Companies generally are allowed to deduct all ordinary and necessary expenses paid during the year to carry on a trade or business, including most expenses related to settlement of a lawsuit or claim relating to the business. But expenses such as illegal bribes and fines paid to the government for violation of any law are not deductible in determining a company’s taxable income.

Non-deductibility of Payments under the Tax Act

The recently enacted H.R. 1 (formerly, the “Tax Cuts and Jobs Act” (the “Tax Act”)) (P.L. 115-97) has expanded the list of nondeductible payments to include any settlement or payment related to sexual harassment or sexual abuse if the settlement or payment is subject to a nondisclosure agreement. In addition, the law provides that the attorney’s fees relating to the settlement are nondeductible if the settlement includes a nondisclosure agreement. While the term “nondisclosure agreement” is not defined, it would most likely include any provision that requires the claimant to keep the settlement confidential or secret. This change to Tax Code Section 162 is effective for amounts paid or incurred after December 22, 2017.

Planning for Nondisclosure Provisions in Settlements

Since the investigation and settlement of a sexual harassment claim could include actions in more than one taxable year of the business, company executives may want to make a preliminary decision at the beginning of the investigation about the inclusion of a nondisclosure provision in any settlement, so to have some certainty about the deductibility of the attorney’s fees during the investigation and negotiation of a settlement agreement. If an employee’s claim includes causes of action in addition to sexual harassment, the company may want to allocate a portion of the settlement to the non-sexual harassment claim, so to preserve the deductibility of the portion of the settlement and related attorney fees not related to the sexual harassment claim, if the settlement agreement will include a nondisclosure provision. While the IRS is not required to accept a tax allocation made by the parties, the IRS may be inclined to respect the allocation if it appears reasonable.

Additional Considerations for Employers

Employees alleging sexual harassment may be hesitant to agree to a confidentiality provision because new Tax Code Section 162(q) is so broad—it states that no deduction is allowed under this chapter—that it could be interpreted as prohibiting the claimant from deducting his or her attorney fees. Generally, a claimant has taxable income equal to the full settlement award and is allowed a miscellaneous deduction for the amount paid to his or her attorney. The Committee Report does not differentiate between attorney’s fees paid by the company or paid by a claimant. Hopefully, future guidance will confirm that the drafters did not intend to limit a claimant’s deduction for attorney’s fees in these lawsuits.