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Court to determine if settlement payments were remedial or punitive

A recent case in the Federal District Court decided in favor of the IRS on procedural grounds, should be followed closely by most businesses. The case will now go to trial on its merits.

The current case has its origins in a settlement agreement signed in 2000 by Fresenius Medical Care Holdings, Inc., resolving several Medicare fraud claims against the company. In the settlement, Fresenius agreed to pay the government more than $100 million to settle criminal claims and over $385 million to settle civil claims.

Fresenius deducted the civil payments as a business expense, which the IRS denied. The current case dealt with Fresenius' request for summary judgment, which the court denied. So now Fresenius will have to go to trial.

Under the tax law, amounts paid to settle litigation may constitute a deductible business expense. However, no deduction is allowed for any fine or similar penalty paid to a government for the violation of any law.

The regulations define a "fine or similar penalty" as a payment made under any one of the following circumstances:

• Paid pursuant to conviction or plea of guilty or nolo contendere for a crime in a criminal proceeding
• Paid as a civil penalty imposed by federal, state or local law
• Paid in settlement of the taxpayer's actual or potential liability for a fine or penalty (either civil or criminal)

However, compensatory damages paid to a government do not constitute a fine or penalty. So the question becomes whether the payments are "remedial" or "punitive." Remedial payments are deductible -- punitive payments are not.

The outcome of this case, and ultimately Fresenius' tax deduction, is going to turn on how the court interprets the language in the documents Fresenius signed agreeing to make the payments. Businesses and their lawyers will follow these developments closely, as they seek to learn the specific language the courts will be looking for to secure tax deductions for settlement payments.

Read more in Fresenius Medical Care Holdings, Inc. vs. United States, 106 AFTR 2d 2010-5028, June 25, 2010.