The Cost Of Confidentiality: Employers Must Weigh Options When Settling Sexual Harassment Claims

By Paloma Peracchio

The price of confidentiality just went up.  Following the passage of the Tax Cuts and Jobs Act (the “Tax Act”) in December 2017, employers entering into settlement agreements with employees for claims of sexual harassment or sexual abuse will now need to weigh their desire to deduct the settlement cost as a business expense against their desire to keep the allegations of harassment/abuse confidential.  Note this does not apply to government entities, only private companies.

Ordinarily, employers may deduct the ordinary and necessary expenses they incur in carrying on their trade or business – including legal settlements or payments to plaintiffs and their attorneys, and legal fees the employer incurred in defending against the plaintiff’s claims. However, the Tax Act added a new section to the Internal Revenue Code (Section 162(q)) that eliminates tax deductions for settlements or payments related to sexual harassment or abuse and attorney’s fees related to that settlement/payment if the payment is subject to a nondisclosure agreement.

This provision is widely believed to be in response to the “#metoo” movement of the last year which incited widespread exposure of sexual harassment in the workplace.  Advocates for victims of sexual harassment in the workplace have characterized these settlement payments and nondisclosure agreements as “hush money” designed to cover up inappropriate corporate conduct.  Therefore, this new provision is designed to take away some of the appeal of settling sexual harassment claims in exchange for confidentiality.

The law was intended to make it harder for employers to “silence” victims, and the immediate result is that it will now be more costly for employers to obtain confidentiality related to sexual harassment claims because the employer will no longer be able to deduct any payments or legal fees related to the settlement of these claims.

Another issue is that the new law applies to settlements related to “sexual harassment or sexual abuse,” but does not define those terms.  Thus, although employers may attempt to structure settlements to avoid having it classified as related to sexual harassment, the IRS has authority to go beyond the terms of the settlement to confirm the purpose of the payment – including reviewing the complaint, the docket, or other documents in the lawsuit.

There are also open questions about exactly which deductions the IRS intended to preclude in connection with the confidential settlement.  For example, does it apply to expert witness fees?  What if the employer carries Employer Professional Liability Insurance and the carrier makes the settlement/attorney’s fee payments? Does the insurance company no longer get a deduction?  It is also not yet clear whether or to what extent a deduction may be made for global settlement of claims that include but are not limited to harassment. It would seem the prohibition against deduction would apply to the entire settlement amount if it is a confidential settlement, to avoid companies “bundling” claims together to obtain the deduction, but this has yet to be clarified.

However, the law presents problems for the “victims” of harassment as well.  First, when a plaintiff wants confidentiality more than the employer does – i.e., to prevent the employer from commenting on the settlement or claims – the employer could use this as leverage to lower the settlement offer.  Second, the prohibition against deduction of attorney’s fees could also be read to apply to the plaintiff’s ability to deduct her own legal fees from the settlement payment received.  In the past, plaintiffs could deduct the amount of attorney’s fees paid from the gross settlement amount. However, the broad language of Section 162(q) appears to prohibit a plaintiff from deducting the fees paid to her attorney, meaning she could pay taxes on settlement money she did not receive.  While it is doubtful that the law was intended to place a tax burden on plaintiffs who raise sexual harassment claims, particularly when there is not yet clear guidance on the issue and this interpretation would contravene normal taxability rules, the language of the statute is unclear.

Employers should continue to monitor developments in this area as the law is interpreted.  Employers should also consider the implications of the law when settling cases involving sexual harassment or sexual abuse.

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