IRC 162(f): Can You Deduct Government Fines?

While businesses can often deduct ordinary and necessary operating expenses for tax purposes, when these payments are made to a government or governmental entity, the rules change. Federal tax law, specifically Internal Revenue Code (IRC) Section 162(f), establishes limitations on deducting payments related to fines and penalties. This distinction applies to any business needing to make payments from a legal violation or government investigation. Understanding this regulation is necessary for proper tax compliance.

The General Rule of Non-Deductibility

This regulation establishes a broad prohibition on deducting amounts paid for the violation of a law. Expanded by the Tax Cuts and Jobs Act of 2017 (TCJA), this rule applies to payments made to a government or certain nongovernmental entities. The scope covers not just adjudicated violations but also payments from investigations into a potential violation. This means even if a business settles before a formal admission of guilt, the payment may still be non-deductible.

The definition of “government” is extensive, including federal, state, local, and foreign governments, along with their agencies. It also extends to certain self-regulating nongovernmental bodies that exercise statutory authority, such as financial regulators. A wide array of payments are captured, including traffic fines, late tax penalties, and fines for violating local health ordinances.

The TCJA’s amendments clarified and broadened what was previously a more ambiguous area of tax law. Before the 2017 changes, disputes often arose over whether a payment was a “fine or similar penalty” versus a deductible compensatory damage. The current law disallows deductions for nearly any amount paid for a violation, including reimbursements to the government for its investigation costs. The clear default position is that such payments are not deductible business expenses.

Exceptions for Restitution and Compliance Payments

Despite the broad rule of non-deductibility, the tax code provides specific exceptions for payments that serve a remedial purpose. These exceptions allow for the deduction of amounts paid for restitution, remediation of property, or to come into compliance with a law. These categories are narrowly defined to permit deductions only when a taxpayer is correcting a problem, rather than paying a penalty for wrongdoing.

One exception is for payments that constitute restitution or remediation. This applies to amounts paid to restore a person, entity, or property harmed by the legal violation. For example, if a company settles a case over a faulty product, a payment directed to consumers harmed by the defect would likely qualify as deductible restitution. The payment must be compensatory, aiming to make the injured party whole.

A second exception exists for amounts paid to come into compliance with a law. This covers the costs a taxpayer bears to correct the noncompliance that led to the violation. For example, a factory that violated environmental regulations and is required to purchase and install new filtration equipment would find the cost of this equipment could be deductible as it directly addresses the underlying legal issue.

Requirements for Claiming an Exception

A taxpayer cannot simply decide a payment qualifies for an exception; specific statutory requirements must be met. The two requirements are the “identification requirement” and the “establishment requirement.” Both must be satisfied for a payment to be deducted as restitution, remediation, or a compliance cost, and failure to meet either one will result in the payment being non-deductible.

The identification requirement mandates that the court order or settlement agreement must explicitly state the nature and purpose of the payment. The legal document must contain language that clearly identifies a specific dollar amount as “restitution,” “remediation,” or an “amount paid to come into compliance with a law.” This requirement forces the parties to agree on the payment’s characterization at the time of the settlement.

Beyond the legal document, the taxpayer must also satisfy the establishment requirement. This is the burden of proof, requiring the taxpayer to maintain documentation to substantiate that the amount was paid for the identified purpose. This evidence can include receipts for repairs, canceled checks to victims, and engineering reports for compliance upgrades. The identification in the settlement agreement alone is not enough; the taxpayer must prove the payment was made as intended.

Government Information Reporting

To increase transparency, the TCJA introduced a reporting requirement for government entities under IRC Section 6050X. This rule mandates that the government entity involved in a settlement must file an information return with the IRS when the total amount required to be paid is $50,000 or more. This reporting is done on Form 1098-F, Fines, Penalties, and Other Amounts.

The government agency sends Form 1098-F to both the IRS and the taxpayer. The form details the total amount paid and specifies any amounts that were identified in the legal agreement as restitution or for coming into compliance with the law. This provides the IRS with third-party verification of the information needed to assess the deductibility of the payment.

Receiving a Form 1098-F is part of the process for a taxpayer seeking to claim a deduction. The form serves as evidence to help meet the identification requirement, as it is an official report from the government confirming the payment’s characterization. While the taxpayer must still meet the establishment requirement through their own records, the Form 1098-F corroborates the information in the settlement or court order.