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California AG Wants Clearer Rules in Proposed Penalty Deduction Regs

JUL. 13, 2020

California AG Wants Clearer Rules in Proposed Penalty Deduction Regs

DATED JUL. 13, 2020
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July 10, 2020

Mr. David J. Kautter
Assistant Secretary for Tax Policy
Department of the Treasury
1500 Pennsylvania Avenue NW
Washington, DC 20220

Mr. Michael J. Desmond
Chief Counsel
Internal Revenue Service
1111 Constitution Avenue NW
Washington, DC 20224

RE: Comments on IRS REG-104591-18: Denial of Deduction for Certain Fines, Penalties, and Other Amounts; Information with Respect to Certain Fines, Penalties and Other Amounts

Dear Messrs. Kautter and Desmond:

The California Department of Justice, Office of the Attorney General (“California DOJ”) respectfully submits the following comments on the proposed regulations implementing amendments to 26 U.S.C. § 162(f) and new 26 U.S.C. § 6050X published by the Department of the Treasury and the Internal Revenue Service.

While California DOJ does not endorse the underlying legislation, the changes made to §162(f) and addition of § 6050X will undoubtedly affect California taxpayers and government entities and the way in which these parties litigate and settle disputes involving a violation of law. California state agencies regularly enter into settlements documented through agreement, consent decrees, and stipulated judgments, and engage in litigation that may result in judgments falling under the scope of § 162(f) and § 6050X. Such settlements and judgments can run to billions of dollars in a single matter. While § 6050X and the proposed regulations set forth reporting requirements related to payments falling under § 162(f), it is important that the regulations do not imply or otherwise indicate that such reporting is determinative as to the amount of any related deduction to which the taxpayer may be entitled. California DOJ therefore appreciates the opportunity to provide its perspectives to the IRS as they develop the final regulations.

I. SUMMARY OF AMENDED § 162(f), NEW § 6050X, AND PROPOSED REGULATIONS

The Tax Cuts and Jobs Act, Pub. L. No. 115-97, amended § 162(f) to deny, with exceptions, the deductibility of any amount paid or incurred to (or at the direction of) a government entity if that amount is related to a legal violation or the investigation or inquiry into a potential violation of law. Section 162(f) provides an exception to disallowance if a payment is for restitution, remediation, or to come into compliance with a law. The exception applies only if the taxpayer establishes that the amounts identified were in fact restitution, remediation, or amounts paid to come into compliance. The Act also added new § 6050X, which requires all government entities (federal, state, and local) to identify and report the amounts described under § 162(f) to the IRS if those payments meet a certain threshold amount.

Through Notice 2018-23, 2018-15 I.R.B. 474, the IRS published transitional guidance on the identification and information reporting requirements under amended § 162(f) and new § 6050X and solicited comments from the public on forthcoming regulations.

On May 13, 2020, the IRS published proposed regulations and accompanying preamble to implement and provide guidance with respect to the amended § 162(f) and new § 6050X. The proposed regulations generally implement the amended § 162(f) and new § 6050X in a reasonable manner. However, as the IRS recognizes in the preamble of the proposed regulations, there are a number of areas that warrant further development or refinement for clearer and consistent application. Although the IRS requests comments on a variety of issues, our comments focus on the following key areas which directly impact government entities:

  • The definitions of several key terms, including deductible amounts (“restitution,” “remediation,” or “amounts paid or incurred to come into compliance”) as well as “material change to order or agreement.”

  • Clarify that the scope of the term, “potential violation of any law” refers to laws that specifically proscribe conduct.

  • The exclusion from “amounts paid at the direction of a government entity” of amounts paid directly to a non-government co-plaintiff.

  • The reporting of payments that are now unknown and cannot be reduced to a monetary value, but are identified as “restitution, remediation, or payments to come into compliance.”

  • The proposed reporting threshold of $50,000.

