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New Tax Act Bars Deductions for Settlements Related to Certain Sexual Harassment Claims
The recently enacted Tax Cuts and Jobs Act (the Act) has been touted as the largest tax reform since 1986. Among its many provisions, the Act adds a new section to the Internal Revenue Code (Section 162(q)) targeting confidentiality agreements in sexual harassment cases. The new section is in response to a realization, in the wake of the #MeToo movement and recent high-profile sexual harassment allegations, that these agreements can silence harassment victims and enable perpetrators to continue their abusive behavior.
Employers can typically deduct the costs of employment-related settlements as ordinary and necessary business expenses. However, under the Act, no business expense deduction is allowed for: (i) any settlement or payment related to sexual harassment or sexual abuse, if the settlement or payment is subject to a nondisclosure agreement; or (ii) attorneys’ fees related to the settlement or payment. In other words, the Act disallows deductions for any settlement, payout, or attorneys’ fees related to sexual harassment or sexual abuse if the payment is subject to a confidentiality agreement.
The new code section is broadly drafted and little guidance has been provided beyond the text itself. As a result, Section 162(q) has created uncertainty and potential issues for employers looking to resolve employment-related claims.
Potential Taxability of the Employee’s Attorney Fees
A strict reading of the Act indicates that both the employer’s and employee’s attorney fees related to the settlement of a sexual harassment claim subject to a nondisclosure agreement would not be deductible. While it is unlikely that Congress intended to prohibit victims from deducting attorneys’ fees they may receive in settlement of their sexual harassment claims, neither Congress nor the IRS has clarified this issue. Until more guidance is issued, attorneys representing employees may be concerned about the taxability of the attorneys’ fees portion of settlements, and may negotiate for additional payment to compensate for this potential tax liability. Employers should take this potential additional cost and the loss of a potential deduction into account when determining whether a non-disclosure provision is appropriate.
Potential Impact on Severance Agreements
Section 162(q) broadly applies to any settlement “related to sexual harassment or sexual abuse.” This new provision may apply to employee severance agreements with common boilerplate language releasing all employment-related claims, including sexual harassment claims. Therefore, employers should consider a “carve out” provision, stating that any applicable confidentiality or non-disclosure clause shall not apply to facts or allegations related to sexual harassment or abuse. In determining whether such a carve out is appropriate, employers should consider the amount of the severance and the impact of losing a potential deduction, and the risk of the departing employee raising a sexual harassment or abuse claim related to his or her employment in the future.
Potential Impact on Lawsuits with Multiple Claims
Sexual harassment claims are often pled in conjunction with other claims, such as discrimination and retaliation claims under state and/or federal law. When these matters settle, Section 162(q) would apply to the portion of the settlement that is related to sexual harassment or abuse. However, neither Congress nor the IRS has clarified how multiple-claim settlements will be allocated for federal income tax purposes. In order to limit the tax risk in these situations, employers should consider including language indicating that both parties agree that only a specified portion of the settlement funds (including attorneys’ fees) are attributable to allegations of sexual harassment or abuse, and that this allocation is being made in good faith based upon the nature of the underlying claims.
Potential Impact of Previously-Negotiated Settlements
Section 162(q) applies to all settlement amounts “paid or incurred” after December 22, 2017. In other words, all settlements paid after that date are subject to the Act even if the agreements were negotiated beforehand, leaving the parties with potentially significant tax liability that they did not anticipate. It remains to be seen whether parties will seek to renegotiate or avoid such agreements.
There are indications that Congress is aware of these issues and plans to fix some of them via technical amendments. However, given the unprecedented scope of technical corrections anticipated for the Act, these issues risk getting lost in the fray. HR Legalist will continue to track this issue, as well as the larger issue of non-disclosure agreements in sexual harassment and abuse cases. In the meantime, employers with questions about these issues should consult tax and employment counsel.
The information contained in this publication should not be construed as legal advice, is not a substitute for legal counsel, and should not be relied on as such. For legal advice or answers to specific questions, please contact one of our attorneys.