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August 31, 2018 Legislative Update

Tax Consequences of NDAs for Sexual Harassment Settlements under the 2017 Tax Cuts and Jobs Act

By Kati Sanford Goodner
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Non-disclosure agreements (NDAs) are common practice in the world of litigation. Lawsuits are filed, a certain amount of discovery ensues, and the parties often reach a settlement agreement, which is almost always confidential. As attorneys, we make these settlements confidential, in theory, to protect all parties. In reality, NDAs are most often drafted to protect defendants who likely have been accused of all manner of horrible things, some of which may be true, some not.

While the threat of damages resulting from the breach of an NDA historically has prevented parties from breaching the confidentiality terms, in the era of the #MeToo movement, NDAs related to sexual abuse and harassment claims recently have become much less secure. Recognizing that many sexual abuse and harassment victims are coerced into signing such agreements under pressure from heavily lawyered and deep-pocketed employers, the validity of these NDAs has come under a much higher level of scrutiny, particularly as more victims of sexual abuse and harassment come forward to expose high-profile defendants and their employers.

NDAs and Tax Advice

Although litigators are typically comfortable drafting and negotiating NDAs, most litigators (except those of us who practice in the tax controversy realm) cringe at the thought of having to advise clients on anything remotely related to taxes. NDAs and taxes previously have not overlapped much, if at all, and attorneys defending and settling sexual abuse and harassment claims generally have been able to avoid having to consider how such a settlement might affect their clients from a tax perspective and could refer the occasional tax questions to a tax attorney or CPA. While tax issues are still best addressed by a tax professional, attorneys representing businesses facing sexual abuse or harassment claims need to be aware of the recent change in how settlements for such claims are treated for tax purposes from the standpoint of employers and defendants settling such suits.

Classification Changes under the 2017 Tax Cuts and Jobs Act

Historically, expenses directly connected with a taxpayer’s business—including litigation expenses, attorney fees, and settlements—were deductible under section 162(a) of the Internal Revenue Code. These section 162 expenses for ordinary and necessary expenses paid or incurred during the taxable year cover expenses ranging from salaries to rent payments to supplies and advertising and help reduce the taxpayer’s taxable income. Among the many changes ushered in by the 2017 Tax Cuts and Jobs Act (the Act), however, is a change to the classification of attorney fees, settlements, and payments resulting from sexual abuse and harassment suits. Specifically, the Senate amendment to the Act establishes a new subsection 162(q), which eliminates a business’s ability to deduct settlements or payments and eliminates attorney fees related to such settlements or payments when the settlement or payment stems from a sexual harassment or sexual abuse claim and is subject to an NDA.

For businesses settling sexual abuse or harassment claims, the addition of subsection (q) and the elimination of the ability to deduct the expense of sexual abuse or harassment settlements and attorney fees in situations involving an NDA requires attorneys handling such claims to help their clients navigate the decision-making process for how to structure release and settlement agreements. Clients now must balance the desire for confidentiality and management of potential public relations issues with the additional financial costs of no longer being able to deduct the settlement-related expenses as ordinary and necessary business expenses. For small settlements, the client may determine that the protection of confidentiality offered by an NDA outweighs the additional tax burden. For larger settlements and hefty attorney fees, however, the additional taxes owed may cause the client to think twice about whether or not confidentiality is worth the extra costs.

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By Kati Sanford Goodner

Kati Sanford Goodner is a litigator in the Tax and Business & Commercial Practice Groups of the Knoxville, Tennessee, office of Lewis, Thomason, King, Krieg & Waldrop, P.C., where she focuses on business litigation and tax controversy. She is the executive editor of the TortSource editorial board and and will become the editorial board chair beginning with the 2017–2018 bar year. She may be reached at [email protected].