Closing the Open Door: Using 'True Economic Realities' to Determine the Tax Deductibility of False Claims Act Settlements
31 Pages Posted: 8 Feb 2015 Last revised: 5 Aug 2015
Date Written: February 5, 2015
A circuit split currently exists over how courts should determine the deductibility of False Claims Act settlement amounts in excess of single damages. These settlements often involve millions of dollars, so both the government and the taxpayer have much to lose. Unfortunately, only two circuits have addressed the issue, and neither circuit's approach is entirely correct. The Ninth Circuit, in Talley Indus. Inc. v. Comm'r focused too narrowly on the "intent of the parties" and effectively created a rule that requires a tax characterization agreement for a taxpayer to prove deductibility. In 2014, the First Circuit attempted to correct the issues with Talley by using an "economic realities" approach. However, the court's analysis was incomplete because it ignored the economic realities of settlements by allowing the taxpayer to prove compensatory damages at the expense of punitive damages without considering the purpose and effect of the settlement.
While both approaches have their merits and are sound in theory, neither actually accomplishes what it claims to. Therefore, a true economic realities approach is needed to cure the inequities created by the existing approaches. If a tax characterization agreement exists, then the intent of the parties should control the deductibility of False Claims Act settlements. In the absence of such an agreement, courts should look to the economic realities of the transaction. This analysis should not be limited to the taxpayer's provable compensatory damages, but instead should consider the realities of the settlement. The court should then prorate the settlement amount above single damages into deductible and nondeductible portions based on the total compensatory and punitive amounts within treble damages. If, however, the taxpayer is unable to meet their burden of proving additional compensatory damages, then the entire contested amount should be nondeductible.
This true economic realities approach combines the best parts of both existing approaches while correcting the inherent inequity of each. The government can no longer use the absence of a tax characterization agreement as a complete bar to deductibility. On the other hand, the taxpayer is not allowed a deduction for the entire amount, but is only allowed a deduction for the percentage of the amount that is determined to be compensatory based on the described proration. While many scholars have discussed the implications of the Talley and Fresenius decisions, none have endorsed a new approach such as the one this article proposes.
Keywords: False Claims Act, Settlement, Tax Deductibility, Economic Realities
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