The following article is reprinted from The M&A Tax Report, Vol. 13, No. 1, August 2004, Panel Publishers, New York, NY.


By Robert W. Wood

Nearly all of the focus of punitive damages tax treatment for the last several years has been on plaintiffs who receive (or who might receive) them. What about the payor's tax treatment of punitive damage payments? Historically, punitive damages paid to private parties have always been deductible. Nonetheless, for reasons which are not entirely clear, many business people (and even some tax practitioners) are often confused about the tax treatment of punitive damage payments.

There is plenty of authority on this point. Generally, as long as punitive damages are paid or incurred by a taxpayer in the ordinary conduct of its business, they will be deductible. See e.g., Rev. Rul. 80-211, 1980-2 C.B. 57; Rev. Rul. 69-581, 1969-2 C.B. 25. Even so, there are some limitations. In the antitrust context, there is a statutory rule denying a deduction for two-thirds of the damages paid pursuant to a treble-damage antitrust suit, if certain conditions are met. I.R.C. Sec. 162(g). The deduction for two-thirds of the payment (in effect, the trebled portion), is disallowed only where there is a conviction in a related criminal proceeding, or a plea of guilty or nolo contendere.

One reason there may be confusion about the deductibility of punitive damages (that is, why many seem to mistakenly believe that payors are restricted in the deductibility of punitives), relates to the nondeductibility of fines or penalties. In contrast to the general rule that payments made in the course of a trade or business are deductible (either by settlement or judgment), the Internal Revenue Code expressly states that no deduction is allowed for "any fine or similar penalty paid to a government for the violation of any law". I.R.C. Sec. 162(f). This provision denies a deduction for both criminal and civil penalties, as well as for sums paid in settlement of a potential liability for a fine. Reg. §1.162-21(b). It is the latter element of the provision that often causes great controversy. It may (or may not) be clear that it is likely that a fine will be imposed when a potential liability is satisfied by way of a negotiated settlement with a governmental entity.

Whether a fine or penalty may be imposed may in some cases depend upon the intent of the perpetrator. Even so, if the fine or penalty is in fact imposed, the denial of the deduction is unwavering in its resolution. It does not matter whether the violation of law was intentional or unintentional. In either case, no deduction will be permitted for the payment of a fine or penalty even if the violation is inadvertent.

These rules seem to be bubbling to the surface a lot lately. One can hardly pick up a newspaper or listen to the news without hearing about another corporate wrongdoer being forced to pay a fine or penalty. For example, in 2003, MCI was fined a record $500 million by the SEC for accounting fraud. See Larsen and Michaels, "MCI fined Record $500M over Fraud Charges," Finanical Times, May 20, 2003, p. 1.

Frequently, the line drawing exercises that take place are not terribly precise. While a fine or penalty (nondeductible under Section 162(f)) and a punitive damages payment may both relate to "bad" conduct, they really invoke different tax rules.

Payors of Punitive Damages: Have They Made a Deal with the Devil Himself?, Vol. 13, No. 1, The M&A Tax Report (August 2004), p. 8.