Jan. 17, 2017 – The Tax Cuts and Jobs Act of 2017 (Tax Act), signed into law on Dec. 22, 2017, created a new tax code provision that purports to disallow any income tax deduction for any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement.
New IRC section 162(q)1 also disallows any income tax deduction for attorney’s fees related to such a settlement or payment. The effects of this relatively obscure portion of the Tax Act may be significant – for plaintiffs as well as defendants.
Section 162(q) disallows deductions for “any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement,” or attorney’s fees “related to such a settlement or payment.”
There was no legislative history to speak of, nor any regulations or other formal guidance defining the key terms “settlement or payment,” “related to,” “sexual harassment or sexual abuse,” and “nondisclosure agreement” – all of which are critical to understanding how the disallowance is to be applied in practice.
Assuming that these terms will each be afforded something close to their ordinary meaning, it seems clear that new section 162(q) was intended as a disincentive to the use of nondisclosure agreements in the settlement of sexual harassment and sexual abuse claims (whether pre-suit or post-suit) – presumably to allow claimants to name alleged harassers/abusers who might otherwise remain unknown, and to disclose specific acts of misconduct which also might otherwise remain unknown.
Whatever the merits from a broader moral and/or public policy standpoint, a plaintiff’s offer of a nondisclosure agreement as part of a settlement has distinct monetary value in the context of an individual case.2 This monetary value is likely to be significant in a sexual harassment or sexual abuse case, as the allegations alone could have enormous adverse consequences for the defendant. Accordingly, the monetary value of a nondisclosure agreement will typically be at its highest when parties are engaged in “pre-suit” settlement talks – precisely because the name of the defendant and specific allegations of misconduct may be less widely known (if at all).
New section 162(q) will have the clear effect of increasing the cost to a defendant of obtaining a nondisclosure provision in a sexual harassment/sexual abuse case.
More precisely, the cost will be increased by an amount equal to the product of (i) the defendant’s effective tax rate, multiplied by (ii) the value of the settlement or payment that relates to the sexual harassment or abuse claim, plus the defendant’s own attorney’s fees related to such settlement. One’s first reaction to this may be something along the lines of, “Good, make the [INSERT EXPLETIVE] pay if he wants to hush things up so badly!” Indeed, this was likely the sentiment motivating section 162(q) in the first place – that, and the fact that a disallowance of deductions likely helped the Act’s Congressional Budget Office score. However, these revisions have the potential for some very real adverse consequences for sexual harassment or abuse claimants, too.
Effects on Settlement Dynamics
If the cost of a nondisclosure agreement is put out of reach by the disallowance provisions of Section 162(q), sexual harassment and sexual abuse claims that might otherwise have been resolved pre-suit and/or at a monetary premium for a plaintiff are more likely to become contested formal proceedings and/or yield less for a plaintiff.
This, in turn, may increase the overall cost (both financial and emotional) to a plaintiff. To the extent that a plaintiff must accept a lower amount in order to bridge the “gap” created by the disallowance and still obtain a pre-suit settlement, then this new provision will have deprived that plaintiff of the full monetary value of a pre-suit nondisclosure agreement.
The public policy justifications for essentially “de-valuing” a plaintiff’s right to keep silent are not without some merit. But the benefits conferred on future, potential claimants from this approach come at a real cost to current, actual claimants.
Intentionally or not, new Code Section 162(q) would seem to make the “first mover disadvantage” steeper than it already is for sexual harassment and sexual abuse victims contemplating civil legal action.
Even in a “post-suit” setting – where the names of an alleged harasser/abuser and the allegations of misconduct (either generally or specifically) are likely matters of public record – nondisclosure agreements remain a powerful tool in facilitating a negotiated settlement. Claims of sexual harassment and sexual abuse are uniquely fraught for all parties – with strong reputational concerns at stake, on both sides.
A seemingly “zero-sum” contest like this is hard enough already to resolve on a negotiated basis. However, with a properly crafted nondisclosure agreement, parties have a better chance to balance their competing concerns.
When confidentiality of settlement or payment terms is assured, a plaintiff can walk away suggesting that the fact of a settlement alone validates all their claims, and a defendant can walk away suggesting that they simply wanted to avoid the time, effort, and expense of dealing with a meritless claim and move on with their life/business.