II. DISCUSSION

A. The Regulations Should Refine the Definitions of Several Key Terms in § 162(f) and § 6050X

1. California DOJ Agrees with USDOJ that Restitution Should Be Defined Differently in Civil and Criminal Cases

Proper and consistent application of the amended § 162(f) and new § 6050X requires clear definitions of several key terms in the statute. Foremost is a clear definition of the term “restitution,” which the proposed regulations define as an amount that “restores, in whole or in part, the person, as defined in section 7701(a)(1); the government; the governmental entity; or property harmed by the violation or potential violation of a law.” Denial of Deduction for Certain Fines, Penalties, and Other Amounts; Information With Respect to Certain Fines, Penalties, and Other Amounts, 85 Fed. Reg. 28,524, 28,536 (proposed May 13, 2020) (to be codified at 26 C.F.R. pt. 1). This definition applies to all forms of restitution, including criminal and civil.

However, USDOJ previously recommended adoption of separate definitions of “restitution” in criminal and civil contexts, for purposes of § 162(f). See Letter from Richard E. Zuckerman, Principal Deputy Assistant Att'y Gen., U.S. Dep't of Just., to Hon. David. J. Kautter, Assistant Secretary for Tax Policy, Dep't of Treasury and William M. Paul, Acting Assistant Chief Counsel, Internal Revenue Serv. (May 18, 2018) (on file with author) (“USDOJ Comment Letter”) at 6. In distinguishing criminal restitution from civil restitution, USDOJ highlighted that the definition of restitution in Title 18: Crimes and Criminal Procedure includes payments to individual crime victims for “the loss or replacement of property or services; the cost of medical and other professional services and devices relating to physical, psychiatric and psychological care; funeral expenses; reimbursement of victim's lost income and other expenses related to participation in the investigation or prosecution of the offense or attendance at proceedings related to the offense; and in identity theft cases, the value of the time spent by the victim to remediate the harm.” USDOJ Comment Letter at 5, citing 18 U.S.C. §§ 3664(f)(1)(f)(1)(A) and 3663(b)(1)-(6). USDOJ then suggested that, for purposes of § 162(f), “[criminal] restitution be defined as a specified amount of money paid to the United States or a state, local or Tribal government . . .”, specifically omitting the payments to individuals and private entities. Id., emphasis added. Similarly, USDOJ further differentiated criminal and civil cases by requesting that payments for “remediation of property,” which would include payments to non-governmental parties, should be limited to civil cases where the definition of restitution should “be broader than in criminal cases.” Id. at 6.

California DOJ supports the definition of “restitution” proposed by USDOJ. This definition would entirely exclude from the class of deductible payments those made to individuals and private entities in criminal matters from being treated as tax-deductible restitution under § 162(f). Convicted criminals, including violent offenders, should not be able to obtain a tax deduction for payments designed to make victims of their crimes financially whole. This result was not only unintended by Congress, but is also contrary to the reasons for changing the language of § 162(f) as stated by the Senate. California DOJ therefore urges the IRS to adopt the definition of restitution in criminal cases submitted by USDOJ.

The California Constitution gives victims of crimes a right to restitution from criminal defendants. People v. Lehman, 247 Cal. App. 4th 795, 800 (2016); Cal. Const. art. I, § 28 (b)(13)(B). In order to implement this constitutional right, the California Legislature enacted Penal Code § 1202.4, which requires the trial court in every criminal case to order victim restitution for economic losses “in an amount established by court order.” Id. quoting Cal. Pen. Code § 1202.4(f). Examples of losses for which criminal defendants have been ordered to pay restitution include: a sexual assault victim's costs for psychotherapy (People v. Garcia, 185 Cal. App. 4th 1203, 1215 (2010)); an assault victim's hospital expenses (People v. Duong, 180 Cal. App. 4th 1533, 1540 (2010)); the wages lost by a burglary victim while he attended the defendant's trial (People v. Moore, 177 Cal. App. 4th 555, 557 (2009)); and the lost wages of a murder victim's parents while attending the defendant's trial (People v. Crisler, 165 Cal. App. 4th 1503, 1509 (2008)).

