Should you find your company managing a claim of sexual harassment, many tough decisions lie ahead. Most of those decisions will be aimed at preserving the safety of employees, company reputation, and all-around company health and culture. Often, through discussion and counsel from an attorney, settlement agreements are used as a tool for resolution. While certainly a good tool – they must now be used with some caution due to new Federal tax rules enacted as part of the Tax Cuts and Jobs Act. As we begin the second quarter of 2018 – understanding what new rules apply to your company and any potential company settlements in this tax year is critical.
More on the New Rules. Internal Revenue Code Section 162(q) as added by Section 13307(a) of the 2017 Tax Cuts and Jobs Act may have a significant impact on the way employers, of all sizes, settle sexual harassment claims. Section 162(q) states that no deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if the settlement or payment is subject to a nondisclosure agreement. Section 162(q) goes on to prohibit a tax deduction for attorney’s fees related to sexual harassment settlements or payments if subject to a confidentiality agreement. This new Code Section affects any amounts paid or incurred after December 22, 2017.
Don’t miss what’s key – the presence or absence of a nondisclosure agreement in your settlement of sexual harassment claims is pivotal to determining deductibility of the settlement and associated attorney’s fees. If you as the employer require the alleged victim of abuse or sexual harassment to keep the settlement – and possibly the underlying claim as well – confidential, you must then bear the expense of the settlement in your end of year taxable income. To gain the benefit of a tax deduction, thus lowering your taxable income, there cannot be a provision of confidentiality.
Why Target This Tax Deduction? It appears Congress has concluded that companies have far too often chosen to ignore their hostile work environments over decisiveness and quick action to resolve wrongful conduct in the workplace. Our current societal climate of ongoing discussion related to #MeToo has driven widespread interest in the ways companies have silently handled victims in the workplace. This new Code Section essentially corners company decision-makers into a position where they must assess whether to obtain a tax deduction through disclosure or forgo that benefit in the hopes of maintaining confidentiality over the claim and settlement. No easy assessment, though one that requires careful weighing of the lasting benefits and harms to the company
What Would You Recommend? A pressing concern for many employers is how can they maintain the confidentiality of settlements such that settlement efforts with one employee do not impact company culture or expectations for other employees. An additional concern is whether there are any ways to resolve claims at an agreeable amount and yet still find some way to deduct all or some of the expenditure.
Not all of the answers will come easy as some clarification of new Section 162(q) is needed, which will take time. For instance, still unclear is whether settlements for more than one kind of employment claim impacts the deductibility of settlement amounts and attorney fees for other claims resolved at the same time. Often, a sexual harassment claim is lodged alongside other legally recognizable claims, such as age or gender discrimination. While Section 162(q) expressly states that settlement or payments related to sexual harassment may not be deducted (when confidentiality is required), it does not indicate when a settlement or payment is related to a sexual harassment claim or some other claim.
However, the Tax Court has previously stated it will respect the express allocation of payments in a settlement agreement if the agreement was (1) entered into by the parties in an adversarial context at arm’s length, (2) in good faith, and (3) reflects the “reality” or substance of the settlement. The IRS takes a similar position, but adds that the settlement terms may not be entirely tax-motivated. If any one of these criteria are not satisfied, the IRS will look to the facts and circumstance surrounding the settlement to determine the proper allocation. See Field Service Advice 200146008.
Bottom Line. Ensuring your company effectively manages sexual harassment settlements and payments is critical. Maintaining a critical eye on the financial ramifications of agreements made today that have impacts tomorrow, will protect your company and limit its financial exposure. Before settling any sexual harassment claims, talk to your employment and tax lawyer – you do not want to err in the assessment of what is truly in the best interests of your company. You will need a thorough analysis of the facts and a well-crafted provision for confidentiality, should you proceed with one.
Bottom Line – seek advice early, tailor any settlement agreements you may enter into moving forward and be sure you have considered all the deductibility consequences of nondisclosure provisions.
Gwendolyn Lewis practices in the area of general civil litigation with a focus on employment litigation and counsel, business litigation, and healthcare counsel and litigation.
Erik Lincoln is the founder of Paragon Law, a full-service tax firm providing tax consulting, tax planning, tax dispute resolution, M&A, transactional, and special project services. Paragon Law also specializes in business and real estate law.
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