#MeToo Can Be #Costly

Photo credit: iStock.com/Maximusnd

By Jeffrey Davine

General Rule- Deduction for Settlement Payments.

If an employer settles a claim made by an employee (or former employee), the employer may generally claim a deduction for the amount that is paid to the employee to resolve his/her claims.  The expense is treated as an ordinary and necessary business expense and a deduction may be claimed pursuant to Section 162(a) of the Internal Revenue Code.

For example, if an employer pays an employee $25,000 to settle the employee’s claims for back wages, emotional distress, and age discrimination, the employer may deduct the $25,000 on its tax return (the employer’s tax reporting obligations with respect to the $25,000 payment and how the payment should be allocated among the claims made by the employee are topics for a different article).

Change Made by the Tax Cuts and Jobs Act.

Now comes the Tax Cuts and Jobs Act (the “Act”).  The Act was signed into law by President Trump on December 22nd.  One of the more peculiar provisions in the Act addresses the deductibility of certain settlement payments made by one taxpayer (typically an employer) to another taxpayer (typically an employee).

Section 13307 of the Act amends Section 162(q) of the Internal Revenue Code to deny a deduction for any settlement or payment (or related attorneys’ fees) paid or incurred after December 22, 2017 if it is “related to sexual harassment or sexual abuse” if the settlement or payment is subject to a nondisclosure agreement.  Although the language is fairly simple, there is quite a bit of uncertainty as to how it will be applied.  There also appears to be a significant unintended consequence of this provision.

Questions and Consequences.

Clearly, the intent of this provision is to eliminate any benefits that may be provided by the tax law for persons or companies that engage in sexual harassment or sexual abuse.  While the purpose may be a noble one, it’s up for debate as to whether this provision is the best way to accomplish it.

What if a settlement agreement contains a nondisclosure provision and sexual harassment/sexual abuse is only one of several claims made by a claimant?  In theory, the defendant should be able to allocate the payment among the various claims and only be prohibited from deducting the amount paid with respect to the sexual harassment/sexual abuse claim.  What if the sexual harassment/sexual abuse claim is a specious one, will the defendant be allowed to not allocate any portion of the settlement payment to that claim?

Generally, a release in a settlement agreement includes all claims, whether known or unknown.  If a claimant doesn’t specifically assert sexual harassment/sexual abuse but the release in the settlement agreement includes a release of all claims, including sexual harassment/sexual abuse, will some portion of the payment not be deductible?

What actually constitutes sexual harassment/sexual abuse?  Does it require some type of unwanted physical contact or are written or verbal statements sufficient?

One significant and, presumably, unintended consequence of the amendment to Internal Revenue Code Section 162(q).  It denies a deduction for attorneys’ fees paid that are related to a settlement or payment for sexual harassment/sexual abuse claims.  This denial, however, doesn’t distinguish between the claimant and the defendant.  Prior to amendment of Internal Revenue Code Section 162(q), a plaintiff was permitted to claim an “above-the-line” deduction for fees paid to his/her attorney in connection with certain employment related cases.  Internal Revenue Code Section 162(q), as amended, appears to override that provision and deny a deduction if the case includes sexual harassment/sexual abuse claims.  Although denying the attorneys’ fee deduction to a claimant is most likely an oversight by the drafters that will need to be corrected, at present it appears to be the law.

Another potential consequence of the amendment to Internal Revenue Code Section 162(q) is that it might make a defendant less willing to resolve a sexual harassment/sexual abuse claim if a deduction will be prohibited.  In addition, if the “cost” of a settlement increases (due to the fact that no tax deduction will be available), a defendant may offer a lesser amount to settle.  Both of these results will negatively affect claimants.

What Now?

The amendment of Internal Revenue Code Section 162(q) raises many issues.  Unfortunately, it is likely that many of these issues won’t be resolved unless/until Congress and/or the IRS provide some guidance as to how this provision of the Act should be implemented.  Until then, taxpayers will simply have to use their best judgment in applying this provision of the tax law.

Of course, one way to avoid the impact of the new law and retain the ability to deduct a settlement payment made with respect to a claim related to sexual harassment/sexual abuse is to not insert a nondisclosure provision in the settlement agreement.  Unfortunately, this may not be a practical solution, because the vast majority of settlement agreements contain a nondisclosure provision, regardless of the character of the claims asserted.

Please feel free to contact any member of the MSK Tax Practice Group if we can be of assistance.

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