Our review of the congressional reports discussing the amendments to § 162(f) reveals no intent to provide convicted criminals a tax deduction for restitution paid to victims of crime. See Joint Committee on Taxation, General Explanation of Public Law 115-97 (JCS-1-18) at 193-194 (Dec. 20, 2018); H.R. REP. NO. 115-466, at 430-431 (2017) (Conf. Rep.); COMM. ON THE BUDGET, 115TH CONG., RECONCILIATION RECOMMENDATIONS PURSUANT TO H. CON. RES. 71 at 187-188 (Comm. Print 2017). USDOJ's proposed definition of restitution is consistent with the purpose of § 162(f) as stated by the Committee on the Budget of the United States Senate:

The Committee believes that taxpayers should not be able to deduct as normal business expenses settlement payments that are intended to punish bad behavior. Allowing these deductions forces other taxpayers to subsidize a part of their wrongdoing and blunts the deterrent effect of the penalty. The Committee believes denying these deductions will help deter taxpayers from violating the standards Congress has enacted to protect the American public, and ensure that wrongdoers fully pay their penalties.

COMM. ON THE BUDGET at 187. Defining restitution in a manner that precludes criminal defendants from deducting their restitution payments to individuals and private entities would further Congress' intent to deter wrongdoing and avoid having taxpayers subsidize the consequences of their criminal behavior.

Because the USDOJ definition of restitution for purposes of § 162(f) in criminal cases would avoid the peculiar result of allowing criminal defendants to deduct their restitution payments to individuals and private entities that are crime victims, California DOJ requests that the IRS adopt that definition. Adoption of the definition not only avoids an unintended tax windfall to criminal defendants, but also is consistent with the purpose of the legislation which is to avoid having bad behavior rewarded and forcing law abiding taxpayers to subsidize the wrongdoing of others.

2. The Regulations Should Adopt A Broader Definition of Restitution for Civil Cases

As for civil cases, California DOJ recommends a broader definition of deductible “restitution,” such as that § 1.162-21(f)(3) of the Proposed Regulations that not only includes specific amounts of money paid to the government, but also amounts paid directly to any person or non-governmental entity harmed by the taxpayer's alleged conduct, where those payments restore, in whole or in part, the person or property harmed. Denial of Deduction for Certain Fines, Penalties, and Other Amounts, 85 Fed. Reg. at 28,536. We also recommend that the definition should include cy pres restitution, a remedy that state attorneys general often require as part of a settlement, consent decree or stipulated judgment, as well as similar payments to restitution funds. Consumer protection judgments, for example, often require the defendant to pay a set amount to compensate victims. Money may remain after several attempts at distribution because victims cannot be located. In such cases, the judgment may require the funds to be paid to an appropriate cy pres recipient, such as an organization that assists consumers who are similarly situated to the defendant's victims. This broader definition for civil cases encompasses restitution obtained for consumers through state attorney general enforcement of consumer protection laws, as well as environmental mitigation obtained through the enforcement of state environmental laws. It is therefore also consistent with the inclusion of the term “remediation of property” in § 162(f)(2)A(i)(I).

3. The Definition Of “An Amount Is Paid or Incurred to Come into Compliance” Should Be Specifically and Narrowly Defined

The definition of “an amount is paid or incurred to come into compliance” in §162(f)(3)(ii) requires further narrowing and refinement. While the proposed regulation identifies costs such as “performing services; taking action, such as modifying equipment; providing property; or doing any combination thereof,” further guidance is required to define the class of services and actions that qualify for a deduction, particularly where the expenditure is not a discrete or one-time expense.

California DOJ recommends that the IRS clarify for the purposes of these regulations that there is a distinction between direct actions that “come into compliance” and actions that are indirect or otherwise actions to maintain compliance.” To that end, we recommend that the actions that qualify as “coming into compliance” be narrowly defined so that only actions that directly lead to compliance with the violations at issue as framed by the complaint or charging document qualify for inclusion.

Conceptually, the definition of the qualifying actions should allow governments the discretion to determine or identify in a settlement document the actions by the regulated entity (as opposed to “costs”) required to come into compliance with the law. The qualifying actions should be narrow, limited to direct actions to come into compliance, and should expressly exclude:

  • indirect or general compliance actions;

  • actions to monitor or report on compliance;

  • actions incurred post judgment except where such actions are specifically identified as corrective action to expressly address a violation covered by the enforcement action; and

  • Actions that are for pre and post settlement audits — these audits are performed to determine whether the defendant is in compliance with the law and therefore should be viewed as indirect, as opposed to direct, compliance actions.

