By George Schutzer and Ora Sheinson

Federal and state agencies often threaten companies with lawsuits or penalties for alleged violations of environmental laws and regulations. Companies frequently settle with the agencies in the form of various types of payments and penalties, often including Supplemental Environmental Projects (SEPs), which reduce the monetary payment or penalty. SEPs are environmentally beneficial projects that a company is not otherwise required to perform, but agrees to undertake in order to settle an enforcement action. Companies can often benefit from implementing an SEP, thereby reducing the total actual cost to the company. One benefit that many SEP participants expect is either an immediate tax deduction for expenses associated with the SEP or the ability to capitalize the cost of the expense and claim tax deductions over a period of time. These deductions are receiving increased scrutiny from the Internal Revenue Service (IRS).

Lately, the IRS is placing environmental settlements under increased scrutiny based on a concern that corporations are improperly deducting portions of settlements, including the costs involved in funding SEPs. While some environmental settlements are deductible as ordinary and necessary business expenses, the IRS does not allow deductions for amounts paid as a fine or similar penalty for violation of any law. In recent years, the IRS has paid more attention to whether payments made instead of penalties in environmental cases should be considered non-deductible under Section 162(f) of the Internal Revenue Code.

The IRS does not want businesses to dull the sting of a fine by getting the tax benefit of treating it as a deductible business expense. Since many federal and state environmental penalties—for example the Federal Clean Air and Water Acts and their state analogues—are intended to be punitive, the IRS has singled out such penalties (and amounts paid in lieu of paying such penalties) under environmental regulations for particular scrutiny. In addition to disallowing deductions for amounts paid as part of punitive penalties, the IRS has determined that taxpayers cannot receive the tax benefits of including those amounts in the basis of the assets under Section 263A of the Internal Revenue Code or property under Section 1012.

In line with this reasoning, the Tax Court denied a deduction for a taxpayer’s $8 million contribution to an environmental endowment fund, when the contribution was given with the understanding that a proposed criminal fine would be reduced by the same amount. In a memo issued in 2006 for a different case, the IRS concluded that a portion of the costs incurred for the performance of a beneficial environmental project (BEP) was comparable to a nondeductible fine or penalty and prohibited the taxpayer from deducting the costs of the project or including the costs in the basis of the assets produced.

Following these cases and memos, the IRS recently issued directives instructing IRS agents to audit amounts paid pursuant to settlements with the Department of Justice under the False Claims Act and the Environmental Protection Agency for SEPs and BEPs. As a result, IRS auditors are now aggressively identifying and examining the tax treatment of environmental settlement payments. One IRS Directive on the subject notes that “in most cases, a portion of the proposed civil payment was reduced for agreeing to perform an SEP, experience has shown that generally most defendant/taxpayers deduct the entire amount of the SEP as either a Section 162 business expense or capitalizes [sic] such costs with related depreciation deductions.” The Directives mandate audits for SEPs in excess of $1 million.

The IRS has noted that SEPs are often proposed and implemented by a corporation as part of a larger settlement project, and often result in a reduction of the total penalty payment. The IRS requires its examiners to determine any reduction in penalty resulting from the inclusion of a SEP in the total settlement package, and to disallow any deduction for the amount of the reduction in penalty attributable to including the SEP in the settlement.

IRS examiners are using press releases on the Department of Justice Web site and news articles to identify settlements with federal and state agencies. In addition, the IRS directs examiners in charge of cases to request from the target corporation and the relevant internal government agencies draft settlement proposals, draft penalty exposure calculations, and the complete correspondence file for the case, which suggests that companies should exercise caution when exchanging potential settlement positions, as the calculations can be used later by the IRS to deny deductions of portions of the settlement amounts.

In light of the IRS’ activity in this area and the guidelines given to its auditors, corporations should consult knowledgeable tax counsel in advance of completion of an environmental settlement agreement on the tax consequences of the settlement structure. Especially in cases involving SEPs, corporations may need to consider the tax consequences in order to determine whether the SEP actually offers additional value. Corporations may also consider seeking explicit language in settlements with federal and state agencies specifically addressing the characterization of penalties under the agreement. In cases where actual penalties are incurred, the settlement agreement should specifically state that there was a penalty assessed, and the amount paid. At minimum, accounting departments should consult closely with attorneys handling any environmental settlements to determine the tax status of those settlements.  Corporations entering into settlements with significant amounts involved may also want to consult with the IRS in advance to determine how payments under a settlement will be treated.

Schutzer is a partner with Patton Boggs in the firm’s Washington, D.C., office, focusing on tax, business, and political law. He can be reached at Sheinson is an associate with Patton Boggs in the firm’s Newark, N.J., office, focusing on environmental litigation, environmental compliance counseling, and industrial crisis management. She can be reached at