Without question, it is bad for a physician or other health care provider to face civil and/or criminal penalties for committing fraud. But, the situation can still get worse when, having to pay back those ill-gotten gains, the physician is denied a tax deduction for the repayment.
Generally, Section 162 of the Internal Revenue Code allows a deduction for all ordinary and necessary expenses paid or incurred in carrying on a trade or business. Similarly, Section 165 of the Code allows a deduction for losses incurred in a transaction entered into for profit even if not connected with a trade or business.
However, several specific subsections of the Code deny a deduction for any kickback, rebate or bribe under Medicare or Medicaid, or for any fine or penalty paid to a government for the violation of any law.
Nevertheless, in a recent private letter ruling, the IRS did allow physicians to claim a deduction on payments made to an insurance company and to two state entities under a consent order arising out of insurance fraud because such payments were characterized as restitution payments, and not in the nature of penalties.
While the private letter ruling goes on to warn that deductibility either as a Section 162 business expense or a Section 165 loss can be overridden by the so-called "public policy doctrine" (that is, where the allowance of the deduction would "frustrate sharply defined national or state polices proscribing particular types of conduct"), that doctrine was held by the IRS in this situation not to apply to the restitution payments to either the insurance company or the State of New Jersey.
Accordingly, it is important that the terms of settlement agreements and court records clearly indicate whether payments are intended as "compensation" or other forms of restitution to a payor, rather than as non-deductible fines or penalties.