Whether or not legal settlements, or parts of them, are tax deductible can materially affect the net economics of such settlements. And settling entities – for example, hedge fund managers in insider trading
or other civil actions – can influence the deductibility of settlements through structuring, drafting of settlement agreements and other actions. In a recent presentation, Shearman & Sterling
tax partner Lawrence M. Hill provided an overview of key concepts, best practices and applicable case law bearing on the deductibility of settlements. In particular, he discussed the differing tax treatment of the following categories of settlement amounts: compensatory damages, punitive damages, multiple damages, damages not specified as compensatory or punitive in the relevant settlement agreement, relator’s fees, legal fees, restitution, disgorgement, fines, penalties and civil forfeiture. He also offered tips on drafting settlement agreements to maximize the proportion of settlements that validly may be characterized as deductible. This article, the first in a two-part series, examines the law governing tax deductibility of settlements, as explained by Hill in his presentation. The second article in the series will relay Hill’s specific guidance on taxation of damages in practice and how a company can make its case that a settlement should be deductible. For more on tax issues relevant to hedge fund managers, see “Internal Memo Describes IRS Position on Whether Limited Partner Exemption from Self-Employment Tax Is Available to Owners of an Investment Management Company
,” Hedge Fund Law Report, Vol. 7, No. 35 (Sep. 18, 2014); and “Are Compensatory Options on Offshore Hedge Fund Shares Subject to the Anti-Deferral Provisions of Internal Revenue Code Section 457A?
,” Hedge Fund Law Report, Vol. 7, No. 23 (Jun. 13, 2014).