As discussed in Part D. below, the “amount” expended to perform the activities to come into compliance (as identified by the government) should be identified by the defendant, and the government/regulatory agency should not be required to verify the accuracy of the “amount” identified by defendants.

4. “Material Change to Order or Agreement” Should Be Narrowed

Section 162(f), as amended, “shall not apply to amounts paid or incurred under any binding order or agreement entered into before [December 22, 2017].” Proposed § 1.162-21(e) provides that, if there is a material change to the terms of the order or agreement, the amended §162(f) will apply to payments made after that material change. Denial of Deduction for Certain Fines, Penalties, and Other Amounts, 85 Fed. Reg. at 28,536. The proposed regulations provide that a material change may include: “changing the nature or purpose of a payment obligation; or changing, adding to, or removing a payment obligation, an obligation to provide services, or an obligation to provide property.” Id. On the other hand, material change does not include “changing a payment date or changing the address of a party to the order or agreement.” Id. The scope of a material change is excessively broad as any change other than a change in payment date or address could be material. We recommend that the IRS narrow the scope of material change.

B. The Regulations Should Make Clear That “Potential Violation of Any Laws” Refer to Laws That Specifically Proscribe Conduct

The regulations should make clear that § 162(f) does not apply unless the “amount is paid or incurred . . . in relation to the violation of any law or the investigation or inquiry . . . into the potential violation of any law.” Certain statutes, particularly environmental statutes, enforced by California state agencies are remedial and are not predicated on a violation of law. See, e.g., Carpenter–Presley–Tanner Hazardous Substance Account Act (“HSAA”), Cal. Health & Safety Code §§ 25300, et seq.; Cal. Water Code § 13304(a) (West). California DOJ assumes that “potential violation of any law” refers to laws that specifically proscribe conduct, and does not apply, for instance, to expenditures to remediate or respond to past releases of hazardous substances that were not illegal at the time of release and whose tax consequences are addressed by IRC sections other than § 162 (i.e., 26 U.S.C. § 198). The regulations should make this clear. As to more current releases that violate an environmental protection standard (i.e., water quality protection requirements), the proposed regulation squarely addresses the fines, penalties, restitution, remediation and compliance costs associated with such violations.

C. Identification and Reporting of “Amounts Paid at The Direction of A Government Entity” Should Not Include Amounts Paid Directly to A Non-Governmental Co-Plaintiff

Section 162(f)(2)(A)(i)(II) provides in relevant part that “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. . . .” California DOJ suggests that the regulations clarify that “amounts paid . . . at the direction of . . .

a governmental entity” do not include amounts paid directly to a non-governmental co-plaintiff to resolve the co-plaintiff's claims, to non-parties for whom the co-plaintiff serves as a class representative, or to persons who participate in administrative complaints. These amounts should be treated as amounts paid at the direction of the co-plaintiff or responding party, not at the direction of the governmental entity. This will ensure consistent tax treatment between settlements and judgments made as a result of a private lawsuit, and settlements and judgments made as a result of litigation that has both private plaintiffs and governmental plaintiffs, and will eliminate the impractical task of determining which or what portion of payments are at the direction of the government.

D. The Regulations and Form Should Not Require Government Entities to Attempt to Quantify Amounts Not Specified in A Judgment or Settlement

Under proposed § 1.6050X-1(b)(1), the information return filed by the government or governmental entity must provide the aggregate amount a payor is required to pay as a result of the order or agreement, the separate amounts required to be paid as restitution, remediation, or to come into compliance with a law as a result of the order or agreement, and any additional information required by the information return and the related instructions. The proposed regulations further provide that if the order or agreement identifies a payment (or the cost to provide property or to provide services) as restitution, remediation, or an amount paid to come into compliance, but does not identify some or all of the aggregate amount the payor must pay (or some or all of the aggregate cost to provide property or to provide services) and, under the facts and circumstances, the government expects the amount to equal or exceed the threshold amount, the appropriate official must file an information return on Form 1098-F, as provided in the instructions to the Form 1098-F. The Form 1098-F information return may constitute the written statement to be provided to the payor, and it is not determinative as to the amount of any related deduction the taxpayer may claim, especially where amounts of restitution, remediation, or to come into compliance are not specified in a judgment or settlement.

