When people misbehave – badly enough – they go to jail. But when corporations misbehave, they can’t go to jail. So they pay fines instead. Recent years have brought a wave of enforcement actions for various corporate offenses, from banks ripping off customers, to investment managers trading on inside information, to drug companies poisoning patients, to energy producers polluting public waters.

Corporations usually find a little bit of silver lining in those monster settlements. They get to deduct the payments on their taxes! You like that? You and I get to help pay the freight for their cheating!

Now, Section 162(f) of the Internal Revenue Code states that “no deduction shall be allowed . . . for any fine or similar penalty paid to a government for the violation of any law.” But defining a “fine or penalty” isn’t as obvious as you might think (and it gives corporate tax lawyers the chance to bill a lot of hours arguing about it). Few of those settlements, especially in the Wall Street arena, require offenders to admit wrongdoing, and most include some form of restitution or disgorgement of profit. Those amounts aren’t considered a fine or penalty, so they remain deductible.

What does that mean for our friends at the IRS? Well, when Exxon-Mobil paid $1.1 billion to settle claims over an oil spill in Alaska, it actually cost them just $524 million after tax. When Bank of America agreed to pay $335 million to settle charges that they had discriminated against black and hispanic borrowers, they got back up to $117 million of it in tax savings. Similarly, when credit card giant Capital One paid $210 million to resolve charges that they had duped customers into paying for credit monitoring and other add-on services, they saved millions in tax.

But now it looks like Uncle Sam is getting fed up with subsidizing the settlements by cutting off those juicy tax breaks. Now he’s working to hit ’em where it really hurts!

  • Back in November, oil producer BP agreed to pay $4 billion to settle the Deepwater Horizon spill. Ordinarily, that might have meant a fat tax deduction to cushion the blow. But no such luck this time – the settlement included language explicitly defining the damages as “punitive,” which prohibits BP from deducting any of that amount from their U.S. taxes.
  • Earlier this month, Swiss bank UBS paid $500 million to settle charges they manipulated the “LIBOR” interest-rate benchmark. Again, that settlement prevents UBS from deducting the penalty on their taxes.
  • Most recently, hedge fund manager Philip Falcone agreed to admit wrongdoing, accept a five-year ban from the securities industry, and pay an $18 million nondeductible penalty. Denying a tax deduction seems especially appropriate in Falcone’s case, since federal regulators said his actions “read like the final exam in a graduate school course in how to operate a hedge fund unlawfully.”

Tax policy questions like these can sometimes sound boring and pointless. But this one has real consequences. On the one hand, some experts argue that letting miscreants deduct settlements on their taxes encourages companies to settle out of court and avoids ongoing litigation. On the other hand, consumer advocates respond that tax-deductible settlements are a slap in the face to taxpayers, who wind up footing 35% of the tab. What do you think? Do the tax deductions still serve a legitimate purpose? Or should Washington keep up the new hard line?

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