Sexual harassment settlements as tax policy: Non-deductibility of settlement payments and legal expenses

Issue March/April 2018 April 2018 By Richard C. Van Nostrand
Labor & Employment Section Review

The Tax Cuts and Jobs Act passed by Congress on Dec. 22, 2017, includes a surprising provision that may have a significant impact on settlements of sexual harassment and other claims. Under Section 13307 of that act, the Internal Revenue Code provision relative to the deductibility of expenses in carrying on a trade or business was amended to read: 

Payments related to sexual harassment and sexual abuse — no deduction shall be allowed under this chapter for (1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney’s fees related to such a settlement or payment.

The amendment (which becomes Section 162(q) in the tax code) took effect immediately. 

Its sponsor, Sen. Robert Menendez, quoted in a recent New York Times article, articulated the reason for the amendment as follows: “I think most Americans would be outraged to know that they are subsidizing sexual predators in the tax code.” 

Unfortunately, Sen. Menendez’s simplistic view ignores the realities of our adversarial system and that many, many sexual harassment claims are settled where there is a legitimate dispute as to whether sexual harassment ever occurred. As every mediator will tell virtually every litigant, settlement has the benefit of controlling the outcome and risk; eliminating further expense, delays and inconvenience; and avoiding the crucible of an unpredictable trial. Unquestionably, there is a strong public policy that favors settling lawsuits over the contested determination of whether a claim has merit.

Ignoring those other factors that drive settlements, Sen. Menendez’s comment equates the confidential settlement of a sexual harassment claim with an admission of sexual predation. As one who almost exclusively represents employers, I would be loathe to encourage my clients to attempt to settle disputed claims if that admission was required. I would similarly expect that my colleagues on the employee’s side of the bar would not embrace the concept of having a potential settlement effectively held hostage by such a prerequisite.

Setting aside that conundrum, what this amendment now does is introduce yet one more tax consideration into the settlement milieu. Practically speaking, attorneys representing both employers and employees must familiarize themselves and their respective clients with the impact of confidentiality provisions upon the settlement of employment claims. 

Settlement of sexual harassment claims

The problem. This amendment to the tax code unquestionably comes into play in a case that directly involves a sexual harassment or sexual abuse claim. Counsel on each side of the aisle must be prepared to advise their respective client accordingly.

On the employer side, the inclusion of a provision by which the claimant agrees to keep the existence and terms of the settlement private and confidential will mean that neither the settlement payment amount nor any attorney’s fees related to that settlement may be taken by the employer as deductible business expenses. Accordingly, the employer must make the initial determination as to whether the confidentiality of the settlement is of sufficient importance that it is willing to forego the tax deduction. If the deductibility of the settlement and attorney’s fees is critical to the economics of the settlement, then no confidentiality provision should be included. The employer, however, should consider whether the cost-benefit analysis is sufficiently altered to warrant passing that increased tax burden along or sharing it with the employee by a reduction in the settlement amount. 

In its current articulation, the amendment is an equal opportunity depriver. On the employee side, the inclusion of a non-disclosure provision will also mean that the employee’s attorney’s fees related to that settlement will also not be deductible. More specifically, this amendment will mean that such fees may not be offset by the employee against the taxable portion of the settlement. Given that impact, the employee should make the determination as to whether to insist on some equivalent benefit as part of the settlement in return for the inclusion of the confidentiality provision.

Needless to say, this amendment is likely to make settlement negotiations even more difficult as each side attempts to shift the negative effect to the other.

A two agreement approach and attendant risk. A possible approach that has been suggested by some to try to preserve some measure of confidentiality of such settlements without sacrificing tax deductibility is to utilize two separate settlement agreements. In this approach, the employer and the employee would execute two agreements — one releasing claims for sexual harassment and sexual abuse and the second releasing all claims against the employer other than those for sexual harassment and sexual abuse. Both would have confidentiality provisions, but the lion’s share of the total consideration to be paid would be loaded into the second agreement. The sexual harassment settlement agreement would be supported by a more modest percentage of the total consideration. Arguably, only that agreement would be governed by the tax code amendment and, therefore, only that modest amount and the attorney’s fees of both the employer and employee associated with that settlement would be non-deductible. 

While disproportionate consideration would not jeopardize the enforceability of the two settlement agreements from a contractual perspective, the approach is not without risk. It does not take much imagination to envision the IRS rejecting certain deductions in a situation where a sexual harassment claim with inflammatorily pleaded facts is settled for $5,000 while all other employment-related claims which may not have ever been asserted are simultaneously settled for $195,000. Because of reporting requirements relative to both settlements, it would not likely be a difficult investigatory task by the IRS to trace the bread crumbs and disallow the deductions. 


