The Employer's Legal Resource: Certain Settlement Payments No Longer Tax-Deductible Under Section 162(q)
In light of the recent high-profile sexual harassment claims (and the ensuing #MeToo movement), legislators included a provision that impacts the settlement of certain employment-related claims in the Tax Cuts and Jobs Act (the "Act") passed in late 2017. This particular provision makes payments related to settlement of a sexual harassment or sexual abuse claim non-deductible as a taxable business expense when made in conjunction with a contractual non-disclosure agreement. To protect its financial and business interests, employers should be aware of this significant change which may impact settlement agreements.
Generally, companies are permitted to deduct ordinary and necessary expenses of conducting business, with certain exceptions under Section 162 of the Internal Revenue Code. Prior to the Act, employers could claim as a tax deduction any payments made pursuant to settlement of employment-related claims, including for legal fees incurred in defending such claims. It has become customary for employers to incorporate a non-disclosure provision when settling employment-related claims so that the nature of the claims and the terms of settlement remain confidential. The tax code did not previously address settlement agreements containing claims of sexual harassment or sexual abuse.
The #MeToo movement revealed widespread sexual misconduct allegations and, in many cases, confidential settlements in connection with those allegations. In what has since been casually referred to as the "Harvey Weinstein Tax," Congress added Section 162(q) in response to recent media attention to sexual harassment in the workplace in an attempt to deter employers from including a nondisclosure clause or confidentiality clause in a settlement for sexual harassment claims.
For amounts paid or incurred after December 22, 2017, Section 162(q) prohibits employers from deducting as a business expense costs for any settlement or payment related to sexual harassment or sexual abuse if it is subject to a nondisclosure agreement. In addition, attorney's fees related to such a settlement or payment are not allowed as a deduction. The law reads:
Payments related to sexual harassment and sexual abuse. No deduction shall be allowed under [Section 162 of the Internal Revenue Code] 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.
29 U.S.C. § 162(q).
The terms of Section 162(q) appear straightforward. However, employers must consider its application to complex, real-world employment issues prior to entering into new settlement arrangements to avoid unwelcome surprises at tax time. This provision is not limited to certain employers or business entities. Unlike many federal employment laws, all employers, large or small, must be aware of the financial implications when settling such claims.
As an initial matter, the statutory language does not define the terms "sexual harassment" or "sexual abuse," nor does it address situations in which the settlement or payment is made in conjunction with a broad waiver or release of all claims (whether or not sexual harassment or sexual abuse is directly alleged by the employee).
Additionally, the IRS has provided no guidance to date, via regulations or rulings, as to the tax treatment of a payment where the employer and employee settle multiple claims, only one of which pertains to sexual harassment or sexual abuse. Settlement agreements pre-existing December 22, 2017, may also be adversely affected if the agreement requires a payment to be made after that date.
Until the IRS provides more guidance on the issue, employers must choose between keeping such settlements confidential without a tax benefit or deducting the settlement and related attorneys' fees as business expenses. If settlement is related to a claim under Section 162(q), an employer should consider whether it is more beneficial to the company to take advantage of the tax deduction versus keeping such claims and terms of settlement confidential.
Given the uncertainty surrounding Section 162(q), employers should carefully review all existing standard terms of employment settlement agreements and seek advice from their legal and tax advisors when resolving employment-related claims against the company.
By Helen M. Callahan, firstname.lastname@example.org