Annette Nellen
Annette Nellen

To be or not to be compensatory

A recent case offers a new perspective on distinguishing between compensatory and punitive payments.

October 30, 2014
by Annette Nellen, Esq., CPA

Fresenius Medical Care Holdings, Inc., No. 13-2144 (1st Cir. 8/13/14), involves what the court described as the “uncertain terrain” of the tax treatment of settlement payments made under the False Claims Act (FCA), 31 U.S.C. §§3729–3733, which permits private citizens to bring whistleblower actions in the name of the government alleging wrongdoing. (Under the FCA, citizens who bring suits in the government’s name are called qui tam relators.) The First Circuit took an approach it described as “at odds” with an earlier FCA tax case—Talley Industries, Inc., 116 F.3d 382 (9th Cir. 1997). This article summarizes the Fresenius case and its history, as well as legislative proposals relevant to this issue.

General rule

Generally, legal settlements paid by a business are deductible under Sec. 162 as ordinary and necessary expenses of carrying on a business. Sec. 162(f) denies a deduction for any fine or penalty. Regs. Sec. 1.162-21(b)(2) provides that compensatory damages paid to the government are not considered a penalty. Where payments are required beyond compensatory damages (such as the triple damages allowed under the FCA), an issue arises of whether the additional payment is compensatory and therefore deductible or punitive, which is usually considered to be a nondeductible fine.

Recent litigation

Fresenius operates dialysis centers throughout the world. In the mid-1990s, various whistleblower actions were brought against it under the FCA. The government took notice of the FCA lawsuits and pursued civil and criminal investigations of Fresenius’s services to government health care programs. Settlements of both the criminal and civil claims were reached in 2000. Litigation ensued, resulting in two federal district court decisions and an appeal to the First Circuit. The following chart shows a breakdown of the $486,334,232 settlement after the district court decisions (see citations at the end of this article).



Original treatment by Fresenius

IRS treatment

District court treatment


Criminal fines

Deducted $92,345,665

Not deductible

Not deductible


Single damages
(the FCA allows triple damages)




$  65,800,555

Amount paid to whistleblowers as qui tam relators





Balance of the civil settlement


Not deductible. Damages beyond single (and qui tam) are punitive unless the agreement states otherwise. Burden is on taxpayer to show intent of parties to treat a payment as compensatory.

Jury found $95,000,000 deductible

2010 district court opinion (Fresenius Medical Care Holdings, Inc., No. 08-CV-12118-PBS (D. Mass. 6/25/10)): The settlement between Fresenius and the government states that it does not include an agreement characterizing the amounts paid for tax purposes. The U.S. Supreme Court has noted that for FCA purposes this additional payment (beyond the criminal fine, single damages, and qui tam award) can have both remedial and punitive purposes (Cook County, 538 U.S. 119, 130 (2003)). Also, while the agreement stated that this payment was not punitive, that statement was not viewed as binding on the government or for tax purposes. Thus, the judge found the agreement language ambiguous and denied Fresenius’s request for summary judgment.

2013 district court opinion (Fresenius Medical Care Holdings, Inc., No. 08-12118-DPW (D. Mass. 5/9/13)): The judge concluded that even without a “manifest agreement,” Fresenius might be able to show that all or a portion of the settlement payments were nonpunitive. In reviewing the language of the agreement, the judge held that the agreement’s use of the term “non-punitive” was in the context of double jeopardy and excessive fines, not tax consequences. According to the judge, Fresenius’s “unilateral belief, intent or fervent hope that the settlement payments are non-punitive is insufficient as a basis for a characterization pursuant to the Internal Revenue Code” (slip op. at 22).

In addition, the “settlement lacks an agreement by the parties as to the characterization of the settlement payments as remedial or punitive for tax purposes” (slip op. at 23). Because the agreement did not indicate the nature of the payments, the judge examined noncontractual evidence. Testimony indicated that damages beyond the “single” damages included interest. “Based on the large amount of pre-judgment interest necessary to make the government whole on losses incurred by the fraud, it was reasonable for the jury to conclude that a vast majority of the settlement payments were compensatory” (slip op. at 29).

First Circuit opinion (2014): The appellate court upheld the district court, but offered additional perspective on how to resolve the punitive vs. remedial issue where a settlement agreement is silent. It ruled that “a court may consider factors beyond the mere presence or absence of a tax characterization agreement between the government and the settling party” (slip op. at 2). The court further noted that this approach “may be at odds with the decision” in Talley Industries.

