In acknowledgment of the recent sexual misconduct allegations and the confidential settlements in connection with those allegations, Congress added a new section 162(q) to the Internal Revenue Code as part of the Tax Cuts and Jobs Act. The new section prohibits companies from deducting costs related to sexual assault and sexual harassment settlements that are subject to nondisclosure agreements. While motivation for this new provision was a well-intentioned nod to the #MeToo movement, this new provision may have unforeseen consequences.
Section 13307 of the Act provides as follows:
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.”
Prior to the inclusion of this provision, the law permitted tax deductions for confidential settlement arrangements and attorneys’ fees incurred in connection with these settlement arrangements. The law did not specifically address settlement arrangements containing claims of sexual harassment or sexual abuse.
The new provision was likely designed to deter companies from seeking nondisclosure agreements in connection with sexual assault and sexual harassment settlements and to consequently protect victims of sexual harassment. However, this provision of the Act raises a number of questions that remain unsettled:
- First, will this new provision actually deter companies from entering into confidentiality agreements in connection with settlement arrangements in the future? It is unclear whether the tax benefits would outweigh the benefits of a nondisclosure agreement from an employer’s perspective. It is arguable that in certain situations, an employer may find it more valuable to keep the sexual harassment or sexual abuse settlement confidential than to receive a deduction.
- Second, the provision states that “no deduction shall be allowed under this chapter.” (Emphasis added.) If this provision is interpreted literally, it would mean that the provision would apply to all of Chapter 1 of the tax code, which covers business entities and individuals. Consequently, it could preclude deductibility for not only the employer but also the plaintiff.
- What is the definition of a claim related to “sexual harassment” or “sexual abuse”? Neither term is defined in the Act. What if the settlement arrangement consists of a variety of claims? The new legislation does not appear to address this possibility.
- Further, what is the actual effect of this provision on the victims of sexual harassment? Under the Act, victims of sexual harassment may be required to pay taxes on the full amount of the settlement they receive if the settlement is subject to a nondisclosure agreement, even where a portion of the settlement payment goes to their attorneys for legal fees. This may result in lower net settlement amounts for plaintiffs. Moreover, this may discourage sexual harassment victims from coming forward at all. The provision seems to ignore the fact that a victim may prefer to keep his or her claim confidential.
- Do the sexual harassment or sexual abuse claims need to be actually proven for this provision to apply, or does it apply to allegations of sexual harassment or sexual abuse?
- Is the prohibition on deductions for attorneys’ fees limited to the fees associated with the drafting and negotiation of the settlement arrangement, or does it extend to all of the fees associated with the settlement?
Because of the numerous questions resulting from this provision of the Act, many commentators are predicting the issuance of technical corrections to the Act in the upcoming year. Until then, employers and employees alike may want to be cautious in applying this law. Importantly, employers can continue to require that their employees participate in sexual harassment and misconduct trainings to avoid sexual harassment and sexual abuse from occurring in the workplace.