Passage of the Tax Cuts and Jobs Act (the “Tax Act”) has greatly altered the individual and business tax landscape.  A significant change under the Tax Act is the income tax treatment for employers and employees that are parties to employment-related settlements. (For more information on how the Tax Act affected the taxation of employment-related settlement payments, see Taxation of Employment-Related Settlement Payments). The language of the provisions included in the new tax law leave some uncertainty about how the law will apply in practice. The IRS will likely issue guidance to clarify some of this ambiguity, but until then, employers and employees must take extra care when engaging in settlement negotiations to understand the plain text of the statute and it’s potential implications.

Confidentiality v. Deductibility

Confidentiality in sexual harassment cases will now be more expensive for employers since they will not be able to deduct any payments related to the matter if nondisclosure provisions are included in the settlement agreement. This deduction elimination essentially leaves employers to choose between deducting payments made or retaining confidentiality of the settlement. Since virtually all settlement agreements involving claims of sexual harassment or sexual abuse contain nondisclosure provisions, employers are going to have to think hard about what they value more – money or reputation. This change will likely alter the dynamic of settlement negotiations moving forward, but how that will actually play out remains unclear.

If employers choose to move forward without nondisclosure provisions included in the settlement agreements, they may not be willing to settle for as much as they would if the agreement would remain confidential. Additionally, in cases where the employee would like the matter to remain confidential, employers may leverage this to settle for lesser amounts. On the other hand, if plaintiffs are subject to additional tax liability due to the non-deductibility of attorney’s fees paid by the employer, plaintiffs may want to increase settlement amounts to account for this additional tax, which will make settlements more costly. These opposing considerations stand to make settlement negotiations more difficult. Additionally, now that confidentiality may be essentially off the table for employers not willing to lose the deduction, these employers may be less likely to settle all together and would rather take a chance and go to trial.

Scope of the Statute

With the broad language used in the relevant Tax Act provisions, there remains a question about what specific payments the statute disallows deductions for. The statute doesn’t define “settlement or payment related to sexual harassment or sexual abuse.” The statute makes clear that it applies to the settlement payment itself, as well as attorney’s fees, but what about other related fees? Does the statute also disallow deductions for fees paid to experts or investigators assisting with the case? If a plaintiff brings a sexual harassment claim in addition to other discrimination claims, can a portion of the settlement be allocated to the sexual harassment claim to allow for a deduction for the remaining portion? Does the statute apply to false or unfounded claims of sexual harassment or sexual abuse as well? These questions will be left open until the IRS clarifies the statute.

It is also unclear how the IRS will treat payments made in accordance with confidential agreements that broadly waive claims, including sexual harassment. If the IRS views such a payment as “related to sexual harassment,” the payment will not be deductible. Until the IRS clarifies this question, employers should consider including a provision in settlement agreements stating that there was no claim of sexual harassment or sexual abuse and that the payments are not related to such claims, to ensure the payments remain deductible.

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Moving forward, it will be important to keep up to date on any additional guidance issued by the IRS on questions noted above, as well as other uncertainties that arise. Both employers and employees will need to consider these new legal and financial issues when engaging in settlement negotiations involving sexual harassment or sexual abuse.

With so many unanswered questions surrounding settlement agreements, it’s important to speak with an experienced attorney before entering into settlement negotiations with an employee or employer. Attorneys at General Counsel PC are experienced in employment law and are informed of any additional guidance given on these new tax laws. Our attorneys have helped businesses and individuals across Virginia, specifically in Fairfax County, Arlington, Loudoun County, and Prince William. Call General Counsel PC at 703-556-0411 today to see how we can help you get the best outcome for your legal claims.