Under a new US tax law, employers may no longer be entitled to deduct the cost of settling sexual harassment and abuse claims from their taxable income. This article gives details of the new provision and raises some questions on how it should be interpreted.

By: Jeffrey Ashendorf

Firm: FordHarrison LLP

Under the new US tax law, known as the Tax Cuts and Jobs Act (‘TCJA’), US taxpayers will lose, or have lost, a number of tax deductions. For employers, one they may not be aware of (or may not have had reason to hear about) relates to financial settlement of sexual harassment or sexual abuse claims by employees. Previously, employers generally could deduct amounts paid in settlement of sexual harassment or abuse claims, as well as legal fees paid with respect to these settlements or payments, from their Federal taxable income. Under the TCJA, this deduction will no longer be available if the settlement or payment is subject to a non-disclosure agreement.

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 non-disclosure agreement forms part of the settlement. The actual cost of the settlement will increase by an amount equal to the tax on the (now non-deductible) settlement payment and related legal fees. In the case of a corporate employer, this could be as much as 21% (or more if the non-deductibility carries through to its income tax liability at state level, 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 provision is not the best, and there are several unanswered questions that need to be resolved by the Internal Revenue Service (the ‘IRS’) before the impact of the provision can be fully understood.

Some of those questions are:

  • Can non-deductibility be limited if settlement amounts are specifically allocated to multiple elements of a claim, or is an entire settlement ‘tainted’ (and therefore not tax deductible) if the plaintiff’s claim relates, even partly, to sexual harassment or abuse? Can non-deductibility be avoided completely by structuring a settlement payment so that no part of the amount is attributed to the sexual harassment or abuse claim?
  • Similarly, could non-deductibility be avoided if a non-disclosure provision were included in the agreement, but applied only to claims other than sexual harassment or abuse?
  • If either of the above questions is answered ‘yes,’ can a non-compliant settlement agreement be changed prospectively to comply with the new requirements, so as to avoid non-deductibility of the payments?
  • Does the definition of a ‘non-disclosure agreement’ for this purpose include a generic confidentiality provision? Or a general release of all claims of the type that is included in virtually all settlements? Some definition of ‘non-disclosure agreement’ would appear to be needed.
  • The Code does not define either ‘sexual harassment’ or ‘sexual abuse’; exactly what will constitute each of these for purposes of this new rule? Will the Equal Employment Opportunity Commission’s definition of sexual harassment (at 29 C.F.R. 1604.11) be used? Will the IRS incorporate some other existing definition? Or will the IRS create 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 sexual harassment claim, but sexual harassment was one of the alleged causes of the injury that was the subject of the claim, will that settlement not be tax deductible?

This change became effective on 22 December 2017 (the date TCJA was enacted), and applies to any payment made after that date, specifically including payments made under pre-existing settlement agreements. This means that a settlement reached in November 2017 but paid on 30 December 2017, or any settlements paid in instalments for the past three years that are continuing past 22 December 2017 will no longer be tax deductible, if the conditions apply; that is, settlement of a sexual harassment or abuse claim that includes a non-disclosure requirement. This is subject to the resolution of any remaining uncertainties, as described above; hopefully we will have that resolution sooner rather than later, particularly for those employers whose 2017 tax deductions are being affected.