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January 26, 2021

Treasury Finalizes Section 162(f) Regulations on the Deductibility of Amounts Paid to, or at the Direction of, a Governmental Entity


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On January 19, 2021, the U.S. Department of the Treasury (“Treasury”) and the Internal Revenue Service (the IRS) published final regulations under section 162(f) of the Internal Revenue Code (the “Final Regulations”).[1] The Final Regulations implement the changes to section 162(f) made by the Tax Cuts and Jobs Act of 2017 (TCJA). Generally, section 162(f)(1) disallows any deduction for amounts paid or incurred by a taxpayer, to or at the direction of a governmental entity, for a violation of law. Section 162(f)(2) provides exceptions for restitution, remediation and costs to come into compliance with a law.

By and large, the changes in the Final Regulations are commendable and incorporate many of the numerous comments received, including comments that we submitted. They make significant improvements to the proposed regulations issued in May 2020 (the “Proposed Regulations”)[2] in terms of expanding the scope of the exceptions, increasing the flexibility of the applicable procedural requirements, and providing clearer guidance on fact scenarios frequently encountered by taxpayers often subjected to a wide variety of regulatory regimes. The Final Regulations, however, may not have gone far enough in including disgorgement and forfeiture within the restitution exception in certain circumstances.


As part of the TCJA, Congress amended section 162(f) by replacing language disallowing a deduction for any “fine or similar penalty” with more precise language.[3] As amended, section 162(f)(1) generally disallows deductions for amounts paid or incurred to, or at the direction of, a government, governmental entity, or non-governmental entity in relation to the violation of law, or investigation or inquiry into a potential violation of such law.[4] Section 162(f)(2) contains exceptions to this general disallowance rule for amounts that (1) constitute restitution (including property remediation) for damage or harm caused by the violation, or (2) are paid to come into compliance with any law that was violated or otherwise involved in the investigation or inquiry.[5] To qualify for either exception, section 162(f)(2) requires that the taxpayer must meet both (i) an identification requirement in the court order or settlement agreement, and (ii) an establishment requirement as to the substance of the amounts.[6]

The TCJA also added section 6050X to the Code, which requires governments or governmental entities to file information returns regarding the amounts relevant under section 162(f) and to notify the payor of the information reflected on such returns.[7] The Final Regulations include regulations under section 6050X.[8]

Final Regulations

The Scope of the General Rule of Disallowance: Clarifications

The Final Regulations restate section 162(f)’s general disallowance rule by providing that, in computing taxable income, a taxpayer may not take a deduction for amounts (1) paid or incurred by suit, settlement agreement, or otherwise; (2) to, or at the direction of, a government or governmental entity; and (3) in relation to the violation, or investigation or inquiry into the potential violation, of any civil or criminal law.[9] The preamble notes that the rule applies regardless of whether the taxpayer admits guilt or liability or pays the amount simply to avoid the expense or uncertainty.[10]

Suits, Settlement Agreements and Otherwise. The Final Regulations set forth a non-exhaustive list of examples of suits, agreements, and other instruments under which payments may be made. These include settlement agreements, non-prosecution agreements, deferred prosecution agreements, judicial proceedings, administrative adjudications, decisions issued by officials, committees, commissions, boards of a government or governmental entity, and any legal actions or hearings which impose a liability on the taxpayer or pursuant to which the taxpayer assumes liability.[11]

Government and Governmental Entity. The preamble notes that the definition of the “government or governmental entity” has been reorganized to identify separately (i) governments at various levels ranging from countries to local governments, (ii) government entities such as agencies and instrumentalities, and (iii) nongovernmental entities treated as government entities such as self-regulatory entities—i.e., qualified boards or exchanges and others that adopt, administer, or enforce rules and impose sanctions as part of performing an essential government function.[12]

Violation of Law. Commenters recommended that the phrase “violation of law” should be clarified to expressly exclude situations in which a government or governmental entity is enforcing rights, as a private party would, for instance, in contractual disputes such as the recovery of vendor overcharge errors.[13] Treasury and the IRS agreed, and the Final Regulations incorporate the clarification.[14]

