In a recent decision by the United States Court of Appeals for the Internal Revenue Service (“IRS”) the Court ruled that payments by a New Jersey physician to an insurance company to settle a civil suit for insurance fraud and to two undisclosed governmental entities in exchange for dismissal of criminal insurance fraud charges were deductible for federal income taxes as nonbusiness deductions. This means that the physician can deduct the amount paid on the physician’s individual income tax return in the year of payment, but that the deduction will be limited based on the physician’s adjusted gross income for that year.

In reaching its conclusion, the IRS found that the loss was not deductible as a business expense since fines or similar penalties for the violation of any law are not deductible under this tax provision. However, the payments can be deducted as a nonbusiness expense under a separate tax provision, which allows a deduction for any sustained loss that is not compensated by insurance or otherwise. In support of its conclusion, the IRS relied on its prior ruling that payments made by a convicted arsonist included the insurance payments in income when they are received. Thus, payments in the nature of restitution to the payor of improperly received payments that had previously been included in income of the payee are deductible under this tax provision.

The IRS found that the physician’s payments to the insurance company were in the nature of restitution since as a result of the settlement payment, the insurance company dismissed its civil case for insurance fraud and released its claims for restitution in the pending criminal action. In resolution of the criminal charges, one of the physician’s practice entities pled guilty and the physician agreed to pay an undisclosed amount to the two governmental entities. The deductibility of the payments by the physician to the governmental entities was a much closer question; as a matter of public policy, payments to a governmental entity as a fine or penalty are not deductible. However, since in this instance, the consent agreement (titled “Consent Order for Restitution”) recited that the purpose of the restitution payments was to enable “the citizens of New Jersey and the United States…[to] recognize significant recoupment of the ill-gotten billings of the company [the physician’s practice entity]”, the IRS concluded the payments were intended to be compensation to a governmental entity and thus deductible as restitution payments.

The lesson to be learned from this ruling is that physicians and other healthcare providers that are required to repay to a governmental agency or private payor amounts previously received by them for improperly billed services should try and characterize the repaid amounts as restitution so as to be tax deductible. By contrast, if the payments are characterized as a fine or penalty, the amounts paid will not be tax deductible.