporate tax write offs would be prevented.
2. In lieu of changing the federal tax code, agencies can make it standard practice to make settlements non-deductible across the board. Agencies will have greater leverage in negotiating if they start with the default position of non-deductibility.
3. Agencies should include language in all settlements specifying whether or not a settlement can be deducted as a busi­ness expense.
4. Tax deductible settlements should only be allowed by an agency if also accom­panied with an explanation of why the conduct should be regarded as an or­dinary and necessary business expense.
5. In cases where agencies do grant tax-deductibility, then agencies should make clear in their public descriptions about the settlement what the net value of the settlement would likely be once it has been applied against taxable in­come as an ordinary business expense.
6. Agencies should similarly be mandated to publicly post all settlement agree­ments online, including their full text.
7. When settlements require confidenti­ality, agencies and signing corporations should be required to explain why a deal has been deemed confidential.