Under the Final Regulations, the general disallowance rule does not apply to any amount paid or incurred pursuant to an order in a suit in which no government or governmental entity is a party.[15] However, in a suit brought by a private citizen, because the government or governmental entity is the real party in interest in the suit and receives any funds paid pursuant to the order or agreement, the preamble notes that the disallowance rule will likely apply absent an applicable exception, though the Treasury and IRS decided not to adopt a single rule applying to such cases.[16]

Commenters also inquired about the appropriate treatment under section 162(f) of amounts paid pursuant to statutes that apply regardless of the violation of law, such as environmental regulatory statutes. The preamble explains that costs paid or incurred to satisfy, for instance, cleanup requirements imposed under a federal environmental statute that do not involve a violation of law generally are deductible, though any penalties or fines for violations of such a law would not be deductible.[17]

Treasury and the IRS also agreed with commenters who requested clarification that amounts paid or incurred in connection with routine investigations or inquiries, such as audits and inspections, of regulated businesses or industries and not related to evidence of wrongdoing or suspected wrongdoing are not subject to the general disallowance rule.[18] The Final Regulations contain clarifying language to that effect and an example to illustrate the rule.[19]

In the example, a banking regulator, at the end of an annual examination conducted in the ordinary course of business, issues a letter to a bank identifying concerns with the bank’s internal compliance functions. The bank takes corrective action consisting of investments in its internal compliance functions. Since the bank’s expenditures are not related to the violation of any law, the otherwise deductible expenditures are not disallowed under section 162(f).[20]

Exceptions to the General Disallowance Rule: Definitional Revisions

The Final Regulations addressed a number of significant issues that commenters highlighted with respect to the exceptions to the general disallowance rule under section 162(f)(2) for amounts constituting “restitution (including property remediation)” and amounts for “coming into compliance with law.” Generally, the Final Regulations reflect changes that are consistent with Congress’ intent in providing these exceptions, though they appear overly restrictive in certain regards with respect to the treatment of disgorgement and forfeiture. 

Environmental Expenditures. A number of comments observed that some harms to the environment might be viewed as irreparable and suggested that true restitution or remediation might not be possible in these circumstances. In response, the Final Regulations clarify that an amount falls within the restitution or remediation exception if its purpose is to conserve soil, air, or water resources, protect or restore the environment or ecosystem, improve forests, or provide a habitat for fish, wildlife, or plants, and has the requisite nexus to the harm alleged to have been caused.[21]

Disgorgement. Several commenters, including Shearman, asked Treasury and the IRS to reconsider the rule in the proposed regulations, which categorically excluded disgorgement and forfeiture from restitution. With regard to disgorgement, we pointed out that the Supreme Court’s decision in Kokesh v. SEC makes clear that disgorgement is a form of “[r]estitution measured by the defendant’s wrongful gain.”[22] Although Kokesh was discussed in the preamble to the Proposed Regulations, commenters argued that the Proposed Regulations misread Kokesh and that consideration should also be given to the Supreme Court’s recent decision in Liu v. SEC, which also recognized that disgorgement of net profits is a form of restitution.[23]

Treasury and the IRS agreed with the commenters that disgorgement of net profits should not be treated as per se nondeductible. Accordingly, the Final Regulations provide that disgorgement of net profits may be deductible under the restitution exception; however, they impose significant restrictions on their deductibility. Specifically, the Final Regulations provide that disgorgement of net profits are deductible only if the amounts are paid directly to the victims or a fund for the benefit of such victims and not disbursed to the general account of the government or governmental entity for general enforcement efforts or other discretionary purposes.[24]

These are significant restrictions because, as a practical matter, governments and government entities often do not take the steps necessary to return net profits disgorged to victims due to the difficulty of identifying victims and administrability concerns. Moreover, the restrictions are contrary to a comprehensive understanding of disgorgement. In Kokesh, the Supreme Court observed: “When the SEC seeks disgorgement, it acts in the public interest, to remedy harm to the public at large, rather than standing in the shoes of particular injured parties.”[25]

The decision by Treasury and the IRS to restrict the deductibility of disgorgement of net profits also contradicts both sound tax policy and sound public policy. Regardless of whether disgorged profits go directly to victims, a fund or a governmental entity, the taxpayer may disgorge income that has been previously taxed. If so, disallowing a deduction for disgorgement imposes a tax on income that the taxpayer does not retain. Not only does this result in taxing phantom income, but in effect it imposes a back-door penalty, or “double sting,” above and beyond the other explicit penalties imposed by regulatory statutes.[26] As a penalty hidden in the federal tax code, the disgorgement provision may be overlooked by compliance personnel and regulatory lawyers. It will, therefore, not serve to deter malfeasance and will operate contrary to due process norms. Remarkably, the preamble fails to discuss these significant definitional, tax and public policy issues.