According to the court, focusing on an agreement that is silent as to the character of payments elevates form over substance. The “common-sense approach” under “generally accepted principles of tax law, [means] a court’s inquiry should then shift to the economic realities of the transaction” (slip op. at 13). The court also noted that if the IRS interpretation of the Talley case is correct, then it “is incorrectly decided and does not deserve our allegiance” (slip op. at 14).

Witty opinion

Judge Bruce Selya, who wrote the First Circuit opinion, brings some flair to his opinion by quoting Shakespeare and using unusual words, such as gallimaufry, praxis, and umbrage, to help explain his ruling. (See author’s blog post of 8/29/14.)

Lessons learned

Fresenius ended up deducting approximately 75% of its settlement payments. This is a much better result than the IRS wanted, yet it involved years of litigation and resources to resolve. Could the tax issue have been resolved as part of the FCA settlement? That is unlikely, as this task is not a responsibility of the U.S. Department of Justice (DOJ) (a point made in the 2013 decision). The 2010 decision mentions “Tracking Forms” prepared by DOJ, which apparently the IRS was aware of, but Fresenius was not. (Fresenius referred to these forms as “ ‘after-the-fact secret government forms.’ ”)

Taxpayers involved in FCA actions should inquire about what the government is preparing that bears on the nature of the settlement payments to see if they can have any influence on them and to be sure they are consistent with the language and intent of the settlement agreement. Once the taxpayer admits liability, efforts to identify and state in the agreement what it takes to make the government whole should prove useful for tax purposes under both the Talley and Fresenius cases.

Changes ahead?

In recent years, at least two legislative proposals would affect the tax consequences of FCA litigation and similar matters. The Stop Deducting Damages Act of 2013, H.R. 3445, would amend Sec. 162(f) to deny a deduction for both compensatory and punitive damages related to any judgment or settlement of any action against a government. In addition, if the taxpayer’s punitive damages are paid by an insurance provider or otherwise, that amount must be included in the taxpayer’s gross income.

The Truth in Settlements Act of 2014, S. 1898, would require public disclosure of certain settlement agreements. The “covered settlement agreements” are ones entered into by an executive agency for alleged violation of federal civil or criminal law with a payment owed of $1 million or more by a nonfederal person (i.e., not an entity within the federal government). The information for disclosure includes the names of the parties, a description of the claims settled, the amount owed, and how much is “expressly specified” under the agreement as not tax-deductible. Co-sponsors of this bipartisan proposal, Sens. Elizabeth Warren, D-Mass., and Tom Coburn, R-Okla., state that the goal is increased transparency (Warren press release of 1/8/14).

In 2005, the U.S. Government Accountability Office (GAO) released a report on civil settlements, deductibility, and whether the agencies involved shared information with the IRS. The GAO found that the IRS does not receive information from the four federal agencies with the largest settlements (Environmental Protection Agency, the SEC, DOJ, and the U.S. Department of Health and Human Services). The GAO recommended that the IRS work with agencies to find a way to cost-effectively obtain information on civil settlements in a manner that would aid in the correct tax treatment of the payments. The IRS agreed with the recommendation (GAO, Systematic Information Sharing Would Help IRS Determine the Deductibility of Civil Settlement Payments, GAO-05-747 (9/15/05)).

Sens. Max Baucus, D-Mont., and Chuck Grassley, R-Iowa, responded favorably to the GAO report, noting the need to be sure settlement payments are not subsidized by taxpayers through improper tax deductions. Baucus stated: “It is galling that artfully crafted settlement agreements create loopholes that allow wrongdoers to escape the full impact of fines and water down any deterrent effect. It is unacceptable that government agencies routinely do not share settlement information with the IRS so payments and deductions can be monitored” (Senate Finance Committee press release of 10/18/05).

In recent years, DOJ has reported record settlement and judgment amounts including under the FCA (“Justice Department Recovers $3.8 Billion From False Claims Act Cases in Fiscal Year 2013,” press release of 12/20/13). Given the proposals noted here, a desire to broaden the tax base to lower tax rates, and challenges in determining the deductibility of settlements and judgments, perhaps there will be some type of change in the 114th Congress.


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Annette Nellen, Esq., CPA, CGMA, is a tax professor and director of the MST Program at San José State University. She is an active member of the tax sections of the AICPA, ABA, and California State Bar. She is a member of the AICPA Tax Executive Committee and Tax Reform Task Force. She has several reports on tax policy and reform and a blog.