Information contained in this publication is intended for informational purposes only and does not constitute legal advice or opinion, nor is it a substitute for the professional judgment of an attorney.
As part of the 2017 Tax Cuts and Jobs Act (Act), Congress enacted Internal Revenue Code (Code) section 6050X, which requires government agencies (and certain nongovernmental regulatory agencies) to issue information returns to payors of fines and penalties to the government. The IRS created IRS Form 1098-F to report such payments. The obligation to issue Form 1098-F began with the 2022 tax year, meaning the first 1098-F forms are due in early 2023.
Limitations on deductions for fines and penalties and exceptions to such limitations
As background, under the Act, Congress changed the rules relating to when a penalty or fine paid to or at the direction of a government agency could be deducted by a taxpayer as an ordinary and necessary business expense under Code section 162(f).1 Specifically, no deduction is allowed for any amount paid to, or at the direction of, a government or specified nongovernmental entity for the violation of any law. The general rule does not apply to the following exceptions:
- Amounts that constitute restitution (including remediation of property);
- Amounts paid to come into compliance with the law;
- Amounts paid or incurred as the result of certain court orders in which no government or specified nongovernmental agency is a party; and
- Amounts paid or incurred for taxes due.2
To be deductible under an exception, the taxpayer must establish that an amount required to be paid is for restitution, remediation or to come into compliance with the law, and the amount must be specifically identified in the settlement agreement or court order as restitution, remediation or to come into compliance with the law.
Any amount paid or incurred as reimbursement to the government for the costs of any investigation or litigation are not deductible under one of the exceptions (under prior law, these amounts were often considered compensatory and deductible).
Code section 6050X and Form 1098-F requirements
Under Code section 6050X, the reporting entity must issue a Form 1098-F that identifies:
- The amount required to be paid as a result of the suit or agreement to which section 162(f)(1) applies;
- Any amount required to be paid as a result of the suit or agreement that constitutes restitution or remediation of property;
- The payor’s taxpayer identification number; and
- Any amount required to be paid as a result of the suit or agreement for the purpose of coming into compliance with any law that was violated or involved in the investigation or inquiry.
The threshold for issuance of a Form 1098-F is $50,000, meaning that payments of penalties or fines subject to Code section 162(f)(1) are not reportable on a Form 1098-F.3 Importantly, this $50,000 threshold applies only to the portion of the settlement that relates to fines or penalties, and not to other amounts paid as part of the settlement. Thus, for example, if the employer pays $1 million in settlement of claims, of which only $10,000 constitutes a fine to a government agency, then the settlement should not be subject to reporting on Form 1098-F.
With respect to Form 1098-F, it requires:
Box 1: Total amount of settlement
Box 2: Amount to be paid for violation or potential violation
Box 3: Restitution amount
Box 4: Compliance amount
Box 5: Date of the settlement or court order
Box 6: Court or entity
Box 7: Case number
Box 8: Case name
Box 9: Code to identify information such as multiple payors or payees
The Instructions to Form 1098-F contain the following example, which is from the Treasury regulation examples relating to deductibility of penalties and fines:
Example. Corporation A enters into an agreement with State Y's environmental enforcement agency (Agency) for violating state environmental laws. Pursuant to the agreement, Corp. A pays $40,000 to Agency in civil penalties, $80,000 in restitution for the environmental harm that the Corp. A has caused, $50,000 for remediation of contaminated sites, and $60,000 to conduct comprehensive upgrades to Corp. A's operations to come into compliance with the state environmental laws. Pursuant to the settlement agreement, the aggregate amount Corp. A is required to pay to, or at the direction of Agency, for the violation or potential violation of State Y law exceeds $50,000. Therefore, an appropriate government official of Agency must file Form 1098-F. Agency will complete the Form 1098-F as follows:
- Box 1. Total Amount To Be Paid Pursuant to the Suit, Order, or Agreement. Total Amount $230,000 ($40,000 + $80,000 + $50,000 + $60,000)
- Box 2. Amount To Be Paid for Violation or Potential Violation $40,000
- Box 3. Restitution/Remediation Amount $130,000 ($80,000 + $50,000)
- Box 4. Compliance Amount $60,0004
For taxpayers seeking to claim deductions, amounts reported in boxes 3 (restitution) and 4 (compliance) are critical information for substantiating the amount of any deduction, because they are an acknowledgment of the amounts that are deductible under Code section 162(f)(2).
