We have covered timing and delivery issues in several articles, such as the recent Demuth and Hoensheid cases.[1] Similarly, the recent Tax Court case of Gage v. Comm’r dealt with the taxpayers that believed they paid a $875,000 settlement to the Department of Housing and Urban Development (“HUD”) in December of 2012.[2] Unfortunately for the taxpayers, governmental entities often move at a snail’s pace, which resulted in the proper timing for the taxpayers’ deduction related to the payment being deferred to 2013. Additionally, the IRS attempted to impose a substantial understatement penalty, but was unsuccessful.
Facts and History
Edwin and Elaine Gage began negotiations to settle an ongoing case with HUD in August of 2012. The parties entered into settlement talks supervised by a magistrate judge and tentatively agreed that the Gages would pay $875,000 in settlement fees, but the settlement was contingent upon final approval by the Department of Justice. The magistrate judge entered an order reflecting that the settlement was contingent upon acceptance and approval by the Department of Justice. The district court then entered an administrative closing order, which terminated the suit without prejudice.
The Gages purchased a cashier’s check in the amount of $875,000 and delivered it to their lawyer on December 27, 2012. Their lawyer emailed the Assistant U.S. Attorney who represented the government to inform him that the check would soon be delivered. The Assistant U.S. Attorney, however, explained that the United States did not have authority to receive the cashier’s check before the settlement was finally approved. The Gages’ lawyer therefore held onto the check. The Department of Justice finally reviewed and approved the settlement over three months later in March of 2013, shortly after which the Gages’ attorney delivered the cashier’s check to the government.
The Gages’, believing that they had paid the settlement fees in December of 2012, claimed a business-loss deduction of more than $900,000 (the sum of the $875,000 payment and their legal fees). The IRS disagreed regarding the deductibility of the $875,000 on audit (although it conceded that the legal fees were deductible) and penalized the Gages with a Section 6662(a) substantial understatement penalty. The IRS sent the Gages a notice of deficiency, and the Gages petitioned the Tax Court arguing that they were entitled to deduct the $875,000 settlement payment under Section 162.
Analysis
The IRS argued that the Gages were not entitled to deduct the settlement payment for two reasons. First, related to timing, the IRS argued that the check was not actually received by the government until 2013, thus the deduction could not be taken in 2012. Second, assuming that the Gages were correct with regard to the timing, that the settlement was for punitive damages and therefore nondeductible under Section 162(f). The court did not have to address the second argument (except with respect to penalties).
The Court began by stating that the Gages were cash-method taxpayers and that as such, they could only claim deductions for expenses that were actually paid in a given year rather than those that were incurred.[3] The Court then recited that the rule for check payments by cash-method taxpayers treats checks as paid when the check is delivered.[4] Even if the check is dated in one year, if it is not cashed until the next, no deduction will be allowed in the first year absent proof of delivery in that year.[5]
The Gages did not deliver the cashier’s check to the government until 2013, rather they gave it to their lawyer in 2012. A copy of the United States’s payment record confirms that check was received on March 18, 2013 and cashed on March 22, 2013, only after the DOJ reviewed and approved the agreement. The Gages argued that the delivery of the cashier’s check to the their attorney followed by his offer to send it to the Assistant U.S. Attorney who worked the case was sufficient to constitute a tender of payment under Oklahoma law.
The Court held that it did not need to review Oklahoma law, since what constitutes delivery of a check made in settlement of a federal lawsuit brought by the federal government is a matter of federal law. As support for this holding, the Court stated that the underlying litigation was between an agency of the federal government and a taxpayer, which is one factor weighing in favor of applying federal law.[6] Additionally, the Court stated that settlement agreements are contracts, and that this contract was entered into under federal law. It was between a federal government agency and the Gages, and it was brought under a federal statute to protect a federal financial interest by the Department of Justice under its own procedures for approval of settlements.
As such, the Gages were dead in the water, which lead to a discussion of whether the Section 6662(a) penalties should be upheld. The Gages claimed they took the deduction reasonably and in good faith, which is valid defense to a Section 6662(a) penalty. The Court found that they acted in good faith in thinking that they’d made the payment in 2012, since it was more likely than not that they delivered the check to their attorney with the intent of fulfilling the terms of the settlement agreement, and in their eyes, they had departed with control over the $875,000.
However, the IRS also argued that the Gages were not entitled to deduct the amount at all because it was for punitive damages. Thus, to have the penalties abated, the Gages had to show reasonable cause and good faith in taking the position that the settlement payment was deductible as an ordinary and necessary business expense.
Section 162(a) allows taxpayers to deduct all ordinary and necessary business expenses. Section 162(f) disallows the deduction for any fine or similar penalty paid to a government for the violation of any law. The regulations define the phrase “fine or similar penalty” for the purposes of section 162(f) as including an amount paid as a civil penalty imposed by federal, state, or local law and an amount paid in settlement of the taxpayer’s actual or potential liability for a fine or penalty (civil or criminal).[7] The regulations also provide that compensatory damages paid to a government do not constitute a fine or penalty.[8] The Gages argued that the settlement payment was compensatory instead of a fine or similar penalty as argued by the IRS.
After reviewing the National Housing Act and the Housing and Community Development Act of 1987, the relevant law under which the United States can recover for breach of a regulatory agreement with HUD, the Court concluded that the double-damages provision under which the government sued the Gages could be used to either compensate the government or punish offenders. The terms of the settlement agreement itself were silent as to whether the amount was compensatory or punitive. As a final resort, the Court attempted to look at other evidence of the parties’ intent.[9] The key fact that ended up persuading the Court was that the amount the Gages’ paid in settlement was far less than the actual damages claimed, much less double the actual damages. This fact coupled with the ambiguity of the situation led the court to conclude that it was more likely than not that the Gages to have thought that their payment was compensatory, and therefore their position was at least reasonable and taken in good faith.
Conclusion
Important here is the fact that the Court did not rule on whether the Gages’ could actually deduct the settlement payment in 2013. Rather, the Court held that they definitely could not deduct in 2012, and that it was more likely than not that they had acted reasonably and in good faith in taking the position of deducting the payment in 2012. While the taxpayers clearly lost on the deduction front, and the window for the taxpayers to amend their 2013 return and claim the deduction has likely passed, they at least were able to avoid the Section 6662(a) penalty. Considering the facts of the case, the taxpayers should probably consider themselves lucky. Other cash-method taxpayers can learn from the Gages that just because cash has been expended, does not mean that they are entitled to claim a deduction yet (or possibly at all).
[1] Charles J. Allen, “Checks Written Before But Cashed After Death Includible in Gross Estate” (July 28, 2022), https://esapllc.com/demuth-estate-case-2022/#_ftn1; and S. Gray Edmondson, “Hoensheid: Assignment of Income and Gift Substantiation” (April 17, 2023), https://esapllc.com/hoensheid-tc-2023/.
[2] Gage v. Comm’r, TC Memo 2023-47, April 12, 2023.
[3] Saviano v. Comm’r, 80 T.C. 955, 964 (1983).
[4] Guy v. Comm’r, 105 T.C.M. (CCH) 1626, 1628 (2013).
[5] Reynolds v. Comm’r, 79 T.C.M. (CCH) 1376, 1383 (2000).
[6] Trout v. Comm’r, 131 T.C. 239, 251 (2008).
[7] Treas. Reg. § 1.162-21(b)(1)(ii) and (iii).
[8] Treas. Reg. § 1.162-21(b)(2).
[9] Ziroli v. Comm’r, T.C. Memo. 2022-75, at *10.
