The new Tax Cuts and Jobs Act has changed certain provisions of the Internal Revenue Code (the Code) pertaining to the deductibility of amounts paid to Government entities for violations of law. Section 162(a) of the Code has traditionally permitted taxpayers to deduct payments under settlement agreements and court orders so long as the underlying claim originated in the taxpayer’s trade or business. Prior to the passage of the new tax law, Section 162(f) of the Code barred deductions for amounts paid as fines or penalties, but did not bar deductions for amounts paid as restitution or compensation. The new tax law amends Section 162(f) to impose additional limitations on the deductibility of payments for restitution or compensation.

Under the new Section 162(f), an amount paid to, or at the direction of, a Governmental entity relating to a violation of law – or an investigation into a potential violation of law – may generally only be deducted if the court order or settlement agreement specifically identifies the amount as restitution or as an amount paid to come into compliance with the law. If the court order or settlement agreement does not contain a tax characterization clause, then the amount is non-deductible.

To date, the Federal Government has generally followed a policy of not providing any representations in settlement agreements regarding tax characterization. Unless there is a change in this policy, no amounts paid under settlement agreements with the Federal Government would be deductible under the new tax regime. It remains to be seen whether the new law will result in any policy changes in this regard.

The changes to Section 162(f) apply to all amounts paid or incurred beginning December 22, 2017, unless the amounts are paid or incurred pursuant to a binding order or agreement dated prior to December 22, 2017.

The changes to Section 162(f) of the Code are detailed in Section 13306 of the tax reform bill, a copy of which is available here.