It is reasonable to expect the government to enter specific amounts provided for in a judgment or settlement in the applicable boxes on Form 1098-F. For example, a typical consumer protection settlement between a defendant corporation and a state Attorney General or District Attorney requires the payment of civil penalties to the government, restitution to victims, and costs and fees to the government, the amounts of which will be set forth on the face of a judgment or settlement. It is reasonable, in such a case, to expect a state government official to enter those specific amounts on a Form 1098-F. However, most consumer protection judgments also include injunctive terms, some of which may require compliance with state consumer protection laws, and some of which may impose additional requirements to address prior wrongdoing and deter its recurrence. These amounts are typically unknown, and unknowable, to the law enforcement agency entering into a settlement, and the law enforcement agency will typically have no mechanism or expertise by which to test a taxpayer's claims about its compliance costs. Requiring the government to provide a random guess at these amounts, without any basis to do so, or to simply trust what it is told by the taxpayer, would do nothing to aid tax administration. The same is true of other forms of “restitution, remediation, or payment to come into compliance” which may be difficult (or not possible) to quantify.

The quantification of “costs to come into compliance” is even more fraught to the extent that a government entity's reporting obligation extends to expenditures incurred over time or for several compliance projects across multiple facilities. In such cases, the burden on the governmental entity to determine whether such expenditures exceed the threshold for reporting, to the extent that they can be quantified may be substantial, and stretch across multiple tax years.

As the preamble observes, it may not be within the expertise of the government or governmental entity to place a monetary value on restitution or remediation costs, or costs to come into compliance with a law. For these situations, the proposed regulations permit the taxpayer to satisfy the identification obligation by providing that, if the order or agreement identifies a payment as restitution, remediation, or to come into compliance with a law but does not identify some or all of the aggregate amount the taxpayer must pay, the order or agreement must describe the damage done, harm suffered, or manner of noncompliance with a law, and describe the action required by the taxpayer (such as incurring costs to provide services or to provide property) with respect to the damage, harm, or noncompliance. Denial of Deduction for Certain Fines, Penalties, and Other Amounts, 85 Fed. Reg. at 28,536.

While this provision is helpful, it mistakenly assumes that the “damage done, harm suffered, or manner of noncompliance” will be set forth in a stipulated judgment or consent decree effectuating a settlement. To the contrary, this information is often found in other related documents — such as complaints filed by the government, or a motion or stipulation for entry of a judgment or consent decree reciting the parties' contentions — and the regulation should therefore allow reference to such related documents setting forth this information.

In light of these issues, California DOJ recommends that the "amount" expended to perform the activities to come into compliance (as set forth by the judgment or settlement document) should be identified by the defendant/regulated entity, who should be solely responsible (and liable to the IRS) for risk of misrepresenting the amounts identified in a settlement or for triggering any notification requirements for the government/regulatory agency. The government/regulatory agency should not be required to verify the accuracy of the "amount" identified by defendants.

In addition, the IRS should revise the regulation, and make conforming changes to Form 1098-F, to require the government entity to report the two facts that are likely to be in its knowledge, to wit: (a) whether the settlement appears likely to require the taxpayer to pay or spend more than the reporting threshold; and (b) the specific amounts (penalties, fees, restitution, etc.) quantified in the judgment or settlement, or otherwise specifically known to the government. The current structure of the form calls for amounts including the “Total amount required to be paid” that are unlikely to be known to the government, and provides no useful means for an enforcement agency to report information on the elements of the settlement, such as civil penalties or investigative costs, that are known to it and useful for purposes of tax administration. Even with respect to these two data points, it will often be impossible for the government to know with any degree of certainty whether a settlement meets the reporting threshold, whether $50,000 or some other amount. Given this, and the broad array of government enforcers, areas of law, industries, and judgments and settlements that will be encompassed by this provision, the IRS should provide broad discretion to enforcement agencies in determining how to estimate the cost or amount of a settlement.

