Confidentiality Disqualifies Harassment Settlement Tax Deductions

Tax reform provision may result in lower settlement amounts

Allen Smith, J.D. By Allen Smith, J.D. February 23, 2018

​A little-publicized provision in the December 2017 tax reform law was intended to discourage the use of confidential harassment settlements by disqualifying them from tax deductions. But it may lead to lower settlement amounts and more litigation, and it raises many questions for the IRS to answer, management attorneys say.

Companies previously could deduct settlement amounts, including attorney fees, if they were connected to sexual harassment claims arising from business operations, noted Katherine Healy Marques, an attorney with Holland & Knight in New York City.

The tax reform provision states: "No deduction shall be allowed under this chapter for—(1) any settlement or payment related to sexual harassment or sexual abuses if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney fees related to such a settlement or payment."

Employers that still want confidentiality may factor in the disqualification of a deduction when deciding the total amount of a settlement they are willing to pay, said Heather Weine Brochin, a lawyer with Day Pitney in Parsippany, N.J.

If it's a truly scandalous case or involves a senior-level executive, the company may opt for confidentiality and forgo the deduction, said John Lomax, an attorney with Snell & Wilmer in Phoenix. But if the settlement will cost huge sums and can't be deducted, that will make it more difficult to settle, he predicted. Employers might make lower settlement offers, which employees are more likely to reject. "A potential outcome is that more of those cases don't settle and go to trial," he said.

An employer also might be more willing to forgo the deduction if the harassment claim has lower visibility, such as with rank-and-file employees, and can be resolved at an early stage with a modest settlement amount, he added.

[SHRM members-only HR Q&A: What are the different types of sexual harassment?]

Fewer than 5 percent of cases in employment law wind up going to trial, Lomax observed.

Employers may be motivated to keep the amount of the settlement confidential to avoid setting a price for such complaints among its employees, Marques said.

Unanswered Questions

One issue the IRS must clarify is whether the restriction applies to general releases and waivers, such as those commonly entered into as part of routine severance agreements, if those waivers don't carve out sexual harassment or sexual abuse claims, Marques noted. General releases and waivers apply to all claims, including sexual harassment and sexual abuse claims.

If there are multiple claims—some sexual harassment or sexual abuse with other allegations such as disability discrimination or wage and hour claims—the employer may try to apportion which part of the settlement is for sexual harassment or sexual abuse, Lomax said.

"If an employer decides to apportion a settlement despite the lack of guidance on the issue, any allocation should be reasonable based on the facts and circumstances of the case," said Andrew McLaughlin, a lawyer with Stearns Weaver Miller Weissler in Tampa, Fla.

The provisions don't define sexual harassment or sexual abuse, noted Michael Schmidt, an attorney with Cozen O'Connor in New York City, making it unclear whether sex discrimination falls within sexual harassment.

McLaughlin said it's an open question whether the new provisions apply to retaliation claims based on reporting sexual harassment or sexual abuse.

The IRS will need to clarify how it defines attorney fees related to a settlement, he added. "Are all fees incurred during the defense of the lawsuit related to the settlement and therefore nondeductible?," he asked, "or are only the fees directly attributable to the negotiation and drafting of the settlement nondeductible?"

The new tax provision went into effect Dec. 22, 2017. But what if a severance agreement has a confidentiality provision entered before this date but with installment payments continuing past Dec. 22? It's unclear how it will affect to what extent settlements may be deducted, Schmidt noted.

The IRS may clarify if plaintiffs also won't be able to deduct their attorney fees. If it's determined that they can't, "a technical correction to the Tax Cuts and Jobs Act will be needed," said David Rosner, an attorney with Ogletree Deakins in Washington, D.C.


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