As a result of the new tax reform legislation, employers may no longer deduct on their tax returns any “settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement” (emphasis added) or any “attorney’s fees related to such a settlement or payment.”

This change in the tax law became effective on December 22, 2017, when the law was enacted.  Previously, employers who settled sexual harassment claims typically did so confidentially and deducted the settlement payments and related attorneys’ fees as business expenses.

Now, the new rule prohibits such deductions if the settlement agreement contains a confidentiality clause prohibiting disclosure of the settlement or payment.

Now, at a minimum, employers must keep this new rule in mind when settling any claim with an employee if there has been any allegation or suspicion of sexual harassment or abuse.  In those situations, employers will need to consider whether they want to include a nondisclosure provision as a part of the settlement and, if so, take into account the additional cost of the settlement as a result of the lost tax deduction for the settlement payment and any related legal fees (for example, those paid to outside counsel to handle the settlement negotiations).

Because of the drop in the corporate tax rate beginning this year (from 35 percent to 21 percent), the “additional cost” of losing the tax deduction will not be as high as it otherwise would have been for those employers that are taxed as a corporation.

For some employers, the benefit of the tax deduction may not be worth sacrificing confidentiality and potentially having to justify settlement payment deductions to tax auditors.

Beyond these basics, a number of questions exist as to the scope of this new rule.  There is no relevant guidance yet from the Internal Revenue Service, and it is not likely that this rule is high on the IRS’ priority list given everything else currently on its plate as a result of the tax reform legislation.  Some of the open questions relate to the following:

  • Claims of sexual harassment are often accompanied by other claims, such as retaliation and gender discrimination, among many others.  How does this new rule apply to an all-encompassing settlement of these claims?  Is the entire settlement non-deductible?  Can the parties bifurcate the settlement into two separate documents, with one settlement being tax-deductible and the other one not?  Will the IRS respect the parties’ allocation of settlement amounts with respect to the various claims?
  • Individuals who bring claims of sexual harassment or abuse sometimes want the settlement to be kept confidential to preserve their privacy.  Does the new law permit a non-disclosure agreement imposed on the employer at an employee’s request?
  • The law says that the “settlement or payment” cannot be subject to a nondisclosure agreement.  Can the specific allegations of the underlying claim be subject to a nondisclosure agreement?  For example, could disclosure be limited simply to the fact that an allegation of sexual harassment was made, and that it was settled for a specified (disclosed) dollar amount?  Would such a provision maintain the employer’s ability to take the tax deduction?
  • Can a settlement agreement with no specific connection to a sexual harassment claim, but which includes a broad general release of claims that encompasses any potential sexual harassment claims, be subject to a nondisclosure provision and still be tax deductible?  For example, separation agreements signed in connection with a reduction-in-force typically have broad general releases and a nondisclosure provision.
  • How broadly will the IRS interpret the rule that attorneys’ fees that are “related to” a sexual harassment settlement are also non-deductible?  Would the cost of an investigation conducted by outside counsel related to an initial allegation of harassment be “related to” an ultimate settlement?  What if outside counsel was retained only to conduct the investigation and played no further role once it concluded that investigation?  Or is the “related to” provision only intended to cover payments made by the employer to the individual’s attorney?

The genesis of this new rule is no doubt related to the recent media storm of women coming forward with accounts of sexual harassment and abuse (the #MeToo movement) by powerful and well-known men, and the related complaints about how some women are not able to come forward and contribute to that conversation because of confidentiality restrictions to which they have agreed.

As a result, besides the financial implications of maintaining or foregoing the tax deduction, employers should consider the potential public relations and employee morale implications of any decision to keep sexual harassment and abuse settlements confidential or not.  Namely, will an employer wind up suffering a greater loss should its decision to keep such settlements confidential become public knowledge because the employer is then perceived as trying to “stifle” public conversation and “cover up” sexual harassment in its workplace?

Some have speculated that this new rule may make it more difficult for parties to reach a settlement of sexual harassment and abuse allegations, particularly in those cases where the employer believes it has done nothing wrong, but is willing to settle the claim as an economic matter.  The law does not differentiate frivolous allegations from those with firm bases in fact.

Without a nondisclosure provision, will an employer be willing to settle what it considers to be a frivolous claim of harassment?  Would the same employer be willing to forego the tax deduction in order to get a commitment of confidentiality?  Time and experience will bear out these answers.

Whatever employers decide in the interim, they should update any standard separation agreements, severance agreements, and releases of claims accordingly.

If you have any questions, please do not hesitate to contact us.