Finally, to remove the incentive for taxpayers to seek to improperly influence the government entity's reporting obligation under § 6050X, the regulations should specify that any agreement by a government entity not to file a Form 1098-F as to a judgment or settlement, or to report a specific amount or characterization of the settlement, is invalid and unenforceable. This will ensure that enforcement agencies are able to be unbiased, and report the best possible information to the IRS, thereby aiding tax administration.

E. The Reporting Requirement Should Apply to Civil Cases Only, and The Threshold Amount Should Be Higher Than The Proposed $50,000 Amount

1. The Reporting Requirement of § 6050X Should Not Apply To Criminal Cases, Or Alternatively, That The Threshold Dollar Amount That Triggers The Reporting Requirement Should Be $10 Million

Under the new § 6050X, all government and certain nongovernment entities involved in suits or agreements covered by § 6050X must identify and report the amounts described under §162(f) to the IRS if those payments meet a certain threshold amount. Under §6050X(a)(2)(A)(ii), the dollar threshold for reporting is met if the aggregate amount involved in all court orders and agreements with respect to a violation, investigation, or inquiry is $600 or more. However, § 6050X(a)(2)(B) states that the Secretary has discretion to adjust the threshold amount to ensure the efficient administration of the internal revenue laws.

California DOJ supports USDOJ's position that the reporting requirement in § 6050X should apply only to civil cases and not criminal cases. USDOJ premised this argument on the fact that in criminal cases the judgments clearly identify the amount of criminal restitution in the judgment order while the “amounts attributable to restitution versus penalties or fines in civil cases are often indistinct.” USDOJ Comment Letter at p. 2. This is equally true in California criminal cases. California courts use a standard order form that clearly specifies how much criminal restitution a defendant owes. See CR 110 — Order for Victim Restitution. We believe that applying the notice requirement would only increase the administrative burdens on criminal enforcement agencies without providing any significant additional information to the IRS that it could not obtain by viewing the court order. Consequently, California DOJ requests that the reporting requirement in § 6050X not include criminal cases.

In the alternative, should the IRS determine that the notice requirement does apply to criminal matters, California DOJ requests that the threshold amount for reporting be raised significantly to avoid burdening agencies with a duty to report insignificant cases to the IRS. As noted by the USDOJ, “a low reporting threshold would have exceptionally burdensome and intrusive consequences for state and local governments, requiring reporting for a host of matters ranging from traffic offenses to minor civil and administrative impositions.” USDOJ Comment Letter at p. 4. If this agency should apply the reporting requirement to criminal matters, California DOJ requests that it raise the threshold amount to $10 million as suggested by the USDOJ. California DOJ believes this threshold is high enough that it will significantly ease the administrative burden on both state agencies and the IRS.

2. The Reporting Requirement for Civil Cases Should Be Higher Than the Proposed Threshold Amount Of $50,000

The proposed regulations raise the reporting threshold from $600 to $50,000 and provide that reporting applies to orders and agreements that become binding under applicable law after January 1, 2022. California DOJ generally supports raising the reporting threshold to reduce the administrative burden on government entities subject to the reporting requirement. However, we believe that setting the threshold amount to $50,000 would still overburden local and state entities to report a number of less significant civil offenses, thereby undermining the purpose of the reporting requirement. California DOJ suggests that a threshold amount of $10 million would be more appropriate as it would allow state and local agencies to focus their reporting efforts to more significant matters. Importantly, the regulations should specify that the threshold amount triggering reporting is not determinative as to the amount of any related deduction the taxpayer may claim, similar to the information provided in the Form 1098-F.

III.CONCLUSION

If we can provide additional information that would be helpful in considering these comments, or if you wish to discuss with us any issue raised above, please do not hesitate to contact the undersigned.

Respectfully submitted,

FOR THE STATE OF CALIFORNIA
XAVIER BECERRA
Attorney General,

By: CARA M. PORTER
Deputy Attorney General

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