Guest Post: Are Class Action Settlements Tax Deductible?
With the exponentially rising role that litigation plays in today’s business world, one might consider the costs associated with settling lawsuits to be “ordinary and necessary” business expenses, rendering them tax deductible under §162 of the Internal Revenue Code (IRC). However, as experienced tax professionals know, there are always exceptions and restrictions to the rules—factors that can leave the unwary with an unexpected and hefty financial burden to bear.
To determine whether payments to the settlement class are tax deductible, settling parties must bear in mind the provisions of IRC §162(c)(2) and §162(f), which prohibit deductions for payments that are:
1. Deemed to be illegal under U.S. or state law
2. For a fine or similar penalty paid to a government for the violation of any law
Therefore, the ability to receive tax deductions on class action settlements is entirely dependent on tracing the lawsuit back to the source of the litigation, as well as the origin and character of the claim and nature of the ultimate payment. If the litigation came about due to acts that can be interpreted to have arisen during the ordinary conduct of the taxpayer’s business, a tax deduction is warranted. However, if the settlement and payment represents a fine or statuary penalty, then the payments are likely not tax deductible.
Another possible scenario occurs if the litigation arose from a capital transaction, such as the acquisition of an asset or in a claim relating to ownership rights to a capital asset. In those cases, Section 263(a) requires capitalization of class action settlement payouts and related costs, meaning the deduction of settlement costs may be required to be spread over several years or the deduction may be disallowed entirely. This is problematic in that the settlement degrades financial statements with no corresponding tax benefit.
Thus, it is important for companies to be aware from the start that not all class action settlements will result in tax deductible payments. Each case is different, and the companies involved must carefully consider not only if, but to what degree, the class action settlement will be tax deductible and how that impacts overall business financials.