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Attachment I to Industry Director Directive on Government Settlements Directive #1

Audit Guidelines

The following audit guidelines are intended to provide examiners with assistance in developing the issue related to settlements under the False Claims Act between the Department of Justice and taxpayer/defendants. There are a number of terms unique to this issue. Knowing and understanding these terms will enhance an agent’s ability to understand and develop this issue.

I.   What is this issue?

Investigations of fraud against the federal government are conducted by the Justice Department, either through a Department of Justice (DOJ) trial attorney or a local Assistant U.S.  Attorney.   The investigations are conducted under Title 31, US Code, Section 3729, referred to as the False Claims Act (FCA), and various other statutory and common law provisions.  The False Claims Act, which is utilized in most of these proceedings, allows the government to recoup funds paid out as a result of fraudulent acts and/or the filing of fraudulent claims for reimbursement with the government.  The FCA also calls for stiff penalties of up to three times the amount of the compensation the government recovers, referred to as treble damages.  In most cases that it investigates, DOJ reaches a settlement with the defendant rather than litigate in the courts.

The issue in question is whether a FCA settlement with the DOJ is deductible in its entirety as a Sec. 162 (a) ordinary and necessary business expense, or is some portion a non-deductible penalty under Sec. 162 (f).  Experience has shown that almost every defendant/taxpayer deducts the entire amount of a FCA settlement as a business expense.  In most cases, a portion of the settlement payment represents a penalty that is not deductible for tax purposes. 

There are two primary questions which must be answered in each case.  First, is a portion of the settlement payment a penalty, and therefore, not deductible for tax purposes?  Second, what amount of the settlement is the penalty?  The tax law is clear:  the taxpayer (TP) bears the burden of proving that it is entitled to deduct any portion of the settlement amount paid.

The FCA contains a whistleblower provision, called a qui tam, which allows citizens to sue on behalf of the government in order to recover funds paid due to fraud.  A whistleblower is referred to as a relator.  Most FCA investigations result from a qui tam action, and in most settled cases the relator is paid a reward for taking this action.

II.   How is this issue identified?

DOJ issues a press release on practically every case that it settles.  This information is available on the DOJ web site.  doj.gov.  It will usually also be reported by national and local newspapers, which can be researched for a lead on this issue for the taxpayer being examined.

The Health Care TA team monitors settlements and in most cases notifies an examination team when its taxpayer is identified as having entered into a settlement.

Taxpayers Against Fraud (TAF) is an organization that monitors False Claim Act investigations and settlements.  All settlement activity is reported by TAF and it maintains a web site on which the identity of the top 100 settled cases is posted, along with the amount of each settlement.

http://www.taf.org/top20.htm

When inspecting the Schedule M-1 or Schedule M-3 of the tax return, the examiner needs to determine if the taxpayer disclosed a penalty.

In addition to research, the initial interview with a taxpayer under examination should include a question(s) concerning whether the TP entered into a settlement with DOJ or any other governmental entity.

III.   How is this issue developed?

A.   Contact with DOJ

The complexity of this issue requires that the facts and circumstances be determined and developed for each case.  Initial contact with DOJ must be made according to the mandatory procedures to which DOJ and the Service have agreed.
 
The Health Care TA has been designated as the liaison between the examination teams and DOJ.  The TA must be contacted by the examination team with this request.  The TA will make the inquiry on behalf of the team and provide the identity of the DOJ attorney who negotiated the settlement.  This is a mandatory procedure which DOJ insists be followed.

The TA will then put the examiner in touch with that attorney.  All field work can then be conducted through that attorney, including interviews and the request for records relevant to each TP.  The examiner needs to discuss the settlement attorney’s personal assessment of his/her case relative to the position of whether or not penalties were included in the total settlement amount.  Confirm the existence of penalties before additional time and effort is spent on the issue.

B.   Importance of Early Involvement
 
While the case may be new to the Service, it is a closed case for DOJ.  The sooner the Service can initiate contact and begin the issue development process after a case is settled, the less likely a problem will arise.  For the Service, early intervention, and consideration of a Pre-Filing Agreement (PFA), is warranted.  Common barriers include: (1) the settlement attorney is no longer at DOJ, (2) records are in storage and either have to be retrieved or cannot be located, and (3) the settlement attorney is busy and time to devote to the IRS is limited. 
      
