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The oil giant BP paid for cleanup and compensation for their massive Gulf oil spill, and rightfully so. But was this a “necessary and ordinary cost of doing business” that deserved a $10 billion tax break? I think most of us would respond with a resounding, “no!”

Companies like BP are being allowed to write off the payments they make as a result of getting caught for misdeeds as tax deductions. By treating these penalties as just another business expense, they effectively force the rest of us to make up for the lost tax revenue.

Let that sink in. When a corporation misbehaves, and gets caught, it’s the American taxpayer that subsidizes the cost. It’s not right, but it’s happening.

Tax laws are supposed to forbid companies from writing off the cost of punitive public payments, such as fines and penalties. However, large companies rarely end up paying big fines or penalties outright. Instead, they have teams of lawyers who negotiate settlement deals with the government. To avoid years of legal wrangling, state and federal agencies almost always agree to a settlement that lets the company off without having to admit guilt and that allows the company to take settlement costs as a tax write off.

How is this possible? These companies tell the IRS that the payments they made, though unfortunate, are just the unavoidable and normal costs of doing business – like paying for a flat tire on a company delivery truck, or a bank writing off some loans when some borrowers go bankrupt. Even if an agency prompted the payment as a direct result of criminal behavior, the company often claims that only a tiny portion of the payment was punitive. That means they’re still allowed to write off the lion’s share of the settlement payments as normal business compensation.  A study by the General Accountability Office found that government agencies typically fail to instruct the IRS on the specific deductibility of these settlements, causing tax authorities to throw their hands up and claim they lack a clear legal basis to prevent these deductions.

The end result: A hidden tax subsidy that essentially rewards America’s largest corporations for wronging the public, while also costing the government billions in lost revenue each year.

But things may be about to change. Four converging factors have brought this issue to a head:

First, the recent unprecedented number of large legal settlements resulting from some very noticeable and bad corporate behavior. BP was forced to pay more than $37 billion in Gulf oil spill settlement and cleanup costs, but they also got an eye-popping $10 billion tax benefit.  In the last few years, there have been at least four pharmaceutical settlements exceeding a billion dollars each. Recent financial scandals related to misleading mortgages, improper foreclosures, interest rate manipulation, and laundering of drug cartel money have led to billions in additional settlements, with many cases still pending. Government’s rebuke to corporate America’s recent misbehavior will translate into many billions of dollars in potential tax write offs.

Second, recurring federal budget standoffs have prompted Congress, and the public, to look much more carefully at every expense, subsidy, and loophole in the budget. While there certainly are wasteful subsidies and misguided spending that continue to escape scrutiny, there is far greater awareness that every dollar that companies avoid paying the Treasury means a dollar cut from public programs, levied in higher taxes for the general public, or added to the national debt. In the context of today’s stark budget tradeoffs and painful cuts, Congress is finding it hard to keep pretending that corporate tax avoidance is a victimless crime.

Third, a few federal agencies have started cracking down on the deduction of some settlements. For instance, the Department of Justice expressly forbid BP from deducting their most recent $4.5 billion settlement from the Gulf spill. The Securities and Exchange Commission (SEC) has said that it will start demanding, in some cases, that corporations admit guilt as part of the settlement agreement. Still, most SEC settlements will not involve an admission or denial of guilt. But those that do admit guilt will presumably have a harder time claiming that no portion of their settlement is punitive. These are small steps, for sure. But public positioning of these federal agencies has brought these hidden tax benefits, which corporations have been receiving just for paying settlements for their own misdeeds, out of the shadows.

Lastly, a recent court decision is likely to embolden companies to deduct even more settlement costs, unless Congress acts to fix the problem. In May, a Boston judge ruled that a company found guilty of bilking Medicare, which had already been told most of their settlement payments were not deductible, could nonetheless deduct most of their settlement payments. The company had been required to pay damages equal to multiple times the amount it had defrauded the government as a result of double billing, paying kickbacks and ordering unnecessary laboratory tests, but the judge ruled that the settlement payments could still be interpreted as an “ordinary and necessary” business expense. This judgment will likely spur even more brazen attempts by companies to cash in on tax benefits from their wrongdoing.

To fix the problem, we need to remove the loopholes that allow these tax write offs, and we need transparency in the settlement process so that we can hold government and corporations accountable for their actions.

  • Agencies should make information about all settlements publicly accessible on their websites, including explicit information about what portion of each settlement is meant to be punitive or otherwise designated as non-tax deductible. For the sake of truth-in-advertising, agencies should also report settlement amounts in after-tax terms.
  • Congress should be clear that most settlements shouldn’t be written off, and they should require agencies to spell out their reasoning and intent for exceptions.
  • All companies involved in settlements should be required to publicly disclose what portion of each settlement they have written off on their taxes and their justification for doing so.

A number of Democrats and Republicans alike have spoken out against the loopholes that allow tax deductions on settlements. It’s high time for lawmakers and agencies to stop rewarding corporate wrongdoing with billions in hidden taxpayer subsidies.

 

For more on these tax subsidies for settlements, read Subsidizing Bad Behavior: How Corporate Legal Settlements for Harming the Public Become Lucrative Tax Write Offs, with Recommendations for Reform.

Also see news coverage on this topic in the New York Times (link), Washington Post (link), and Associated Press (link).

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