On December 22, 2017, President Donald Trump signed sweeping tax reform legislation. Most of the tax changes take effect beginning in the 2018 tax year. But a little-publicized aspect of the law may affect some 2017 returns. More notably, and surprisingly, it results in the Internal Revenue Code leading the way as the first federal statute of general applicability to be amended in direct response to the #MeToo movement.
Section 162 of the Internal Revenue Code establishes tax deductions for ordinary trade or business expenses. The December 2017 tax reform legislation added a new subsection (q). Senator Bob Menendez (D-NJ) introduced this component to the complex tax bill in response to recent media attention to sexual harassment/abuse.
Section 162(q) provides that:
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.
Despite the extensive (and well-warranted) attention on the underlying societal issue of sexual harassment and on the tax reform generally, this new Code provision has largely flown under the radar. However, it has potentially broad consequences for businesses and individuals trying to resolve disputes—perhaps including those involving no allegation of sexual activity.
What Does It Mean?
This amendment appears to apply to all amounts paid or incurred after December 22, 2017. Accordingly, it would affect pre-existing settlements with payments made since then. By destroying the tax deduction, this will increase the net settlement cost paid by businesses who had no way of anticipating the change in tax law when they agreed to resolve their dispute.
Going forward, at least, the parties can attempt to plan for the impact of Section 162(q). However, many important questions remain unanswered.
First, the Code does not define “sexual harassment” or “sexual abuse.” Nor does it define “nondisclosure agreement.”
Moreover, neither the Code nor the Congressional Conference Report on the tax reform legislation further explains which “settlements” or “payments” are “related” to sexual harassment or sexual abuse.
And here’s another wrinkle. As written, Section 162(q) could even be read to result in the beneficiaries of the settlement proceeds (e.g., the claimant employees) having to pay income tax on previously excluded portions of the settlement proceeds, such as their attorneys’ fees, including those paid by the employer to the employee’s attorneys as a component of the settlement. Although Section 162 generally addresses business deductions, subsection (q) refers to any deductions “under this chapter,” broadly encompassing most of the basic income tax provisions of the Internal Revenue Code. Does this encompass, for example, Section 62(e)’s deduction for “attorney fees and court costs paid by, or on behalf of, the taxpayer in connection with any action involving a claim of unlawful discrimination”? As a policy matter, it seems doubtful that Congress intended to disadvantage a victim of sexual harassment or abuse. But it further demonstrates the lack of clarity in this amendment.
Hopefully, we will eventually receive clarifying guidance from the IRS on these key components of the new provision. Meanwhile, both employers and employees must wrestle with the new statutory language in resolving employment disputes.
How Will This Affect Settlements?
Section 162(q) will most often come up in the employment context. In some cases, an employer and an employee (or former employee) will be settling an asserted claim involving sexual harassment or sexual abuse (or circumstances that may reasonably fit into those undefined terms). In other circumstances, the employer may be seeking a general release to cover all employment-related claims where the employee has not specifically alleged sexual harassment/abuse.
In the first situation, the employer will certainly need to be aware of and weigh the trade-off between a nondisclosure agreement (to preserve confidentiality) and the tax deduction (which reduces cost). The employee may have the same trade-off, though perhaps with a lower financial impact (with no certainty at this point on how 162(q) will apply to individuals).
In the latter situation, employers should re-evaluate their use of relatively standard broad release language. Such provisions often have the employee waive any and all claims arising out of earlier events, including claims under Title VII of the Civil Rights Act of 1964 and similar state laws that, among other things, prohibit sexual harassment as a form of employment discrimination. Where employers still want to obtain confidentiality assurances from the employee that may qualify as a “nondisclosure agreement” in connection with such a release, it may be prudent to specifically disclaim any release of claims “related to sexual harassment or sexual abuse,” assuming there are no known circumstances that may support such claims.
This is not the only tax consideration related to settlement of employment-related claims. Parties also must consider allocations of back pay and other forms of damages, such as reimbursement of expenses, attorneys’ fees, etc. This can affect both whether the employer must make withholdings and the employee’s income taxes. Section 162(q) adds an additional consideration in these situations—and one, at this point, that raises more questions than clear answers.