On February 28, 2019, the IRS posted an FAQ clarifying Section 162(q) of the Internal Revenue Code, which was added by the 2017 Tax Cuts and Jobs Act.
As previously summarized by HR Legalist, a strict reading of Section 162(q) indicates that both the employer’s and employee’s attorney’s fees related to the settlement of a sexual harassment claim subject to a nondisclosure agreement may not be deductible. However, it was initially unclear whether Congress actually intended to prohibit harassment victims from deducting their attorney’s fees related to settled sexual harassment claims.
The IRS, in its recent FAQ, clarified that this rule is only applicable to employers and not employees:
Does section 162(q) preclude me from deducting my attorney’s fees related to the settlement of my sexual harassment claim if the settlement is subject to a nondisclosure agreement?
No, recipients of settlements or payments related to sexual harassment or sexual abuse, whose settlement or payment is subject to a nondisclosure agreement, are not precluded by section 162(q) from deducting attorney’s fees related to the settlement or payment, if otherwise deductible. See Publication 525, Taxable and Nontaxable Income, for additional information on when all or a portion of attorney’s fees may be deductible.
Publication 525, available here, permits employees to deduct certain attorney’s fees and court costs related to an unlawful discrimination lawsuit as adjustments to income, rather than as a miscellaneous itemized deduction. See Publication 525, page 30, “Deduction for costs involved in unlawful discrimination suits.”
Thanks to the clarification contained in this FAQ, we now know that only the employer’s attorney’s fees related to the settlement of a sexual harassment claim subject to a nondisclosure agreement are not deductible. This removes some uncertainty for employees, and will help facilitate settlements of these types of claims.
As previously discussed by HR Legalist, settlement and severance agreements often contain common boilerplate language releasing all employment-related claims, including sexual harassment claims. When Section 162(q) was first enacted, both employers and employees had an incentive to include a “carve out” provision, excluding any sexual harassment or abuse claims from a confidential settlement or severance agreement, in order to avoid losing potential tax deductions. This latest clarification removes that incentive on the part of the employee who would be signing off on the settlement or severance agreement.
However, employers still need to carefully consider the implications of Section 162(q), especially in larger-value settlements or settlements of employment claims that include sexual harassment or abuse allegations. In some instances, Section 162(q) will force employers to choose between two less-than-ideal results: a non-confidential settlement of a sensitive sexual harassment claim, or the loss of a valuable tax deduction for the business. Employers facing this situation, or with questions about the impact of Section 162(q) in general, should consult tax and employment counsel.