Confidential sexual harassment settlement payments no longer tax-deductible

by McAfee & Taft
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In a workplace era that may soon be referred to as “Pre-Weinstein,” employers not only could quietly settle sexual harassment claims by including a nondisclosure agreement that virtually assured the matter would be kept confidential and out of the public spotlight, but they could also deduct the settlement payment and attorney’s fees as a business expense.

Those days came to an end on December 22, 2017, when the new comprehensive Tax Cuts and Jobs Act was signed into law. Buried in the tax reform law is a provision, codified at Section 162(q) of the IRS Code, that eliminates deductions for “any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement.” Deductions for attorney’s fees related to such settlements or payments are also eliminated.

As a result of this new law, employers are now forced to choose between confidentiality and tax-deductibility when settling sexual harassment-related claims.

Clarity needed as questions remain

While one intent of the law, presumably, was to reduce the incidence of sexual harassment and abuse in the workplace by discouraging confidential settlements, the law’s lack of specificity has already started to raise questions. The biggest issue with the new law is that it fails to define “sexual harassment,” “sexual abuse,” or “nondisclosure agreement,” leaving considerable questions as to the scope of the legislation and how it is intended to apply.

For example, many employers will enter into settlement agreements with former employees that include a release of sexual harassment or other gender-based claims, even if the primary claim in the actual lawsuit was not sexual harassment. Employers (and oftentimes, former employees) tend to insist on confidentiality (or nondisclosure) of any such settlement agreement. The failure to define key terms in the new legislation leaves open-ended whether or how the law would apply to settlements of non-sexual-harassment disputes that nevertheless contain a release of sexual harassment claims, or whether other claims like gender discrimination, gender retaliation, or bullying are subsumed by the Act.

Considerations when drafting settlement agreements

While we wait on further clarification from the government, there are steps employers can take to attempt compliance with the new law. In order to avoid application of Section 162(q), employers could consider carving out from settlement agreements any claims or disputes that are unrelated to sexual harassment or abuse; in fact, employers could consider implementing separate agreements altogether: one to cover sexual harassment, and the other to cover non-sexual-harassment based claims. In addition, employers could allocate a portion or percentage of the settlement to the sexual harassment claims, and the remainder to the unrelated claims being settled. Although these allocation provisions are not binding on the IRS, they can be considered persuasive.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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