Are Fines and Penalties Tax Deductible Under 162(f)?

Businesses can deduct ordinary and necessary expenses, but specific rules apply to fines, penalties, and other amounts paid to a government. The Tax Cuts and Jobs Act of 2017 (TCJA) altered these regulations under Internal Revenue Code (IRC) Section 162(f), broadening the scope of what is considered a nondeductible payment. These changes affect any business that makes payments to a government entity due to a violation of law or an investigation into a potential violation.

The General Rule of Nondeductibility

The general rule prohibits businesses from deducting amounts paid or incurred to, or at the direction of, a government or certain nongovernmental entities. This disallowance applies to payments related to the violation of any law or the investigation into a potential violation. The scope is broad, covering not just payments labeled “fines” or “penalties,” but also amounts from suits and settlement agreements. A payment may be nondeductible even if a business settles a matter without an admission of guilt.

The TCJA expanded this prohibition. Before this change, the law primarily disallowed deductions for payments that were punitive in nature. The current law disallows a wider array of payments, including those made to cover a government’s investigation costs, regardless of the outcome. For example, a penalty paid to a government agency for breaching environmental regulations is nondeductible under the current rules.

The disallowance applies even if there is no formal finding of wrongdoing, as long as the payment relates to an investigation. The rule also extends to payments made “at the direction of” a government. This occurs when a company is ordered by a regulatory agency to pay consumers for a violation of consumer protection laws.

Exceptions for Certain Payments

Despite the broad rule of nondeductibility, the law provides specific exceptions for certain payments. Deductions are allowed if payments are for restitution, remediation of property, or to come into compliance with a law. These categories are narrowly defined, and a payment must fit within one to qualify. It is important to note that these exceptions do not apply to amounts paid to reimburse a government for its investigation or litigation costs.

Restitution refers to payments made to a specific party for the damage caused by the legal violation, restoring them to their prior position. For example, if a company is ordered to pay a specific amount to customers who were overcharged, that payment could be deductible restitution. This is distinct from a payment made to a government’s general fund, which is treated as a nondeductible penalty.

Another exception applies to payments for the remediation of property, which involves repairing property damaged by the violation, such as cleaning a polluted river. A third exception covers amounts paid to come into compliance with a law. This could include the costs of upgrading equipment or changing business processes to meet legal requirements that were previously violated.

Requirements to Qualify for an Exception

To claim a deduction under one of the exceptions, a taxpayer must satisfy two requirements: the “identification requirement” and the “establishment requirement.” Both conditions must be met for the payment to be deductible. Failure to meet either one will result in the payment being classified as a nondeductible fine or penalty.

The identification requirement mandates that the court order or settlement agreement must explicitly identify the payment’s purpose and amount. The legal document must state that the payment is for “restitution,” “remediation,” or to “come into compliance with a law.” While using these exact words is best, regulations allow for flexibility if the document’s language clearly describes the payment’s restorative purpose.

The establishment requirement compels the taxpayer to prove that the payment was actually made for the identified purpose. This is accomplished by providing documentary evidence that substantiates the nature of the payment, such as proof of the legal obligation, the amount paid, and the date of payment. The taxpayer must maintain records that connect the payment directly to the restorative activity described in the legal order.

Successfully navigating these requirements often depends on proactive engagement during legal proceedings. Taxpayers and their counsel should work to include precise language in any settlement or court order. Agreeing on the specific allocation of payments upfront can prevent future disputes with the IRS over the deductibility of the amounts paid.

Information Reporting Requirements

To enforce these rules, the law also created information reporting requirements for government agencies under IRC Section 6050X. When a business makes a payment to a government entity from a legal violation, the agency is often required to report the payment to the IRS and the taxpayer. This is done using Form 1098-F, “Fines, Penalties, and Other Amounts,” which shows the total amount required to be paid.

Government agencies must file Form 1098-F when the total amount of all payments required by a court order or agreement equals or exceeds $50,000. The form will show the total amount to be paid and may break down the amounts for penalties versus potential restitution or compliance payments. A copy of this form is sent to the taxpayer, providing them with a record of what the government has reported to the IRS.

Receiving a Form 1098-F does not automatically mean a deduction is allowed. The form is informational and serves to notify the IRS of the payment. The taxpayer’s ability to meet the specific identification and establishment requirements determines deductibility. Taxpayers should use the information on Form 1098-F to ensure their tax return filings are consistent with the amounts reported by the government, but they must rely on their legal agreements and supporting documentation to justify any claimed deduction.