Payments for Sexual Harassment/Sexual Abuse and Related Attorney Fees are No Longer Deductible if Subject to Confidentiality Agreements

metoo movementThe MeToo movement continues to have impact.  For income tax purposes, payment of a judgment or settlement of a suit or claim arising out of a business matter is generally deductible as a business expense. Under the law before the enactment of recent tax reform, this general principle applied to payments in settlement of claims for sexual abuse and harassment. The new tax bill also reduced the corporate income tax rate to 21% from the previous 35% which means a disallowed deduction of $100,000 would only be an additional cost to an employer of $21,000 as opposed to $35,000 under prior law.

That all changed with the enactment of the Tax Cuts and Jobs Act (“TCJA”) in December 2017. Effective December 23, 2017, payments relating to sexual harassment and abuse claims that would otherwise be deductible will no longer be deductible to the extent that they (i) are payments of a settlement subject to a nondisclosure agreement, or (ii) are payments of attorney’s fees for such a settlement. Specifically, TCJA section 13307 added new Internal Revenue Code (“IRC”) section 162(q), which provides that payments related to sexual harassment and sexual abuse. No deduction shall be allowed under this chapter for any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or attorney’s fees related to such a settlement or payment.

The change appears to have been made in response to recent highly publicized claims of sexual harassment and/or sexual abuse that were hidden from public view because the parties involved agreed to be bound by a nondisclosure agreement.

Scope of Disallowed Deduction

New IRC section 162(q) disallows a deduction for attorney’s fees and payments or settlements “related to” sexual harassment or sexual abuse where the settlement or payment is subject to a nondisclosure agreement. As discussed below, this new provision yields some ambiguities and some currently unanswered questions.

“Related To” Sexual Harassment / Sexual Abuse

How primary the issue of sexual harassment or abuse has to be in a claim in order for a settlement payment to be “related to” it is not exactly clear. For example, if a plaintiff brings a claim for retaliation in conjunction with a claim for sexual harassment and is paid a single settlement amount for all claims, is the entire amount of the settlement nondeductible if the agreement reflecting the settlement contains a nondisclosure clause?

Currently, the parties to the settlement can decide how much of the settlement should be allocated to sexual harassment/abuse claims. In theory the parties could allocate a very small amount to sexual harassment/abuse claims, but one could expect the IRS to scrutinize how taxpayers choose to allocate settlement amounts for multiple claims in light of these new rules. Neither the IRS nor the Courts are bound by the allocations of damages reached in settlement agreements.

These questions are unresolved and could be clarified with additional guidance from the Treasury Department or Congress.

Nondisclosure Agreements

Nondisclosure agreements can be used to keep all or just certain aspects of a sexual harassment settlement confidential. For example, the parties might choose to allow the nature of the claim to be made public but agree to keep confidential the settlement amount or just the more prurient aspects of the claim’s allegations.

It is not clear how the new section 162(q) would apply to a settlement agreement that only required confidentiality for certain aspects of a sexual harassment settlement or whether such a confidentiality provision would be accepted. The statute could be read to mean that if the plaintiff’s receipt of the payment is predicated on the plaintiff agreeing to the nondisclosure agreement (which is often the case), then the settlement is “subject to” the agreement, even if the agreement does not cover all aspects of the claim and its resolution.

Additionally, could the parties overcome the confidentiality restriction in the statute by allowing plaintiff to describe a certain set of facts underlying the plaintiff’s claims without disclosing the entire settlement? Would such a “permitted disclosure” mean that the payment was not subject to a nondisclosure agreement?

Non-Deductibility for Both Defendants and Plaintiffs

Plaintiff’s counsel (or plaintiff’s tax advisor) might have read the new IRC section 162(q) and thought, “that only applies to the defendant who made the payment of attorney’s fees.” However, this may be a trap for the unwary, or more likely, an unintended consequence of Congressional drafting.
The United States Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005) ruled that plaintiffs must generally recognize as income the contingent fees awarded to their attorneys. However, Congress provided an above-the-line deduction for legal fees in employment cases. IRC section 162(a)(20) to mitigate the harsh result that a plaintiff would be taxed on an amount payable to their attorney.

On the face of the newly enacted IRC section 162(q), the disallowed deduction applies to any payment of attorney’s fees, including such a payment by the plaintiff. The result of this language could be especially harmful for plaintiffs. A plaintiff could be subject to tax on 100% of the settlement, including the portion representing payment of their counsel fees, even when 40% of the settlement amount is paid to her attorney.

The IRS could offer guidance in this area that the deduction is only disallowed for defendants and not for plaintiffs. Or alternatively, Congress could fix this (oversight?) with a technical correction to the statute. Until there is additional guidance or a legislative fix, plaintiffs and their tax counsel will find themselves asking whether Congress really intended to punish plaintiffs in such a fashion.

Further Allocation of Settlement Amounts

Parties in employment-related litigation should currently allocate settlement amounts between wage claims and non-wage claims, as wage claims require employment tax withholding.
Now, parties should consider a separate allocation of settlement amounts between sexual harassment claims and non-sexual harassment claims in order to preserve deductibility for that portion of the settlement that is unrelated to the sexual harassment claim. Further, the parties should also consider a similar allocation of attorney’s fees between amounts related to sexual harassment/abuse and fees related to other claims.

Of note, the IRS is not bound by allocations contained in settlement agreements to which it was not a party. See Robinson v. Commissioner, 102 T.C. 116 (1994), rev’d in part on other grounds, 70 F.3d 34 (5th Cir. 1995), cert. denied 519 U.S. 824 (1996). The parties’ allocation among various claims of the settlement can be challenged where the facts and circumstances indicate that the allocation does not reflect the economic substance of the settlement. See Phoenix Coal Company, Inc. v. Commissioner, 231 F.2d 420 (2d Cir. 1956). However, an allocation in a settlement is generally binding for tax purposes to the extent that the agreement is entered into by the parties in an adversarial context, at arm’s length, and in good faith. Threlkeld v. Commissioner, 87 T.C. 1294, 1306-1307 (1986).

Key Takeaways

There a number of key takeaways and unsettled questions as a result of the new Code provision on the settlement of sexual harassment or sexual abuse claims subject to nondisclosure agreements: The cost of confidentiality is the loss of income tax deductions for payments made to settle sexual harassment/abuse claims and related attorney’s fees. Will the statute be read broadly to encompass other claims settled in connection with a sexual harassment claim? Will the loss of the income tax deduction cause employers to value settlements differently? Will the disallowed deduction for attorney’s fees be extended to plaintiffs, causing a much larger tax liability for plaintiffs than under prior law? Parties may consider larger allocations to non-harassment/abuse claims, though allocations can be challenged by the IRS and may not be respected by the Courts. Will employers forego confidentiality provisions to preserve income tax deductions, perhaps coupled with a policy or practice of transparency or will the desirability for confidentiality be worth the additional cost.

About the Author

Mr. Turanchik is an attorney in the Tax Department at Paul Hastings LLP. The new Code provision is effective for payments made or incurred after December 22, 2017. In fact, payment for punitive damages is deductible. See Rev. Rul. 80-211, 1980-2 C.B. 57. The new tax bill also reduced the corporate income tax rate to 21% from the previous 35% which means a disallowed deduction of $100,000 would only be an additional cost to an employer of $21,000 as opposed to $35,000 under prior law.

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