You have probably heard about the many tax deductions that you are losing (or have lost) as a result of the new tax law (known as the Tax Cuts and Jobs Act, or TCJA). But, if you are an employer, one that you may not have heard about – or may not have had reason to hear about – is loss of the Federal income tax deduction for amounts paid in settlement of claims relating to sexual harassment and/or sexual abuse, as well as attorneys’ fees paid with respect to any such settlement or payment, if the settlement or payment is subject to a nondisclosure agreement.

Obviously, this will have a major effect upon the economics of any settlement that an employer may enter into in cases involving claims of sexual harassment or abuse, where a nondisclosure agreement is desired, as the actual cost of the settlement will increase by an amount equal to the tax on the now-nondeductible settlement payment (and related attorneys’ fees). In the case of a corporate employer, this could be as much as 21% (or more if the disallowance carries through to its state income tax liability, if any). For an employer subject to individual tax rates, such as a partnership, the cost could be much higher, as the individual rates are potentially much higher. However, the wording of the new Code provision is not the best, and there are several unanswered questions that need to be resolved (by the IRS) before the impact of the provision can be fully understood; some of those questions are:

  • Can nondeductibility be limited if settlement amounts are specifically allocated to multiple elements of a claim, or is an entire settlement “tainted” if the plaintiff’s claim is even partly attributed to a sexual abuse claim? Can nondeductibility be avoided completely by assigning no part of a settlement payment to a sexual harassment or sexual abuse claim?
  • Similarly, could nondeductibility be avoided if a nondisclosure provision were included, but applied only to claims other than sexual harassment and/or abuse claims?
  • If either of the foregoing is answered “yes,” can a noncompliant settlement agreement be changed prospectively so as to avoid nondeductibility of the payments?
  • Does “nondisclosure agreement” include a generic confidentiality provision? Or a general release of all claims, such as that included in virtually all settlements? Some definition of “nondisclosure agreement” would appear to be needed.
  • The Code also does not define either “sexual harassment” or “sexual abuse”; exactly what will constitute each of these for purposes of this new rule? Will the EEOC definition of sexual harassment (at 29 C.F.R. 1604.11) be utilized? Will the IRS incorporate some other existing definition? Or will the IRS prescribe its own definitions of the relevant terms? (Even though it would be rather confusing were the IRS to provide its own definitions, that has never stopped them before.)
  • When is a payment considered “related to” sexual harassment or sexual abuse? If there was no actual claim of sexual harassment, but sexual harassment was one of the alleged causes of the injury that was the subject of the claim, will that settlement be subject to disallowance?

This change became effective on December 22, 2017 (the date TCJA was enacted), and applies to any payment made after that date, specifically including payments made under pre-existing settlement agreements. So a settlement reached in November 2017 but paid on December 30, 2017, or a settlement that has been paid in installments for the past three years that are continuing past December 22, 2017, are both subject to this new disallowance of deduction, if the conditions for the disallowance apply. That is, settlement of a sexual harassment/abuse claim, subject to a nondisclosure requirement, and resolution of any remaining uncertainties that apply in the particular circumstances. Hopefully we will have that resolution sooner rather than later – particularly for those employers who have 2017 deductions in question.