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Beware of including nondisclosure agreements when settling sexual harassment claims, because neither the settlement payment nor the attorneys’ fees related to that settlement will be deductible under new Internal Revenue Code Section 162(q).
This so-called “Weinstein Tax” denies an 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” and for any attorneys’ fees “related to such a settlement or payment.” This new law is effective for any amounts paid or incurred after December 22, 2017, the date of enactment of the Tax Cuts and Jobs Tax Act.
A lack of definitions of key terms in the law is creating uncertainty as to the law’s scope. In order to preserve a deduction for amounts paid to settle sexual harassment claims, nondisclosure provisions will have to be removed from release agreements. However, the lack of a definition of the term “nondisclosure agreement” makes it unclear as to whether allowing the payee to disclose the agreement and the settlement amount is sufficient to protect the deduction, or whether all confidentiality provisions relating to the alleged harassment or abuse must be removed. Likewise, limitations on an employer’s ability to discuss the settlement (such as agreements not to discuss the circumstances of the plaintiff’s termination with future employers) could be deemed to be nondisclosure agreements that cause loss of the deduction.
As an alternative to eliminating the nondisclosure provisions, a settlement agreement that relates to allegations of wrongdoing in the workplace that are unrelated to sexual harassment or abuse could potentially carve out and preserve such claims in order to avoid applicability of Section 162(q). But, because the law does not define “sexual harassment or sexual abuse,” the law is unclear as to whether claims of sex discrimination or other claims relating to bullying would also constitute sexual harassment or abuse.
Finally, the law is unclear as to when settlements and payments are “related to sexual harassment or abuse.” Thus, in cases in which the facts do not include any allegations of sexual harassment or abuse, a broad release that includes waivers of all claims, which would include sexual harassment and abuse claims among all the many types of claims being released, and also contains a nondisclosure provision, may still be affected by this deduction limitation.
If the IRS interprets the law to only disallow the portion of a payment and the related attorneys’ fees that relate to sexual harassment and abuse allegations, then the parties may want to include allocation provisions in their settlement agreements, such as allocating 10% of the settlement to the sexual harassment/abuse claims and the balance to the other claims that are being settled. These allocation provisions are not binding on the IRS, but their presence in an agreement may be persuasive if a deduction is denied.
The loss of the attorneys’ fee deduction is also unclear. The attorneys’ fee deduction is lost if the fees are related to “such a settlement or payment.” Presumably, that is only a settlement or payment that does not contain a nondisclosure agreement, but this is not clear. However, there is some legislative history that may clear up this issue. The Conference Committee Report on page 279 suggests that the entire provision, including the attorneys’-fees portion, only applies if there is an nondisclosure agreement because it states: “Under the provision, no deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement.”
The loss of the deduction for attorneys’ fees also affects plaintiffs. Even if the provision only applies to agreements with nondisclosure agreements, an employer may still be willing to lose the deduction for the settlement payment and its own attorneys’ fees and may continue to require a nondisclosure agreement as part of the settlement. In such cases, plaintiffs may still lose the deduction for their own attorneys’ fees.
Under a 2005 Supreme Court ruling in Commissioner v. Banks, plaintiffs have to include the gross amount of a settlement amount in their taxable income, and contingency fees that come out of that gross amount must then be deducted under an applicable deduction provision. An above-the-line deduction is available under Internal Revenue Code section 62, but Section 162(q) says no deduction “under this chapter” is allowed if Section 162(q) applies, and Section 62 is in the same Internal Revenue Code chapter as Section 162(q).
Until further guidance is issued by the Internal Revenue Service on these issues, clients who make any payments that could be construed as settling a sexual harassment or abuse claim should use caution when including any sort of nondisclosure or confidentiality provisions when making those payments.
For more information regarding this alert, please contact a member of the firm's Labor & Employment Team.