No one can claim to be happy, but everyone can claim a victory of sorts. However, if the actual terms of the resulting settlement or payment could be made publicly known –including the amount of the attorney’s fees and litigation costs incurred, relative to the plaintiff’s “take home” proceeds – then both sides (not just defendants) need to worry about the resulting public perception of a “win/loss” calculus based solely on money. This perception may make a negotiated resolution infeasible.
Deductibility of Attorney’s Fees by Plaintiffs
The new disallowance provision, although specifically contained in section 162 (regarding trade or business expenses), purports to apply to all deductions under Chapter 1 of the Code – not just deductions arising under section 162 itself.
Thus, this new disallowance might arguably apply to disallow deductions by individual plaintiffs. This could be significant.
To the extent a settlement or payment relates to a personal “physical” injury within the meaning of section 104(a)(2), then such portion of the settlement or payment would be completely “excluded” from income, not merely “deducted” – so new section 162(q) would not affect those situations.
As a practical matter, most “sexual abuse” claims (as that term is commonly understood) are likely to fall into this category.3 However, it is far more difficult than one might expect to prove a “physical” injury – as distinct from “emotional distress” – in a “sexual harassment” case, especially where there is no physical contact that might otherwise be regarded as “sexual abuse” (e.g., a hostile workplace situation where there may be words or actions of a graphic sexual nature and/or displays of graphic sexually-oriented materials – but no actual touching of the plaintiff).
In these cases, the entire settlement or payment – including amounts required to be paid directly to a plaintiff’s attorney under a contingent fee agreement – are included in the plaintiff’s income, and the attorney’s fees and costs must then be deducted under some other provision of the Tax Code.4
Importantly, section 62(a)(20) was specifically created in order to afford taxpayers a special “above-the-line” deduction for certain attorney's fees in a variety of cases (including sexual harassment and sexual abuse cases5) in order to avoid the adverse effects of miscellaneous itemized deduction treatment under section 212 (specifically, the imposition of alternative minimum tax).6
However, inasmuch as section 62(a)(20) is still a deduction under Chapter 1 of the Code, the disallowance under new section 162(q) may still be operative where there is a nondisclosure agreement.
There may be other protective measures that can be taken in terms of “time-keeping” (even in a contingent fee context) to maximize the deductibility of attorney's fees even when a confidential settlement is unavoidable. Whether these protective measures might work depends on whether and to what extent attorney’s fees are regarded as “related to” a “settlement or payment” that is subject to a “nondisclosure agreement.”
The IRS may attempt to argue that all attorney's fees incurred throughout an entire piece of litigation – from the initial complaint to the final confidential settlement – should be regarded as the fees “related to” the resulting settlement or payment.
However, this seems unduly broad – as much of the heavy lifting in any litigation matter (i.e., pleadings, discovery, pre-trial motion practice, etc.) has to be done with the assumption that there will be no settlement (confidential or otherwise) and that the parties will have to try the case.
A more rational interpretation would be that the disallowance should only be applied to those attorney’s fees associated with actual mediation activities and/or settlement discussions. For example, if a particular case takes 500 hours (from initial demand start to final settlement) and the resulting attorney’s fees (exclusive of costs) are $125,000, you’d have an average hourly rate of $250 per hour.
If time sheets show 470 hours of full-tilt litigation and discovery activity of the sort necessary to prepare for a trial in all events – i.e., not specifically related to settlement – and only 30 hours of actual mediation and settlement activities, it could be argued that only $7,500 of attorney’s fees (i.e. 30 x $250) should be disallowed.7 Again, there is a lot to unpack in the definition of “related to.”
Finally, it should be noted that “costs” would seem to be another area for planning, as the disallowance under new section 162(q)(2) only purports to apply to “attorney’s fees” – not court costs and other litigation expenses.8
Other Planning Concerns and Possibilities
Another significant area of uncertainty is the question of how the terms “related to” and “settlement or payment” will be applied. If an actual claim is made for sexual harassment alone, the application might be reasonably clear where there is a payment made for the express purpose of resolving the claim made.
However, settlements tend to be much broader in scope than a single claim. Moreover, parties might be disposed to enter into “general releases” as part of a transaction – even in the absence of an actual claim made – simply to avoid future disputes. Consider the following scenario:
Employer implements a reduction in force which nominally uses a “last in, first out” approach for identifying the employees to be terminated in each affected department.