Requests from government agencies for information needed to issue Form 1098-F
Some government agencies, notably the Equal Employment Opportunity Commission (EEOC), have been communicating with employers with whom it reached settlements in 2022 asking that the employer fill out a survey to meet the EEOC’s compliance obligations under Section 6050X to issue a Form 1098-F. Many employers may wonder whether they should respond to such requests.
Because many settlements may not clearly identify the amounts subject to deductibility and those amounts not subject to deductibility, government agencies may not be able to know what amounts to report on Form 1098-F. As such, they are soliciting information from the payors in order to meet their reporting obligations. Ultimately, because the payors have the obligation to substantiate any deductions for expenses incurred, it is in the payor’s interest to ensure that it is fully able to meet those substantiation obligations.
Accordingly, an employer has an incentive to cooperate with a government agency with respect to providing information that may result in its ability to claim a deduction for any penalties or fines pay in association with a government action or court order, and in particular that boxes 3 (restitution) and 4 (compliance) of the Form 1098-F accurately reflect all amounts that are deductible for such amounts paid.
At present it is unclear what the IRS will do with Form 1098-F or the lack of information as it relates to the deduction of penalties or fines. Thus, employers want to ensure that this information is properly reflected for tax reporting purposes.
What is a fine or penalty in the first place?
In the context of employment-related litigation, an employer may end up settling or being ordered to pay various kinds of damages including back wages, various labor code penalties such as liquidated damages, waiting-time penalties, other kinds of compensatory damages, or, as part of a conciliation agreement, may be required to conduct trainings. Which of these kinds of payments fall under the non-deductible provisions of Code section 162(f)(1), and which may be deductible as an exemption under Code section 162(f)(2), are critical questions to answer.
The label applied to a payment does not determine its character. The Ninth Circuit, for example, looks to “the purpose which the statutory penalty is to serve” in determining whether a civil penalty is deductible.5 The general test used to distinguish a “fine” or “penalty” that is deductible from one that is not is as follows:
If a civil penalty is imposed for purposes of enforcing the law and as punishment for the violation thereof, [the payment is not deductible.] However, if the civil penalty is imposed to encourage prompt compliance with a requirement of the law, or as a remedial measure to compensate another party for expenses incurred as a result of the violation, [it is deductible because it] does not serve the same purpose as a criminal fine and is not ‘similar’ to a fine within the meaning of section 162(f). If the ‘payment ultimately serves each of these purposes, i.e., law enforcement (nondeductible) and compensation (deductible),’ the tax court must determine which purpose the payment was designed to serve.6
The U.S. Tax Court, in turn, has “look[ed] to [state] law to determine the nature of the civil penalties.”7 Thus, a determination about a state “penalty” does not necessarily make it non-deductible. For example, California Labor Code section 226.7 requires an additional hour of pay for a missed meal or rest period. The California Supreme Court held:
the administrative and legislative history of the statute indicates that, whatever incidental behavior-shaping purpose section 226.7 serves, the Legislature intended section 226.7 first and foremost to compensate employees for their injuries. This conclusion is consistent with our prior holdings that statutes regulating conditions of employment are to be liberally construed with an eye to protecting employees.8
Since the California Supreme Court concluded that payments under Labor Code section 226.7 were wages intended to compensate employees, rather than penalties, it appears that payments made in compliance with that section would not be subject to Code section 162(f) as a “fine or similar penalty.”
In addition, in the Office of Chief Counsel Information Release 2005‑0094, the IRS stated that the payment required to be made under California Labor Code section 226.7 was a payment subject to FICA, FUTA and income tax withholding. The IRS acknowledged that the California Division of Labor Standards Enforcement (DSLE) had promulgated regulations indicating that amounts paid by an employer for failing to pay a meal period or rest period was a penalty and not a wage, and thus not required to be included in the calculation of wages for state employment tax purposes. However, it found that the DSLE’s regulation and treatment for state employment tax purposes “has no bearing on whether the payment is wages for” federal employment tax purposes. To the contrary, the IRS found that while the employees do not “perform services directly related to receipt of the additional hour of pay, the payment arises from the employment relationship and is analogous to ‘idle time’ payments” that the IRS had previously held were subject to federal employment taxes. See Rev. Ruling 76‑217, 1976‑1 C.B. 310. Therefore, the IRS concludes that the additional hour of pay an employer must pay to an employee for failure to give the employee the required meal period or rest periods is wages for federal employment tax purposes.
