Ain't Misbehavin'


When people misbehave – badly enough – they go to jail. But when corporations misbehave, they can't go to jail, so they pay fines instead. Recent years have brought a wave of enforcement actions for various corporate offenses, ranging from banks ripping off customers to drug companies poisoning patients.

Although huge fines and settlements can be painful, corporations can usually find a silver lining – they can often deduct the payments on their taxes! How? Well, Section 162(f) of the Internal Revenue Code states that "no deduction shall be allowed... for any fine or similar penalty paid to a government for the violation of any law." But defining a "fine or penalty" isn't as obvious as one might think. The problem lies with the nature of the settlement. Many settlements, especially in the Wall Street arena, do not require offenders to admit wrongdoing, and most include some form of restitution or disgorgement of profit. Those amounts aren't considered a fine or penalty, so they remain deductible.

Let’s look at a few examples. When Exxon-Mobil paid $1.1 billion to settle claims over an oil spill in Alaska, it actually cost them just $524 million after tax. When Bank of America agreed to pay $335 million to settle charges that they had discriminated against minority borrowers, they got back $117 million of it in tax savings. Similarly, when credit card giant Capital One paid $210 million to resolve charges that they had duped customers into paying for credit monitoring and other add-on services, they saved millions in tax.

Now, it seems the government is finally catching on. Back in November, oil producer BP agreed to pay $4 billion to settle the Deepwater Horizon spill. Ordinarily, that might have meant a fat tax deduction to cushion the blow. But this time, no such luck. The settlement included language explicitly defining the damages as "punitive," which prohibits BP from deducting any of that amount from their U.S. taxes.

Earlier this month, Swiss bank UBS paid $500 million to settle charges they manipulated the "LIBOR" interest-rate benchmark. Again, that settlement prevents UBS from deducting the penalty on their taxes.

Most recently, hedge fund manager Philip Falcone agreed to admit wrongdoing, accept a five-year ban from the securities industry, and pay an $18 million nondeductible penalty. Denying a tax deduction seems especially appropriate in Falcone's case, since federal regulators said his actions "read like the final exam in a graduate school course in how to operate a hedge fund unlawfully."

Tax policy questions like these can sometimes sound boring and pointless. But this one has real consequences. On the one hand, some experts argue that letting corporations deduct settlements on their taxes encourages them to settle out of court, avoiding ongoing litigation. On the other hand, consumer advocates respond that tax-deductible settlements are a major disservice to taxpayers, who wind up footing 35% of the tab. Per usual, there are multiple sides to the story. If you have a small business or corporation, the best strategy is obviously to stay out of trouble in the first place.