One of the employees to be terminated is the only woman in an affected department, is over the age of 40, and is also the only member of a particular race and/or national origin in that affected department. Employer unilaterally (i.e., before any claim is made) offers a severance arrangement which is conditioned upon a complete release by employee of any and all claims she might have (including, but not limited to, sexual harassment and sexual abuse) and further contains a nondisclosure provision. If the employee accepts the severance arrangement without ever having made a claim of her own, then query:
Does the “severance” arrangement fall outside the definition of a “settlement” on account of the fact that there was never any claim made to be “settled” (as distinct from merely being “released”)? Does this even matter if the “severance” is still regarded as a “payment”?
Assuming that the severance would at least be regarded as a “payment,” is that payment properly regarded as being “related to” sexual harassment or sexual abuse if there was never any specific claim of sexual harassment/abuse made, and there is simply a general release of any and all claims? Or would some portion of the payment be “deemed” to have “related to” the sexual harassment/abuse claims released thereby – as distinct from the other gender-based, age, or racial/national origin discrimination claims also released?
If the severance payment may be allocated among the universe of potential claims wrapped up in the general release, could the employer simply include a percentage allocation to which the employee agrees? Or would such a stipulated allocation be disregarded since both parties would seem to benefit from an allocation weighted against harassment/abuse claims – viz. there is no “tax adversity” between them?
Employment lawyers will recognize that this is not an outlandish hypothetical, and these are all questions their clients will need addressed.
Last but Not Least
Last, but by no means least, there is a significant question as to what sorts of contract terms might constitute a “nondisclosure agreement” for purposes of section 162(q). This is an important consideration, as it may suggest other practical solutions that might avoid engaging section 162(q) in the first place.
For instance, if a plaintiff agrees to retract their allegation of harassment/abuse and/or specifically deny same, would a contract provision prohibiting any statement to the contrary – but not prohibiting disclosures generally – constitute a “nondisclosure agreement?”
Hopefully, the IRS will be issuing regulations or other formal guidance in the near term, as new section 162(q) applies with respect to all settlements, payments, and attorney’s fees from and after the date of enactment. Already, there are far more questions than answers.
1 See Tax Cuts and Jobs Act of 2017, P.L. 115-97 (December 22, 2017), at Section 13307.
2 See, e.g., Eugene Amos, Jr. v. Commn’r, T.C. Memo. 2003-329 (2003) (Tax Court unilaterally allocated 40% of settlement proceeds in an action for claimed personal physical injuries to the agreement of taxpayer/plaintiff not to (1) defame the defendant, (2) disclose the existence or the terms of the settlement agreement, (3) publicize facts relating to the incident, or (4) assist in any criminal prosecution against the defendant. with respect to the incident).
3 See, e.g., C.C.A. 2008-09-1 (Nov. 27, 2007) concluding that, in an apparent case of sex abuse sustained by a plaintiff when he was a minor, “it is reasonable for the Service to presume that the settlement compensated [taxpayer] for personal physical injuries, and that all damages for emotional distress were attributable to the physical injuries” –notwithstanding the fact that taxpayer would have difficulty establishing the extent of the personal injuries due to passage of time and the fact that he was a minor at the time. This memorandum appears to indicate that the Service does not have a lot of interest in putting sexual abuse claimants to their proof where common sense dictates that the conduct complained of might reasonably give rise to some sort of physical injury.
4 See, Commissioner v. Banks, 543 U.S. 426 (2005).
5 See I.R.C. § 62(e)(18), defining the term “unlawful discrimination” broadly to include “[a]ny provision of Federal, State, or local law, or common law claims permitted under Federal, State, or local law–(i) providing for the enforcement of civil rights, or (ii) regulating any aspect of the employment relationship ….”
6 See Office of Chief Counsel Internal Revenue Service Memorandum, Income and Employment Tax Consequences and Proper Reporting of Employment-Related Judgments and Settlements, PMTA 2009-035 (Oct. 22,2008).
7 Note: Even this approach might be overbroad, and it may be appropriate to distinguish between unsuccessful mediation work and the final mediation work actually giving rise to the settlement terms agreed in principle–particularly in cases where a court compels an early mediation before certain dispositive motions are heard, thereby reducing the chances of a meaningful settlement arising from such early mediation.
8 Cf. I.R.C. § 62(a)(20), which expressly applies to “attorney fees and court costs.”