Sexual Harassment Settlements With Non-disclosure Agreements Are No Longer Tax Deductible.

 

The 2017 Tax Cuts and Jobs Act (the “Act”) affects employers who settle sexual harassment claims and wish to keep the settlement from being disclosed.

Payment of a judgment or settlement of a lawsuit or claim is generally deductible under §162 of the Internal Revenue Code of 1986, as amended (the “Code”), as a business expense when the subject of the claim is a business matter.

The Act added a new subsection, §162(q), whereby the business expense deduction is disallowed for any settlement or payment made, including attorney’s fees, in settlements for sexual harassment or sexual abuse claims when the settlement or payment is subject to a non-disclosure agreement.

Employers must now weigh the tax benefit of a deduction against the intangible value of a non-disclosure agreement. Section 162(q) conceivably applies to a wide range of business relationships, whether it be employer-employee, client-contractor or retailer-customer. This provision of the Act is effective for any payment incurred after December 22, 2017.

Options to Manage Multiple Claims 

In many EEOC charges and employment suits, employees bring multiple claims in addition to sexual harassment claims. For instance, what if an employee brings a sexual harassment claim and an age discrimination claim?

One option may be to break down the settlement payments into separate agreements whereby the parties allocate specific amounts to each claim (e.g., $10,000 for age discrimination, $1,000 for sexual harassment, etc.), and allocate attorney’s fees by the same break-down percentage. This bifurcation could be subject to IRS challenge. The IRS may argue the “origin of the claim” was the sexual harassment incident and accordingly, the deduction for all expenses related to the settlement would be disallowed.

In cases not involving known harassment claims, the settlement agreement should include specific language that ultimately dictates the payment is not related to the sexual harassment claim and the employee represents that s/he was not the victim of sexual harassment. That, of course, might have potential consequences on the validity of the release if a future harassment claim were filed.

While these options are creative-without specific IRS guidance-it is unclear whether the IRS would interpret “related to” to encompass settlements for claims that were brought in conjunction with sexual harassment claims, regardless of the final settlement structure.

As the IRS begins to issue rulings and regulations related to new §162(q), we will better understand the expanse of the disallowance of the deduction.

Alternatively, the employer is faced with the same disallowance for the deduction when it is forced to fire an employee for sexual harassment claims against the employee. Although the employee may not be entitled to much in the way of severance payments, the deductibility of the attorney’s fees would still be disallowed.

Immediate Review: Employment Agreements

In the meantime, employers should revisit the language in their employment contracts, paying particular attention to the confidentiality provisions that would apply during and after a term of employment.

Until the IRS provides more guidance, the employer should exercise care in paying severance under existing employment agreements with non-disclosure provisions in the event that an underlying reason for the severance was a claim of sexual harassment. By attacking non-disclosure on the front end, parties could execute an employment agreement or settlement agreement without a non-disclosure agreement and still be afforded the beneficial protections of confidentiality created by the earlier contract.

In addition to IRS regulations, it is likely amendments to the new law are on the horizon. In the meantime, employers should continue to rely on counsel for review and revision of current employment agreements, as well as drafting settlement arrangements address these concerns.

Conclusion

This is a significant change in the law as it applies to business deductions and we want business owners and HR professionals to work hand-in-hand with their CFO, financial advisor, and attorney to develop the best game plan for the business.

Article brought to you by:

Victor Cardwell
Principal and Chair
Labor and Employment Practice Group

Leah M. Stiegler
Associate
Labor and Employment Practice Group

Joshua C. Wykle
Of Counsel
Tax Practice Group