Deductions for certain employment settlements in jeopardy

Global Publication January 16, 2018

The new tax law changed the legal landscape for employers. Employers may no longer treat sexual harassment settlements subject to nondisclosure as a tax deduction, and they also cannot deduct their related legal fees. Effective December 22, 2017, a provision in the new tax law prohibits deductions for “any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement” and for “attorney's fees related to such a settlement or payment.” Pub. L. No. 115-97 § 13307 (2017), adding subsection 162(q) of the Internal Revenue Code of 1986. Previously, many employers settled employees’ sexual harassment claims confidentially and deducted the settlement payments and related attorneys’ fees as business expenses, and the tax code permitted them to do so if the alleged harassment occurred in the course and scope of employment. Now, read literally, the new tax law would prohibit such deductions if the settlement agreement contains a confidentiality clause prohibiting disclosure. Presumably, the reason for this new provision is the current environment where numerous allegations of longstanding sexual harassment are only now being publicly revealed, starting with the widespread allegations in the entertainment industry and even in public institutions. The tax law appears to express a new public policy aimed at deterring non-disclosure of settlements involving sexual harassment claims.

At present, many employers include broad nondisclosure or confidentiality provisions in their settlement agreements. These provisions generally prohibit employees from discussing the terms of the settlement, including the financial payment, and they also sometimes prohibit employees from discussing their allegations to the extent permitted by law, a clause that raises other issues unrelated to tax deductibility. The new law does not define the term “nondisclosure agreement” or describe the full scope of confidentiality provisions that will trigger the new deductibility prohibition, but standard nondisclosure or confidentiality provisions in settlement agreements are likely covered. Employers may continue to have employees sign broad nondisclosure provisions, but, if they do so, they must be prepared to forego deducting the payments and attorneys’ fees related to the settlement. 

The broad language in the new tax law leaves many questions unanswered. For one, it is unclear whether, and to what extent, employers may partially deduct combined settlements that include other claims, particularly if the parties enter into two agreements, one that is not confidential related to settlement of sexual harassment claims and one that is confidential related to settlement of any other potential claims. Additionally, if the IRS and the courts read the law broadly, then employers may ultimately be unable to deduct more expenses related to employment claims than Congress seems to have intended to include in its legislation, as sexual harassment allegations frequently accompany claims unrelated to sex discrimination or harassment, and, regardless, settlements typically cover a full release of any and all potential claims. The law also fails to differentiate frivolous allegations from those with firm bases in fact. Still further, the law fails to recognize that it is often employees who seek to have claims kept confidential or who desire confidentiality as strongly as the employer. Indeed, one of the reasons why some employees do not come forward with their allegations is that they do not want to risk losing their privacy.

We anticipate that many unanswered questions will be litigated in the future. At present, it is unclear what will work or how employers will react to the new tax law. We suspect some employers may attempt to parse out a separate settlement agreement for sexual harassment allegations, but this presents the added complication of allocating the appropriate portion of the total settlement to the sexual harassment allegations. It also raises the question of whether the IRS will attack such settlements as a subterfuge to avoid the new tax law. For now, it is clear that employers will have to monitor their trade and business deductions more closely and assess the subject matter of claims beings settled before treating settlement payments and related attorneys’ fees as deductible. This issue involves a business decision for employers, and it may turn on factors such as the marginal impact on tax liability, the importance of keeping sexual harassment settlements confidential, the countervailing view that such settlements should be public and known to those with vested interests such as shareholders and other employees, and the anticipated public reaction should an employer’s choice of proceeding become an issue in the court of public opinion.

Time will tell what impact the new law has on the settlement of sexual harassment claims. We anticipate that many large employers will continue to include confidentiality and nondisclosure provisions, as the added tax burden may not significantly affect their bottom lines, particularly in light of the accompanying drop in the marginal corporate tax rate from 35% to 21%. For these employers, the added tax burden may not be worth the costs of sacrificing confidentiality and justifying settlement deductions to auditors. By contrast, some smaller employers may wish to forego the inclusion of nondisclosure language if tax savings will be substantial. In any event, employers should be aware of this change when settling lawsuits with allegations of sexual harassment or abuse and ensure that they treat any associated payments properly for tax purposes.

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