The deductibility of class-action settlement costs is dependent on tracing the origin of the claims asserted in cause of the class-action lawsuit back to the source of the litigation and the origin and character of the claim and nature of the ultimate payment. To the extent the litigation arose from acts that can be construed to have been conducted in the ordinary conduct of the taxpayer’s business, a current tax deduction is warranted. In contrast, if the settlement and payment represents a fine or statutory penalty, then the payments are likely not tax deductible.

Further, to the extent the litigation arose from a capital transaction such as the acquisition of an asset or in a claim relating to ownership rights to a capital asset, Section 263(a) requires capitalization of class-action settlement payouts and related costs.

If capitalized, the deduction of settlement costs may be required to be spread over a number of years or the deduction may be disallowed entirely. This second scenario is problematic in that the settlement creates the degradation to the financial statements with no corresponding tax benefit.

Nightmare Scenario
Let’s go back to Company X, which was involved in a $250 million class-action settlement. This amount must be reported as an accrued liability and Company X must provide detailed disclosure of the claim to alert readers to the liability. Ongoing, quarterly disclosure will also be necessary and the current financial statements for Company X will show a charge to income of $250 million.

The management of Company X may attempt to spin the settlement in a positive light, but it will most likely be difficult to convince investors that a $250 million loss is anything but a significant loss that harms not only the company’s economic position, but also the investor’s individual investment in the company.

Additionally, attempts to minimize or mitigate the real economic impact of the settlement may set up the company for potential shareholder derivative and securities fraud lawsuits.

Worse still, if the claim is found to have arisen from a capital transaction or is punitive in nature the loss may not be deductible on the tax return further harming the company’s financial position.

Even if the claim is deemed to be deductible, the company is further exposed to scrutiny by the IRS and potentially the necessity of defending the tax position.

Insurance: the Risk Transfer Alternative
A company that is entering into a claims-made settlement of a class-action lawsuit has only two paths it can take when booking the settlement and preparing its tax return. First, it can adhere to current ASC 450, Form 8-K and other disclosure requirements and take a GAAP charge for the full amount of the claims made settlement fund and review the facts and circumstances of the settlement to determine the proper tax filing position.

This approach can cause shareholders (both present and prospective) to impugn the company’s financial stability, which directly influences its capital reserves and operations. In addition, the tax consequence either further harms the company or opens an avenue for IRS scrutiny.

As an alternative, the company can insure the class-action settlement, which will effectively transfer the settlement liability from the company to the insurer. The purchase of an insurance policy for a specific class-action case can help minimize the economic, tax and investor disapproval exposure and result in more benign financial disclosure as the net liability is represented by the paid and incurred insurance premium.

The specific accounting treatment of the settlement and the insurance touch on numerous provisions under GAAP and must be evaluated on a case-by-case basis. Generally, with respect to the financial reporting requirements under ASC 720, insured entities recognize a liability for the probable losses from incurred but not reported claims and incidents if the loss is both probable and reasonably estimable. There is not a general rule that would eliminate the liability even with insurance in place unless certain requirements have been met.

Once the insurance is in place, a company would normally continue to present the liability on its balance sheet, but also report an insurance receivable for claims that the insurance contract will pay. The practical effect of this accounting treatment is that the settlement liability is balanced against the insurance asset thereby mitigating the ultimate financial impact of the claims made settlement fund.

Assuming the insurance covers 100 percent of the expected loss contingency; the balance sheet will contain both an asset and a liability in the same amount. The net impact on the income statement would be a charge for the cost of the insurance only rather than the charge for the entire amount of the claims made settlement fund.

Directly offsetting prepaid insurance and receivables for expected recoveries from insurers against a recognized incurred but not reported liability or a liability incurred as a result of a past insurable event is not appropriate. While at first blush it would seem that the liability and insurance receivable could offset and simply be eliminated from the statement, the fact that the liability has not been extinguished or legally released requires that the reader of the financial statements be made aware of the potential continuing obligation of the company in the event that the insurer is unwilling or unable to honor the insurance contract.

While insurance can be effectively used to eliminate or mitigate the GAAP charges arising out of the settlement, it is also a critical tool for tax purposes. Companies can face class-actions arising out of both federal and state statutory schemes including but not limited to the Telephone Consumer Protection Act, the Video Privacy Protection Act, and the Fair and Accurate Credit Transactions Act. These laws provide for statutory or punitive damages for violations. For this reason, many courts have taken the position that liability for the underlying conduct is not insurable.

A company faced with a class-action settlement must accept the variability of the class-action suit and GAAP charges on its financial statements, or obtain class-action settlement insurance coverage, thereby limiting the company’s exposure by fixing its loss to the amount of the insurance premium.

Companies need to weigh carefully the financial and investor impact of the charge against earnings, the ultimate take rate risk, the issue of tax deductibility, and the certainty and finality of the insurance alternative in order to determine whether the purchase of insurance will provide the best option to mitigate the financial and tax impact of the class-action settlement liability.

Peter Robbins, CPA, became a partner with CliftonLarsonAllen LLP in November 2011 when his predecessor firm, Middleton, Burns & Davis, merged into CLA. He was a shareholder of MBD and had been with the firm since January 1998. Previously he spent seven years with Ernst & Young in Milwaukee and four years with Grant Thornton in Dallas.

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