HR Management & Compliance

TCJA Creates Catch-22 for Sexual Harassment Settlements

One of the primary concerns addressed through the #MeToo movement is that claims of sexual harassment in the workplace are often settled discreetly and without scrutiny. For years, employers have resolved sexual harassment claims with a settlement payout in exchange for a general release of the company from all liability. The terms of the settlement would include a confidentiality or nondisclosure clause barring the employee from discussing the allegations or the settlement with others.sexual harassment

In particularly egregious circumstances, this creates a culture of secrecy in which employees are kept in the dark about a supervisor’s, owner’s, or some other individual’s past indiscretions. The recently enacted Tax Cuts and Jobs Act (TCJA) encourages employers not to cloak settlements with a nondisclosure or confidentiality clause.

Deduction Narrowed for Sexual Harassment Payments

Congress took note of the #MeToo movement in its sweeping changes to the tax code last year. The TCJA, which largely took effect on January 1, 2018, has eliminated businesses’ ability to deduct from their taxable income any settlement payments and attorneys’ fees related to a claim for sexual harassment or sexual abuse if the settlement is subject to a nondisclosure or confidentiality clause.

The practical effect of the legislation is that employers must now decide whether to keep sexual harassment settlements confidential or retain the ability to write the settlement off on their taxes. Payments to settle claims and lawsuits ordinarily are deductible business expenses under Section 162 of the Internal Revenue Code. The new law, which adds Subdivision (q) to Section 162, eliminates the deduction for any payment or settlement related to sexual harassment or sexual abuse that is subject to a confidentiality or nondisclosure provision.

The common practice of including a nondisclosure clause in a settlement of sexual harassment claims is strongly discouraged by the new law. Without the benefit of regulations or rulings from the IRS, employers must choose between keeping such settlements confidential without a tax benefit or deducting the settlement and related attorneys’ fees as business expenses.

Section 162(q) further eliminates the ability of employers to deduct from their taxable income the payment of attorneys’ fees related to a settlement for sexual harassment or sexual abuse if the settlement is subject to a nondisclosure agreement. In other words, neither the settlement payment to the employee nor the attorneys’ fees incurred to investigate, negotiate, litigate, and resolve the claim would be deductible.

Broad Application

The new law specifies that the business expense deduction is not allowed for any settlement or payment “related to” sexual harassment or sexual abuse. Clearly articulated sexual and gender harassment claims under state, federal, and local law will fall squarely within the scope of that prohibition. However, the tax implications of inserting a confidentiality clause into a settlement agreement for whistleblower claims that include harassment-based allegations are uncertain.

A difficult situation will arise for employers that wish to confidentially settle a lawsuit, administrative proceeding, or other claim in which sexual harassment is alleged in conjunction with one or more other employment-based claims. Because of the broad language of the prohibition on deductions, the IRS may take the position that the entire action will fall within the purview of the law. Employing tax-efficient resolution strategies is imperative under such conditions.

The IRS likely will take a broad view of the provision, and businesses will need to assess their risk tolerance with respect to tax liability and confidentiality as they structure their settlement agreements. That may be the case even if a separate discrimination or wage claim predominates over ancillary sexual harassment allegations. Accordingly, companies should work with counsel and their tax adviser to structure the settlement of employment claims.

Tax-Efficient Resolution Strategies

Businesses have a number of options to settle claims for sexual harassment or sexual abuse. If a claim isn’t based on allegations that reasonably meet the legal standard for sexual harassment or abuse, counsel may meet and confer in an attempt to convince the employee to voluntarily dismiss the claim before settling the lawsuit. Litigants may also ask the court to dismiss or summarily adjudicate the claim.

Another option is for businesses to settle claims in parts, with only the allegations that don’t involve sexual harassment or sexual abuse being subject to a nondisclosure agreement or the settlement payment being appropriately attributed to each claim according to its value.

For example, if the employee refuses to dismiss a sexual harassment claim or if litigating the case to a motion for dismissal or trial is cost-prohibitive, the parties could apportion the settlement into two agreements so the employer might avail itself of a tax deduction for at least a portion of the total settlement payment.

Importantly, employers must keep in mind that under its “origin of the claim” test and general tax doctrine, the IRS will look at the underlying nature of the claim to determine if expenses and fees were properly apportioned. The true nature of the allegations, which is often apparent on the face of the initial charge or complaint, will likely rule the day.

Of course, the structure of the settlement will depend on the facts and circumstances of the particular case. Companies are advised to consult with counsel and their tax adviser to ensure that the settlement meets their legal and tax-planning goals.

Severance Agreements

The law doesn’t address whether a severance agreement for a departing employee would fall within the scope of Section 162(q). However, the IRS may take the position that the severance payment is nondeductible if the departure is related in any way to a sexual harassment or sexual abuse allegation.

Unless and until the IRS provides guidance on this and other issues, employers and their counsel and tax adviser will need to make the best decision, considering all possible tax and employment implications in light of the specific facts and circumstances of the situation.

Bottom Line

Tax-efficient resolution of the claims is always a major factor in settlement negotiations. The TCJA imposes an additional consideration: whether to settle sexual harassment or sexual abuse claims with a confidentiality clause or deduct the payment and fees at tax time.

Jim Brown and Nicholas J. Ferraro are contributors of California Employment Law Letter, and can be reached at  jamesbrown@duanemorris.com and njferraro@duanemorris.com, respectively.