This one example demonstrates that determining whether a payment is a non-deductible penalty or an exemption is a complicated process that will require careful analysis. Nonetheless, in the context of employment-related litigation, the payment of back wages to employees would appear to be restitution and not a penalty. The fact that such payments are subject to employment taxes would further support that the payments are not penalties. Similarly, payments an employer might make to engage in further training would appear to constitute amounts to come into compliance with the law, and thus also fall within the exemptions to the nondeducibility rule. Employers concerned about whether a particular payment would fall within the exemptions under Code section 162(f)(2) should consult their tax advisors and counsel.
Employers should consider the following action items:
- Determine whether any settlements meet the threshold and reporting obligations for issuance of a Form 1098-F, including payments to or at the direction of government entities or certain nongovernment entities and the $50,000 threshold amount;
- Respond to government inquiries to ensure that Form 1098-F reporting is accurate;
- Ensure that any Form 1098-F contains correct information reported in boxes 3 and 4 for purposes of seeking to claim deductions of such expenses; and
- Consider adding language to settlement agreements in the future that make clear that specify the information needed to comply with Code section 6050X and reporting on Form 1098-F.
1 Code section 162(f) states:
(f) Fines, penalties, and other amounts
(1) In general
Except as provided in the following paragraphs of this subsection, no deduction otherwise allowable shall be allowed under this chapter for any amount paid or incurred (whether by suit, agreement, or otherwise) to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law.
(2) Exception for amounts constituting restitution or paid to come into compliance with law
(A) In general Paragraph (1) shall not apply to any amount that—
(i) the taxpayer establishes—
(I) constitutes restitution (including remediation of property) for damage or harm which was or may be caused by the violation of any law or the potential violation of any law, or
(II) is paid to come into compliance with any law which was violated or otherwise involved in the investigation or inquiry described in paragraph (1),
(ii) is identified as restitution or as an amount paid to come into compliance with such law, as the case may be, in the court order or settlement agreement, and
(iii) in the case of any amount of restitution for failure to pay any tax imposed under this title in the same manner as if such amount were such tax, would have been allowed as a deduction under this chapter if it had been timely paid.
The identification under clause (ii) alone shall not be sufficient to make the establishment required under clause (i).
(B) Limitation Subparagraph (A) shall not apply to any amount paid or incurred as reimbursement to the government or entity for the costs of any investigation or litigation.
(3) Exception for amounts paid or incurred as the result of certain court orders
Paragraph (1) shall not apply to any amount paid or incurred by reason of any order of a court in a suit in which no government or governmental entity is a party.
(4) Exception for taxes due
Paragraph (1) shall not apply to any amount paid or incurred as taxes due.
(5) Treatment of certain nongovernmental regulatory entities For purposes of this subsection, the following nongovernmental entities shall be treated as governmental entities:
(A) Any nongovernmental entity which exercises self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange (as defined in section 1256(g)(7)).
(B) To the extent provided in regulations, any nongovernmental entity which exercises self-regulatory powers (including imposing sanctions) as part of performing an essential governmental function.
2 26 U.S.C. § 162(f)(2); 26 C.F.R. § 1.162-21(b), (c).
3 26 C.F.R. § 1.6050X-1(f)(6); see also Instructions to Form 1098-F.
4 See Instructions to Form 1098-F, see also 26 C.F.R. § 1.162-21(f)(1), Example 1.
5 Tally Industries Inc. v. Commissioner, 116 F.3d 382, 385 (9th Cir.1997).
6 Id. at 385-86.
7 Huff v. Commissioner, 80 T.C. 804 (Apr. 26, 1983).
8 Murphy v. Kenneth Cole Productions, Inc., 40 Cal.4th 1094, 1110-1111 (2007) (emphasis added).