Blanket releases of all employment-related claims

The problem. Even in a case in which no sexual harassment or sexual abuse claims are expressly asserted, the amendment can be a trap for the unwary. If the settlement agreement contains a nondisclosure provision, it can potentially have the same unfortunate tax ramifications if the release in the settlement agreement sweeps too broadly. This arises as a result of the prevalent practice of trading the settlement payment for a comprehensive peace. 

In virtually every settlement of a claim made by an employee (and even in the documentation surrounding severance payments where no claims have been made), it has been common practice for employers to include a broad release of any and all claims arising out of the employment relationship, and to include a non-disclosure provision. This broad release, which by its nature sweeps in potential claims of sexual harassment or sexual abuse, may also trigger the non-deductibility provision of the tax amendment. Various ideas have been floated to try to avoid this unintended consequence. 

Express disclaimer and attendant risk; employee representation. In such cases, one approach that should preserve the deductions would be to expressly disclaim that the release applies to claims of sexual harassment or sexual abuse. From the employee’s perspective, it is difficult to imagine any objection to that approach — essentially it would mean that employee would be releasing fewer claims for the same consideration. 

An attempt by the employer to fix the problem in this manner, however, may create a different one. While such a disclaimer would preserve the deductibility of the settlement payment and legal expenses, it leaves the employer open to a subsequent claim of sexual harassment. If the time period to assert such a claim has expired, the employer may consider this potential exposure sufficiently slight to adopt this approach. If that limitations period has not run, this could result in an employer believing it bought peace only to find itself in the midst of a subsequent war.

A potential work-around for that problem could be including an express representation by the employee that he or she had not experienced any sexual harassment or sexual abuse during the course of employment. If that representation is accurate, the employee should not be hesitant to sign it. While not as good as a release, such a representation is of benefit to the employer due to its deterrent value, or alternatively, its potential to flush out a claim about which the employee has remained silent.

Exclusion by omission and attendant risk. In some iterations of this type of agreement, the release language contains the specific delineation of every possible type of employment-related claim (e.g., release of claims arising under any federal, state, or local law relating to employment, discrimination, retaliation, harassment, breach of contract, fraud, identity theft, tortious interference, emotional distress, or any common law claim). Another approach would be for the employer to use only a broad form release without identifying any claims specifically. A variation on that theme where a litany of specific types of claims are identified would be to omit “sexual harassment,” “sexual abuse,” “harassment,” “abuse” or similar words from that list. If the IRS takes an aggressive approach, however, either form of release (broad or specific) could potentially jeopardize deductibility for both the employer and the employee. 

Complicating the problem

Questions, questions and more questions. Because of the brevity of the amendment, numerous questions arise about how its language will be interpreted by the IRS or the courts. The answers to these questions will be critical for the advice attorneys give their clients, whether employee or management. Some of those questions include:
  • Will the IRS take an aggressive approach to this exclusion?
  • How will it interpret the word “any” in “any settlement or payment related to sexual harassment or sexual abuse?” 
  • How will the phrase “related to” be interpreted in practice?
  • Will a claim for retaliation for asserting a sexual harassment claim be interpreted as “related to sexual harassment or sexual abuse” even if the underlying claim lacks merit?
  • If the two-agreement approach is adopted, how likely is it that the IRS will “look behind the curtain” at the claims asserted, the settlement payment and attorney’s fees amounts and the deductions taken?
  • Must a claim first be expressly asserted by the employee before the exclusion will apply?
  • If so, must that expressly asserted claim be for sexual harassment or sexual abuse?
  • Will this provision apply to agreements required in return for the payment of severance where no claims have been made?
  • How broadly will the phrase “nondisclosure agreement” be interpreted?
  • Will a non-disparagement provision prohibiting the disclosure of negative statements about the employer also trigger the non-deductibility penalty? 
Is clarification forthcoming? By the enactment of the Tax Cuts and Jobs Act, Congress has dramatically increased the workload of the IRS. Any clarification from that agency on how this relatively minor provision will be interpreted is not likely to be coming soon. Similarly, it will undoubtedly take quite some time for this issue to materialize on tax returns, mature into a battle between the IRS and a taxpayer, and result in guidance from the courts. Absent such guidance, counsel for employers and employees alike should be cautious in their advice, but thorough in their identification of the risks associated with confidentiality provisions in the settlement of employment claims. 
The recent tax bill has certainly stirred considerable debate about its economic merits. It is probably safe to say, however, that not many of us anticipated that the current revelations about sexual harassment would also become part of that tax bill’s landscape. Now that it has, yet another tax conversation will need to be incorporated into the settlement negotiations of employment claims.