It seems like every time a corporation announces a settlement with the government, someone expresses outrage upon learning that a corporation’s payment may be deductible.  How dare the government subsidize bad behavior by allowing a corporation to reduce its taxes?  Take a look at this Newsweek story, for example.

The deductibility of settlement payments actually isn’t terribly remarkable.  If we understand the income tax as designed to reach net gain, then a business’s outlays must be taken into account in computing its taxable income.  That is, if a company has $10 million of receipts in a given year and also makes a $10 million settlement payment, such that it has nothing left, its taxable income should be zero.  To deny the company a deduction would mean the company must pay $4 million of income taxes (assuming a 40% rate) even though it hasn’t earned anything.

But if things are so straightforward, why does the deductibility of settlement payments cause so much angst?  The answer, I think, relates to the class of deductions that most ordinary taxpayers are familiar with.  Those of us who are ordinary wage earners generally don’t take business deductions on our tax returns.  Instead, we are most familiar with so-called itemized deductions, which often don’t have much to do with properly calculating net gain.

That is, when you or I take a tax deduction, that deduction is likely to be on account of a deduction for a charitable gift, a home mortgage interest payment, a medical expense, or a similar item.  Unlike deductions designed to accurately measure net gain, itemized deductions tend to reflect an effort to achieve some nontax goal, whether it’s more charity or homeownership, or an attempt to show some sympathy for someone who faces difficult circumstances.  We are thus trained to associate tax deductions with goodness.  But we suffer from a skewed understanding, because deductions generally are about measuring net gains, not about handing out rewards.

This skewed understanding may explain why, over time, Congress has limited business deductions for apparently optical reasons.  Payments that reflect government fines & penalties, as opposed to settlement payments for damages, generally aren’t deductible, nor is excess compensation, as specially defined.  These limitations don’t really make much sense from the perspective of measuring net gain — if a business earns $20 million and squanders that entire amount on an overpaid executive, why should we deny the business a deduction and ask it to pay $8 million of taxes when it actually has nothing left?

To suggest broader deductibility of business-related outlays, as I do, does not condone or encourage bad behavior.  I think it’s perfectly appropriate and desirable to use environmental laws to impose environment-related fines, to use criminal laws to punish criminal behavior, and so on.  But to suggest that the tax code should be used to buttress those deterrents — via the denial of a deduction — reflects a misunderstanding of the nature of business deductions.  Alas, there are many political points to be scored in lambasting the deductibility of settlement payments, so many talking heads will continue to seize on that misunderstanding.

Andy Grewal