Every year, the Federal Trade Commission, or FTC, negotiates hundreds of millions of dollars in deals with corporations to settle allegations of wrongdoing. The charges include everything from consumer fraud, to privacy violations, to false advertising. Despite the seriousness of the crimes and the large profits sometimes connected to them, however, the FTC has ended up allowing bad actors to claim massive tax deductions for their wrongdoing.
The shoe company, Skechers, is one such example. After years of advertising their "Shape-ups," the FTC found that Skechers' workout shoe seemed too good to be true. According to advertisements, you could burn fat, tone your muscles, and even improve your posture just by wearing them around the house.
By the time the FTC caught up with Skechers and charged them with unfair and deceptive practices for falsely advertising the near-magical powers of Shape-ups, the company had already pocketed close to $1 billion from selling the shoes. It turned out that the advertisements' "independent" clinical study to test the shoes was conducted by Dr. Steven Gautreau -- who was married to a Skechers marketing executive, and paid by Skechers to conduct the study.
In its official complaint, the FTC stated that, "Consumers have suffered and will continue to suffer substantial injury as a result of [Skecher's] violations of the FTC Act."
Sketchers cut a deal with the Federal Trade Commission last year to pay $40 million to settle the charges of deceptive practices and false advertising. In the FTC's words, the agreement was to stop the company from "injuring consumers, reaping unjust enrichment, and harming the public interest." However, the FTC failed to include any provision in the agreement to stop Sketchers from taking a massive tax deduction for its misdeeds.
As a result, Sketchers will most likely be able to pocket a tax deduction worth as much as $14 million. Stated more bluntly, because the FTC didn't include any language barring Skechers from deducting the cost of the settlement from its taxes, the company will most likely be able to collect a tax windfall equal to 35 percent of the $40 million it paid to settle charges with the FTC.
Federal law forbids companies from deducting public fines and penalties from their taxes, but payments made as part of a settlement can be treated differently. Companies that cut deals with an agency to resolve charges through a legal settlement typically manage to deduct the penalties as a tax write-off unless specifically forbidden from doing so. This "settlement loophole" allows companies to receive a tax windfall for their wrongdoing.
To be fair, there are many cases for which tax deductibility is a moot point. Many defendants in FTC cases are fly-by-night, illicit corporations or fraudsters that don't pay any taxes to deduct. However, when major corporations like Sketchers settle with the agency, the settlements usually fail to include language to prevent them from becoming a tax windfall.
According to senior FTC officials, the amount of legal leverage the agency has in each case largely dictates whether it will try to prevent tax deductibility. The more certain that the FTC is that they would easily win a court case if the company refused to settle, the more willing they are to use that extra leverage to press for denying tax deductibility in the terms of the settlement. They don't press the matter unless they have leverage to spare.
Finding additional leverage to protect taxpayers would be less of a concern if agencies like the FTC made it a standard practice to prevent defendants from taking tax deductions for their settlements.
According to Steven Blum of the University of Pennsylvania's Wharton School, "If it was widely understood that government agencies barred the tax deductibility of settlements as a matter of course or policy, it would strengthen their hand in the negotiation leading up to the settlement," Blum said. "As things stand now, though, it is the government that must offer something when it seeks a consensual bar on deductibility. It is fair to say that such a standard would enhance the negotiating leverage of the agencies."
In pursuing their goal to safeguard American consumers from deception and fraud, agencies like the Federal Trade Commission should be set up to ensure that corporations that engage in such practices don't get a tax break for doing so. It should be agencies' standard practice to bar tax breaks for settlement payments -- that will put the onus on corporate wrongdoers to convince agencies that they deserve a tax break for their settlements, not the other way around.
You can read more about the settlement loophole in U.S. PIRG's Report, "Subsidizing Bad Behavior: How Corporate Legal Settlements for Harming the Public Become Lucrative Tax Write-Offs."