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Should Disgorgement in Securities Cases Be Considered Tax-Deductible 'Restitution'?

The IRS views disgorgement as a penalty, and thus not deductible as restitution, but the Supreme Court recently issued a decision in “Liu v. SEC” undercutting the IRS’s rationale. In light of “Liu,” the IRS needs to rethink its rationale.

Deductibility of Government Settlement Payments

Payments to a government constituting civil fines or penalties have long been nondeductible under Section 162(f) of the Internal Revenue Code. Yet the meaning of “fine” or “penalty” was unclear, requiring courts to inquire into the underlying laws’ purposes. For example, payments to resolve single damages under the False Claims Act were deductible “compensatory” payments, while double and treble damages were often deemed “punitive” and nondeductible.

The 2017 Tax Cuts and Jobs Act dramatically changed Section 162(f). Deductibility no longer turns on whether the amount is a “fine” or “penalty.” Instead, amended Section 162(f) generally denies a tax deduction for any amount paid to a government or governmental entity to resolve civil liability for an actual or potential violation of law. A major exception to nondeductibility is “restitution” for damage or harm caused by the alleged violation. Remarkably, however, Congress did not define “restitution.”

In May, the Treasury Department issued proposed regulations interpreting restitution as an amount intended to “restore” the victim. But this oversimplifies a complex and nuanced legal concept. Particularly problematic is that the Treasury Department excludes “disgorgement” from the definition of restitution, reasoning that disgorgement “focus[es] on the unjust enrichment of the wrongdoer, not the harm to the victim.” Citing Kokesh v. Securities and Exchange Commission, the IRS views disgorgement as a penalty, and thus not deductible as restitution, because “[t]he primary purpose of disgorgement orders is to deter violations … by depriving violators of their ill-gotten gains.”

Impact of Liu v. SEC

Recently, the Supreme Court issued a decision undercutting the IRS’s rationale. Liu v. SEC suggests that disgorgement should be treated as restitution, at least where the disgorgement is measured by the wrongdoer’s ill-gotten net profits and the damages are intended to be paid to victims.

In Liu, the court held that the SEC may obtain disgorgement under its equitable powers, as long as the disgorgement equals the net profits from the wrongdoing and is earmarked for victims. The Liu appellants argued that the SEC lacked authority to obtain disgorgement because it is a penalty for limitations purposes under Kokesh. But the court held disgorgement is permitted because it is restitution under equitable principles. The court clarified that “disgorgement” is “restitution” by another name, analogizing it to an “accounting.”

The argument rejected in Liu—that disgorgement is punitive—is the very basis of the IRS’s proposed regulations. In light of Liu, the IRS needs to rethink its rationale and treat disgorgement as restitution.

Looking Ahead

If the final Section 162(f) regulations are modified accordingly, the practical impacts on tax deductibility may depend on changes in SEC enforcement practices and how courts interpret questions unresolved by Liu. In fact, the SEC Division of Enforcement confirmed in its 2020 annual report that it is evaluating the impact of Liu, stating there will be “changes in the balance between the penalties and disgorgement that the Division seeks and recommends to the Commission.” The SEC indicates it may seek higher penalties in some cases, reflecting its understanding that penalties and disgorgement are not the same, further weakening the IRS’s stance. But it signals a policy shift that will disadvantage taxpayers.

New IRS documentation and reporting requirements also will change practices. Restitution is deductible only if the operative agreements include certain “magic language” specified in regulations. And agencies will have to start reporting potentially deductible amounts to the IRS by 2022.

Meanwhile, lawyers handling SEC enforcement actions should consider the following.

  • Under Liu, “disgorgement” must be based on the wrongdoer’s net profits (after deducting legitimate business expenses). But the SEC seeks gross profits in certain enforcement actions—e.g., the Foreign Corrupt Practices Act. The SEC may contest business expenses in future enforcement actions, but net-profit-based payments should be treated as disgorgement and thus deductible.
  • In recent years, the SEC collected more than twice as much in disgorgement damages as civil penalties. However, as noted, the SEC may seek higher penalties to avoid Liu’s restrictions on disgorgement. Amounts characterized as civil penalties are nondeductible.
  • The Liu court left open whether the SEC may collect disgorgement that cannot be returned to victims. This question is critical where there is no obvious victim, as in certain FCPA cases. Would the SEC take profits from one company (that arguably won a contract by paying a bribe) and pay them to a competitor that lost the bid? What if there were no evidence the contracting party was overcharged? As with FCPA cases, disgorgement proceeds often are remitted to the Treasury Department, not victims, in insider trading and accounting misconduct cases.

Regardless of how these questions are answered, the assumption underpinning the IRS’s determination that disgorgement cannot be “restitution” has been forcefully debunked. If, post-Liu, the SEC adopts procedures to ensure disgorgement proceeds are returned to investors, disgorgement should be valid under the court’s precedent and thus deductible Section 162(f) restitution. Similarly, if courts determine in some cases disgorgement may appropriately be paid to the Treasury, it should also be deductible restitution. More concerning, the SEC may resort to seeking higher penalties to avoid issues with disgorgement.

Settlements must be structured and documented to ensure appropriate amounts are deductible. Government lawyers, often unwilling to address the tax treatment of settlement payments, will now be forced to because of Section 162(f)’s documentation requirements and new tax reporting rules. If final regulations remain inconsistent with Liu, practitioners should consider challenging the nondeductibility of disgorgement damages. Given the magnitude of some settlement payments, the financial consequences could be significant.

Reprinted with permission from the “November 16, 2020” edition of the “The National Law Journal”© 2020 ALM Media Properties, LLC. All rights reserved.

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This information is provided by Vinson & Elkins LLP for educational and informational purposes only and is not intended, nor should it be construed, as legal advice.