Senators Want To Close Tax Loophole After JPMorgan Case, But Bank Will Still Probably Save Billions

Pedestrians walk by the offices of JPMorgan Chase & Co. in New York, U.S., on Friday, May 17, 2013. As JPMorgan Chase & Co.?s
Pedestrians walk by the offices of JPMorgan Chase & Co. in New York, U.S., on Friday, May 17, 2013. As JPMorgan Chase & Co.?s Jamie Dimon prepares for a vote tomorrow on whether he should keep his chairman and chief executive officer titles, he may take comfort knowing most of his biggest shareholders are led by men with the same dual role. Photographer: Victor J. Blue/Bloomberg via Getty Images

Two senators introduced legislation on Wednesday to close a loophole that lets companies claim tax deductions on penalties and fines they pay the federal government.

But much of a pending JPMorgan Chase settlement that inspired the bill -- and a lot of outrage -- probably won't be affected.

The bill, co-authored by Sens. Jack Reed (D-R.I.) and Charles Grassley (R-Iowa), comes in response to the growing controversy over as much as $4 billion in tax savings JPMorgan Chase might realize from write-offs of part of a $13 billion mortgage fraud settlement with the Department of Justice. The settlement is not yet finalized.

“A penalty is supposed to deter others because it causes pain to a company’s bottom line," Reed said in a statement. "If a company is paying thousands, millions, or even billions in fines, it shouldn't save money for those same misdeeds, it should be held accountable."

Though the final text of the bill was not immediately available, it appears that under the legislation, JPMorgan would still be permitted to realize savings of about $4 billion based on how it classifies certain required payouts under the tax code.

Tax law lets companies claim deductions on so-called "restitution" payments. Of JPMorgan's total $13 billion expected settlement, a reported $4 billion will go to help homeowners, and would thus qualify for the deduction as restitution. Some of the rest would likely go to compensate investors, leading to even more savings for the bank.

The proposed legislation would force the government to clarify how payouts in its legal deals should be treated for tax purposes. In doing so, it could potentially block companies from claiming huge tax breaks from fines that are meant to be punitive in nature.

Current tax law is actually fairly clear about what part of a government settlement may or may not be deducted. Punitive fines and penalties can't be deducted; restitution and compensation can. But the Justice Department, unlike other federal agencies, does not always clearly spell out in its agreements how certain types of payouts should be classified.

The legislation proposed this week would force the government to clarify in advance how penalties and fines should be treated, thus heading off such future disputes. But JPMorgan could still be allowed to write off certain parts of its settlement as a business expense. A summary of the legislation mailed to reporters reads, in part: "Amounts paid by corporations, which constitute restitution for damage caused by the violation of any law, are exempted and remain deductible."

It's not clear whether the bill would rule out deductions on another slice of JPMorgan's deal: the company's agreement to pay $5.1 billion to Fannie Mae and Freddie Mac.

As the Wall Street Journal first reported last week, that entire sum is technically tax deductible because it qualifies as restitution and compensation.

Fannie and Freddie, which together guarantee almost every new mortgage made in the U.S., are a special case. Typically, private companies can write off the cost of settlements with other private companies. But Fannie and Freddie are essentially wards of the state: recipients of a massive taxpayer bailout, and under the control of the Federal Housing Finance Agency, which negotiated the deal with JPMorgan.

Because many Justice Department settlement agreements are not made public, it is impossible to say how often companies use tax breaks to their benefit in a punitive situation. But in recent years, several lawsuits brought by the Internal Revenue Service against companies attempting to claim a tax deduction on money paid as part of a government settlement have bubbled to the surface. These cases suggest that companies are having success in claiming deductions in situations when the language isn't very clear.

In July, for example, a Massachusetts federal judge upheld a jury verdict permitting Fresenius Medical Care to deduct $95 million of a total $385 million it paid to settle allegations it defrauded government health programs.

In the case, Fresenius argued that the penalties it was assessed were compensatory in nature, and thus deductible. The IRS argued the penalties were punitive, and thus could not be deducted. Despite reaching an agreement, the settlement was silent on the question.

Reed spokesman Chip Unruh said the intent of the bill is to make sure the rules are clear and that there is transparency, especially at the time of settlement, "so corporate wrongdoers can’t use accounting gimmicks to turn penalties into tax write-offs."

Francisco Enriquez, a tax expert at the U.S. Public Interest Research Group, a left-leaning group that recently delivered 160,000 signatures to the Justice Department to protest the agency's settlement policy, said his group supports the legislation.

"This is a step in the right direction," he said. "Our position is that in most cases, restitution payments made as a part of a settlement should not be deductible."

CORRECTION: A previous version of this story referenced tax credits in several instances, when the correct term should have been tax deductions.