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The IRS has recently issued two pronouncements of its intent to treat a larger portion of False Claims Act settlements as nondeductible. The pronouncements, made in September and October 2008, apply to settlements reached under both federal and state false claims laws. In October, the IRS announced that a settlement payment will be treated for tax purposes as a non-deductible penalty where the complaint seeks civil penalties in excess of the settlement amount and the complaint does not specifically ask for compensatory damages. In an earlier pronouncement from September, the IRS concluded that any sum measured as a multiple of damages – such as the treble damages provision in the federal False Claims Act – is taxable as a nondeductible penalty. Specifically, the IRS stated: “[I]f the government’s intent in assessing multiple damages was punitive and not compensatory, the portion of the payment that represents multiple damages, less certain relator fees, will be a penalty that is not deductible.” Relator fees that are known and specific may be deducted as compensatory damages, according to a 2007 IRS pronouncement, even where such fees are not reflected in the settlement agreement. But for other settlement amounts that are not plainly delineated in the settlement agreement as repayment of government losses as opposed to penalties, taxpayers will face a more difficult task in establishing a tax deduction in False Claims Act settlements. Because the IRS will acknowledge as compensatory specific amounts contained in settlement agreements, lawyers should take care to obtain specific language in settlement agreements to support a tax deduction.
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