Elsewhere I have written about how the so-called “Tax Cuts and Jobs Act” — enacted this past December under the banner of “Tax Reform” — altered relationships between employers and employees. A closer look at three new provisions to the Internal Revenue Code (IRC) is warranted to appreciate some of the surprising (and maybe unintended) implications.
New Section 45S to the IRC generally provides a tax credit to encourage “family and medical leave” and last week the IRS released this brief explanation that will be relevant to many employers. But don’t be too impressed with this congressional largesse as it has a not-so-subtle political component: the credit is not available to the extent employees are in jurisdictions where local law requires employers to provide such leave. So there is generally no benefit to employers in those locations (mostly “blue states” and “blue cities”).
However, I digress — this article is about two other politically-motivated provisions of so called “Tax Reform” that I find far more interesting because of who they affect. New Section 162(q) of the IRC denies a tax deduction 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.
Thus, confidentiality now has a cost in the form of forfeited tax deductions. I can see the wisdom of making it more expensive for businesses to hide evidence of sexual harassment behind such confidentiality agreements, though I am less convinced that businesses will bear this burden rather than plaintiffs. On the other hand, I can also understand that some victims of sexual harassment may prefer to keep their identities private and this new tax law probably makes that objective more expensive for them. At a minimum, this new law will alter how settlement agreements are negotiated and will motivate some parties to settle some cases earlier — and others to go to trial if a confidential settlement is too expensive on an after-tax basis.
More importantly, we the people need to recognize that this new tax penalty doesn’t apply to sexual harassment committed by our elected officials because governments don’t pay taxes. So what’s good for the goose seems to be irrelevant to the gander where the gander is the U.S. Congress (or other non-taxpayers such as governments and tax-exempt entities). That’s because entities that don’t pay taxes are not affected by the economics of denying tax deductions for settlements that include confidentiality agreements. I cannot imagine a good policy justification why a law designed to shine more daylight on sexual harassment claims should be limited to claims against for-profit businesses. If sunlight is supposed to help reduce hostile work environments and discourage serial offenses, why would Congress craft a law that allows sexual harassment settlements to remain shrouded in secrecy just because the (alleged) perpetrators are members of the U.S. Congress, their staff and other employees of governments and tax-exempt entities?
Of course, we can all guess how this tax-focused policy will play out where the harasser is a senior executive or business owner. The brutal reality is that the paying company likely will consider non-deductibility simply a cost of doing business where the executive or business owner is the (alleged) perpetrator. Where businesses are willing to drop their demand for confidentiality, expect to see it replaced with a rigorous non-disparagement provision.
Oddly, under a literal reading of the new rule, the presence of a confidentiality agreement precludes deduction of both the settlement payment and all related attorney’s fees — including the plaintiff’s attorney’s fees! Neither the statute nor the legislative history clearly distinguish between attorney’s fees paid by the plaintiff and those paid by the defendant, which means that a defendant’s willingness to forgo a tax deduction in favor of confidentiality could prove very expensive for the plaintiff. Accordingly, the defendant employer in a sexual harassment suit is still likely to demand confidentiality even if it is not a taxpayer — at a potentially material cost to the plaintiff.
For example, assume that the victim of sexual harassment (or other civil rights violation) hires an attorney to seek redress by suing her employer. After hearing the victim’s story, a good plaintiff’s attorney will inform her that, in the absence of any physical injury, the gross amount of anything recovered from her harasser (or her harasser’s employer) will be taxable to the plaintiff/victim as ordinary income — if she concedes to keeping any settlement confidential — even when the plaintiff/victim likely will need to share 33 percent to 40 percent of her recovery with her contingency-fee attorney. Assuming a combined state and local tax effective tax rate of 40 percent and a 40 percent contingency fee, that means a plaintiff recovering $200,000 — conditioned on a confidentiality provision — from someone who violated her civil rights may be left with a mere $40,000 after paying the tax man $80,000 and paying her lawyer another $80,000. (If the attorney’s fees were deductible, the net recovery would be $72,000.)
Some practitioners have suggested that a sexually-harassed plaintiff might no longer be able to deduct her attorney’s fees even in the absence of a confidentiality provision. Another “tax reform” provision now denies individual plaintiffs the right to deduct attorney’s fees and costs in many situations. Specifically, until 2026, new IRC Section 67(g) disallows deductions for many “miscellaneous itemized deductions.” Legal fees and costs will fall in this category in many cases, such as when they are paid to challenge an IRS tax assessment. However, legal fees incurred in most cases involving sexual harassment will be linked either to employment, civil rights violations, or other forms of unlawful discrimination within the scope of IRC Section 62(e). Pursuant to IRC Sections 62(a)(20) and 63(d)(1), such expenses are still allowed as above-the-line (i.e., non-itemized) deductions (up to the amount of any taxable recovery). Accordingly, to preserve deductibility of attorney’s fees for sexual harassment claims, good plaintiff lawyers will generally find a way to bring such claims under “provisions of Federal, State, or local law (i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship…” or other provision listed in IRC Section 62(e).
Sometimes tax law can prove an interesting means for implementing public policy. Ill-conceived “tax reform” can have exactly the opposite effect. Of course there is no evidence of malicious intent here so maybe the real culprit was just ignorance and incompetence?