It is important to understand that no issue is ever proposed to a TP unless the existence of a penalty is fully supported by DOJ.  The Service makes no attempt to interpret the application of the FCA.  All interpretation of the FCA as it applies to each case is that of DOJ.  In addition, no penalty amount is based on any computation made by IRS.  All figures are those of DOJ.  The entire issue is based on the facts, figures, documentary evidence and interpretation of DOJ.

C.   Document Requests-Critical Documents from TP and DOJ
 
No two cases are identical and every document requested may not be provided.  Nevertheless, all critical documents should be requested including the following:

  • All communication between DOJ and the defendant, its representatives and/or employees, including formal letters, memos, and emails, in particular those that make it clear to the defendant that the settlement will be made under the FCA and that DOJ will include multiples (penalties) under the FCA in any settlement the two parties reach.  Often an initial letter is sent to the defendant that formalizes the party’s intent to enter into negotiations to settle the investigation, and includes the position of DOJ that multiples will be included in any settlement reached.
  • All computations and settlement proposals made by DOJ and the defendant.  This includes the initial proposal made by DOJ and the defendant’s initial offer or counter-offer, all those proposals made by either party during the negotiation process leading up to the final settlement, and the final proposal made by each party.
  • Communication between DOJ attorneys and the TP and/or its representatives in which penalties are specifically stated and addressed by either party.  (The term that is used by DOJ to refer to a penalty is “Multiple.”)
  • Correspondence in which any tax consequences of the settlement was mentioned or discussed. (It is rare for this subject to be addressed, however, the request for this type of correspondence needs to be made.)
  • Formal presentations made to the defendant or by defendant to DOJ, such as a PowerPoint.
  • Disbursements Records-FMIS Debt Management Module-Receipt and Payment Detail Report.  This document reflects the receipt by DOJ of the total settlement amount, and their disbursement of the total to all sources to which this total goes.  This will break it down between singles and multiples, and show each party that got a portion of the settlement, including the relator(s) fee.  (The FCA contains a whistleblower provision; the whistleblower is referred to as a relator.)  This record can be requested by the Health Care TA at the same time the request is made to identify the settlement attorney, in advance of any formal request for documents from DOJ.  The exam team should get an interpretation of every line item on this document from DOJ, that is, those items that are singles and those that are multiples.  This is a critical piece of documentation because it reflects DOJ’s assessment of the settlement and categorizes each component as singles or multiples, with a dollar amount for each.  (NOTE: This is a DOJ document; the TP may not have a copy.)
  • Final, signed copy, of the Settlement Agreement.
  • List of all defendant's representatives, officers, and employees that participated in settlement negotiations.  This may be in the form of a sign-in sheet utilized at formal meetings.
  • Notes and minutes of all meetings held between DOJ and anyone on behalf of the TP. 
  • Copy of the Signed Criminal Agreements.  Many defendants agree to a criminal violation in addition to the civil settlement.
  • Sentencing Memorandum (this is only written by DOJ in criminal cases).
  • All correspondence between DOJ and the relator and/or the relator’s attorney(s).
  • Notes and minutes of all meetings between DOJ and the relator(s) and/or the relator(s) attorney(s).
  • A copy of the Complaint, which is filed by DOJ, and the Answer, which is filed by the defendant, and any other relevant pleadings filed with the Court.
  • Mitigation Reports reflecting mitigated settlement amounts.  (This is only for a case that went to mitigation, most do not.)
  • Copy of the signed Corporate Integrity Agreement (CIA).  (Will be required in most, but not all, cases.)

The same records requested from DOJ should also be requested from the TP, except as noted.  Experience has shown that neither party will likely produce every document requested.  By requesting the same from both, the probability of getting a more complete set of records is enhanced.  Often one party has a document(s) that the other does not have or does not provide.  This also allows the exam team to determine and evaluate the support the TP has for any argument it makes that the entire settlement does not include any penalty and is, therefore, deductible in full.

IV.   Taxpayer Arguments
 
TPs frequently argue that the total settlement was to compensate the government for its losses, as evidenced by the fact that at the beginning of an investigation, DOJ usually publicizes its investigation of a defendant and reports an amount by which it believes the government was over billed.  Ultimately, the settlement is less than this initially publicized amount.  The TP argues that since it is less than the losses DOJ reported, all of the settlement has to be singles, which are compensatory and, therefore, deductible.  This argument has no real merit as it is not factually based and is not representative of the final settlement agreement.  The final figures are those contained in the final settlement agreement and these are the facts upon which the Service’s position is based.