Forfeiture. In the preamble, Treasury and the IRS observed that commenters did not address forfeiture independently from disgorgement. Since virtually all states have different asset forfeiture provisions, the Final Regulations do not attempt to provide specific rules providing guidance with respect to the deductibility of amounts paid or incurred under the various statutes.[27] Instead, the Final Regulations drop the per se disallowance of forfeiture amounts contained in the Proposed Regulations. But, as with disgorgement, they condition deductibility on the amounts being paid directly to the victims or a fund for the benefit of such victims and not being disbursed to the general account of the government or governmental entity for general enforcement efforts or other discretionary purposes.[28] As a result, the forfeiture provision as applied in many instances may suffer from the same definitional and policy infirmities as the disgorgement provision.

Payments to a Fund, Account or Similar Arrangement. The Proposed Regulations adopted a per se disallowance for amounts paid to an entity, fund, group, government or governmental entity for restitution or remediation to the extent it was not harmed by the taxpayer’s violation or potential violation of law. Commenters asked for reconsideration of the per se rule, and Treasury and the IRS agreed.[29] Under the Final Regulations, amounts paid pursuant to an entity, fund, group, government or governmental entity for restitution or remediation that are otherwise deductible (and meet the restrictions on use described above) are not subject to the general disallowance rule under section 162(f).[30] The Final Regulations further provide that if such amounts are subsequently returned, the taxpayer will be required to include those amounts in income under the tax benefit rule.[31]

Coming Into Compliance With Law. In response to comments, an example in the Final Regulations clarifies that amounts paid or incurred to upgrade equipment or property to come into compliance with a law are deductible even if the taxpayer elects to upgrade to a higher standard than required as long as the other deductibility requirements are met.[32]

Exceptions to the General Disallowance Rule: Identification & Establishment

The Final Regulations also set forth the two procedural requirements that a taxpayer must meet for an amount to qualify for the restitution, remediation and coming into compliance with law disallowance exceptions: the “identification” and “establishment” requirements.[33]

Identification. The Final Regulations provide that, in general, a court order or agreement identifies an amount qualifying for an exception to the general disallowance rule by stating the nature of, or purpose for, each payment that each taxpayer is obligated to pay and the amount of each payment identified.[34]

With regard to the terminology used in the order or settlement, the Final Regulations provide that the identification requirement is met if the order or settlement states (1) the amount of the payment, and (2) that the payment constitutes “restitution, remediation, or an amount paid to come into compliance with a law.”[35] If the order or agreement uses a different form of the required words (such as “remediate” or “comply with a law”) and describes the purpose for which the payment will be made or the law with which the taxpayer must comply, the order or agreement will be treated as satisfactory.[36] Alternatively, even in the absence of terms such as “remediate” or “comply with the law,” if the order or agreement specifically describes the damage done, harm suffered or manner of noncompliance with a law and describes the action required by the taxpayer, the order or agreement will be treated as satisfying the identification requirement.[37]

With regard to situations in which the payment amount is not identified (e.g., because the amounts consist of goods or services to be provided in the future), the identification requirement may be met if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer.[38] Similarly, if the order or agreement identifies a lump-sum payment or multiple damages award as restitution, remediation, or to come into compliance with a law but does not allocate some or all of the amount the taxpayer must pay or incur among the particular exceptions, or does not allocate the total payment amount among multiple taxpayers, the identification requirement may be met if the order or agreement describes the damage done, harm suffered, or manner of noncompliance with a law, and describes the action required of the taxpayer, such as paying or incurring costs to provide services or to provide property.[39]

Establishment Requirement. The Final Regulations provide that the establishment requirement is met if (i) the documentary evidence submitted by the taxpayer proves that the taxpayer was legally obligated to pay the amount identified in the order or agreement as restitution, remediation or to come into compliance with a law, and (ii) the amount was paid or incurred for the nature and purpose identified. In the case of lump-sum payments or multiple damage awards, the taxpayer must establish the exact amount paid or incurred for restitution, remediation and to come into compliance with a law with respect to each taxpayer subject to such obligations.

