#MeToo: new tax law impacts the deduction of legal settlement amounts

Image of Pen and Spectacles with Disclosure Agreement

Employment Alert

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For every action, Sir Isaac Newton's third law of motion tells us, there is an equal and opposite reaction. The new Tax Cuts and Jobs Act illustrates this, with a hidden Newtonian bounce regarding the deduction of settlements for claims involving sexual harassment.

As you will recall, December brought not only the new tax law but also Time magazine's designation of "The Silence Breakers" as The Person of the Year. What Time captured in that December 18 headline is paralleled by a provision in the tax act effective December 22, 2017.

From that date forward, Congress has disallowed a corporate tax deduction for any settlement, payout or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure (confidentiality) agreement. Given the ubiquity of confidentiality clauses in employment discrimination settlements, that is significant.

Previously, employers could take a deduction for ordinary and necessary expenses paid or incurred, which included settlement agreements with general releases and nondisclosure agreements. The limitation on such deductions reflects a policy decision to address how confidentiality has facilitated recidivist behavior by prominent harassers.

Significantly, the tax code does not ban confidentiality. Instead, due to concerns regarding employers using nondisclosure agreements to help avoid the court of public opinion, Congress has now forced employers to balance the opposing elements of confidentiality against tax savings: ie, employers can have either, but not both.

There are still open questions, both legal and practical.

First, does this exclusion impact a separation agreement where a former employee releases all claims against an employer even though the demand, charge, or complaint did not specifically assert claims "related to sexual harassment and sexual abuse" (the limiting term that Congress neglected to define)?

Second, what about the precautionary release used in a RIF where there is no charge or demand?

Third, can settlement amounts in such contexts be bifurcated so that only a designated portion is allocated to sexual harassment or sexual abuse, with the balance remaining fully deductible? For more on allocations, see this post on the Labor Dish.

Fourth, drafting a last-minute provision to be voted on after one hour of review creates unintended consequences. There is now concern that this pro-victim provision inadvertently eliminated any deduction of the victim's own attorney fees.

Finally, there is the unknown impact on the price of settlement. Will employers pay less in settlement to account for the tax impact? Will employers forego confidentiality in order to maintain the deduction (or to demonstrate that their business is socially aware) Will such issues be part of the bargaining, as numerous other tax considerations are in employment settlements?

Right now, employers will be making case-by-case judgments pending issuance of IRS guidance.

Learn more about this aspect of the Tax Cuts and Jobs Act by contacting the author or your regular DLA Piper lawyer.