Prior to June 2005 most DOJ settlement agreements included the following phrase, “The Parties agree that this agreement is not punitive in purpose or effect”.  TPs argue that this phrase makes it clear that the entire settlement is compensatory.  DOJ had intentionally included this phrase in its settlements.  It relates only to Double Jeopardy under the Constitution.  It has no meaning for tax purposes.

V.   In Conclusion
 
This is an issue that is based on the settlement of an investigation by DOJ under the FCA.  It relies on DOJ’s documentation and interpretation of each settlement to determine if it includes a non-deductible penalty.  It can only be developed through communication, coordination, and cooperation between the IRS and the DOJ.

TERMINOLOGY UNIQUE TO FALSE CLAIMS SETTLEMENTS

 Compensatory

The amount repaid to a government agency to compensate it for its losses as a result of fraud.

Corporate Integrity Agreement (CIA)

Those who commit fraud against the government, specifically those who violate the False Claims Act, can be barred from participating in the government program in which they were a participant at the time the fraud was committed, such as the Medicare Program.  Instead of taking this drastic action, defendants (TP) are usually offered the opportunity to enter into a Corporate Integrity Agreement.  The CIA requires the defendant to establish its own internal controls in order to insure that the fraudulent acts are not repeated.  This typically means that the company will establish within its operation a position that has direct responsibility for fraud prevention.  It is agreed to and signed by the company and is effective for a specific time frame.  The government has the right to evaluate the company’s compliance with the CIA.  The CIA typically will not provide any additional facts in support of a penalty issue.  It does, however, reflect the seriousness of the violations it committed and is further evidence of the view of DOJ that the violations of the FCA raised to the level of warranting penalties.

Multiples

The amount of the fine/penalty determined by DOJ during a FCA fraud investigation evidenced by the amount over and above the singles.  Multiples are the term used by DOJ to refer to the penalty amount they determine to be appropriate for each case.  It can be as high as a multiple of three, or treble damages.  In most settled case the multiple is less than three.  The use of “Multiples” in a settlement is meant to penalize in lieu of the $5,500-$11,000 penalty for each claim, per the FCA.

Punitive

Penalty or fine

Qui Tam

The FCA contains qui tam, or whistleblower, provisions.  Qui tam is a unique mechanism in the law that allows citizens with evidence of fraud against government contracts and programs to sue, on behalf of the government, in order to recover the stolen funds.  In compensation for the risk and effort of filing a qui tam case, the citizen whistleblower or &quotrelator&quot may be awarded a portion of the funds recovered, typically between 15 and 25 percent.  A qui tam suit initially remains under seal for at least 60 days during which the DOJ can investigate and decide whether to join the action.

Relator

Whistleblower --See Qui Tam.

 Relator Fees

That portion of a FCA settlement that is paid to the relator.  The relator fee is computed based on the total settlement amount that is attributed to be the result of the information provided by the relator.  Example-Total settlement is $100.  Relator information accounted for $50 of the settlement, relator fee or award is based on the $50.  In most cases the fee is computed on the total settlement amount.

The Court makes the final determination of how much the relator collects.  DOJ recommends an amount.  In some Circuits the Court actually makes that determination, in others, if DOJ and the relator agree on the award the Court accepts it.

Relators can disagree and contest the settlement amount and the relator award.

The relator fee is paid out of the total amount.  The government is required to pay the relator fee, so the relator gets paid even if the recovery is insufficient to cover the government’s loss. 

The payment of a relator award is a multi-step process:

  1. The defendant is assessed a total amount by DOJ, which typically includes singles, the compensatory amount, as well as multiples, the fine/penalty, and the funds are paid directly to DOJ.  At this point, the multiples in the hands of both the defendant and DOJ is penalty.
  2. After collection of the settlement funds, DOJ pays the money into certain funds and/or to a relator(s).  There is a statutory 3% that goes back into an account which is used to fund subsequent investigations.  It is not to compensate the government for the expenses it incurred during the investigation which resulted in the settlement in question.  This fund is not controlled by DOJ.  It must request funds out of this account, which are awarded based on need. 

Singles

The amount of the loss(es) suffered by the government, as determined by DOJ during a FCA fraud investigation, and evidenced by the amounts paid to each harmed agency with the proceeds from the settlement.

 Treble Damages

The maximum amount that can be assessed against a defendant under the FCA is three times the amount of the loss suffered by the government.

Page Last Reviewed or Updated: 29-Jan-2014