The Final Regulations provide a non-exhaustive list of documents that may be used to satisfy the establishment requirement. These documents include receipts, the relevant law, regulation or other legal provision, documents issued by the government or governmental entity relating to the investigation or inquiry, including relevant court pleadings, judgments, decrees, documents showing how the amount was determined, and relevant correspondence between the taxpayer and the government or governmental entity.[40]


[1] T.D. 9946, 86 Fed. Reg. 4970 (January 19, 2021). The effective date of the Final Regulations is January 14, 2021. Id.
[2] See our previous client publication, “Proposed Treasury Regulations Clarify Requirements for Deducting Restitution and Legal Compliance Costs Under Section 162(f).”
[3] Pub. L. No. 115–97, § 13306(a), 131 Stat. 2054, 2126 (2017).
[4] Section 162(f)(1).
[5] Section 162(f)(2).
[6] Section 162(f)(2)(A)(i)–(ii).
[7] Pub. L. No. 115–97, § 13306(b), 131 Stat. 2054, 2128 (2017). The Final Regulations exercise the authority granted under the statute to increase the threshold amount for information reporting purposes from the statutorily provided $600 to $50,000. Reg. § 1.6050X-1(f)(6).
[8] 86 Fed. Reg. at 4989.
[9] Reg. § 1.162-21(a).
[10] 86 Fed. Reg. at 4971.
[11] Reg. § 1.162-21(f)(4).
[12] Reg. § 1.162-21(e)(1)–(3).
[13] 86 Fed. Reg. at 4976.
[14] Reg. § 1.162-21(c).
[15] Id.
[16] 86 Fed. Reg. at 4976.
[17] 86 Fed. Reg. at 4972.
[18] 86 Fed. Reg. at 4973.
[19] Id.; Reg. § 1.162-21(a)(3)(ii).
[20] Reg. § 1.162-21(f)(5), Example 5.
[21] Reg. § 1.162-21(e)(4)(A).
[22] 86 Fed. Reg. at 4974 (quoting Kokesh v. SEC, 137 S. Ct. 1635, 1640 (2017). [23] Id. (citing Liu v. SEC, 140 S. Ct. 1936, 1946 (2020).
[24] Reg. § 1.162-2(c)(4)(B).
[25] Kokesh, 137 S. Ct. at 1643 (quoting the government’s concession of this point on brief). The preamble to the Final Regulations cites Nacchio v. US, 824 F.3d 1370 (Fed. Cir. 2016) in apparent support of the proposition that disgorgement paid to the SEC and then, in the SEC’s discretion, used to compensate victims, is not restitution. Nacchio, however, was decided under the pre-TCJA version of section 162(f) and before the Supreme Court’s decision in Kokesh.
[26] See Stephens v. Commissioner, 905 F.2d 667, 671 (2d Cir. 1990) (observing that the disallowance of a deduction for disgorgement of profits imposes a “double sting” on a taxpayer who is simultaneously subjected to other penalties for the same conduct).
[27] 86 Fed. Reg. at 4974.
[28] Reg. § 1.162-21(c)(4)(B).
[29] 86 Fed. Reg. at 4974.
[30] Reg. § 1.162-21(c)(4)(C).
[31] Reg. § 1.162-21(d)(2).
[32] Reg. § 1.162-21(f)(3), Example 3.
[33] Reg. § 1.162-21(b)(1).
[34] Id.
[35] Reg. § 1.162-21(b)(2)(ii).
[36] Id.
[37] Id.
[38] Reg. § 1.162-21(b)(2)(iii)(A).
[39] Reg. § 1.162-21(b)(2)(iii)(B).
[40] Reg. § 1.162-21(b)(3)(ii).

Authors and Contributors

Mark D. Lanpher



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Washington DC

Todd Lowther



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