In Brief

• Both the U.S. House and Senate are floating proposals to close a loophole that allows tax deductions when there is a question of whether a fine is punitive.
• Debate centers on whether the deduction encourages settlements that reduce public spending on legal expenses or soothes the pain of fines at taxpayer expense.

Two members of the U.S. House of Representatives want to limit a tax deduction on settlements paid to the government by companies accused of wrongdoing. The bill – proposed by Reps. Peter Welch (D-Vt.) and Luis Gutiérrez (D-Il.) – would prevent companies from deducting fines and other penalties, whether imposed via a court judgment or a settlement agreement. Under current law, companies are prohibited from deducting “punitive” fines paid directly to the government. Often, however, it is not clear which fines are punitive, or the fines are paid to a “non federal entity,” such as the regulatory arm of Fannie Mae and Freddie Mac.

The impetus for the proposed House bill stems from the recent settlement announced between the Department of Justice and JPMorgan Chase & Co. over JPMorgan’s involvement in mortgage-backed securities. The parties have reached a settlement that will require JPMorgan to pay $13 billion in fines. As the law currently stands, JPMorgan may be able to deduct nearly $7 billion of that settlement from its taxes. A group of five Senate Democrats also wrote a letter to Attorney General Eric Holder in late October expressing concern that allowing JPMorgan to write off a portion of any settlement would limit the deterrent effect of the government’s enforcement actions.

The House bill is known as the Stop Deducting Damages Act, and is similar to a Senate bill proposed by Sens. Jack Reed (D-R.I.) and Charles Grassley (R-Iowa) called the Government Settlement Transparency and Reform Act. As a general matter, the House bill would eliminate the tax deduction altogether, while the Senate bill would take a more nuanced approach. The latter would treat quasi-governmental entities as government agencies, require that every settlement specify the tax treatment of fines, and clarify what types of fines are punitive.

Critics of the bills point out that these tax deductions incentivize companies to settle claims out of court, thereby saving taxpayers the expense of lengthy and costly litigation. However, others say that such deductions amount to taxpayer subsidies to companies that blunt the effect of fines resulting from the companies’ own improper activity. From a practical perspective, eliminating or substantially reducing this tax deduction would increase the true cost of a fine, as companies would have to pay more of the settlement amount. However, in the future, it is likely that the parties to a settlement agreement would appreciate the true cost of any fine and ultimately reach a lower overall amount – consistent with the penalties imposed by similar settlements in the past.

These legislative proposals stand to impact numerous companies and individuals who may be considering settlements with government entities.