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.

Claims Involving Sexual Harassment or Sexual Abuse

Under the old tax law, employers could deduct the ordinary and necessary expenses incurred in carrying out a trade or business, which generally included legal settlement payments or other payments made to a plaintiff, such as a plaintiff’s attorneys fees, and other legal fees the employer incurred in the course of its defense.

However, under the new tax law, settlement agreements may be more expensive for both employers and employees. Now, under Internal Revenue Code Section 162(q), employers are not entitled to deduct “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.” This provision seems to also apply to legal fees paid by the employee. There is some uncertainty regarding whether or not “attorney’s fees related to such a settlement or payment” refers to claims of sexual harassment in general, or only to settlements or payments for such claims when a nondisclosure agreement is included. The IRS will likely issue guidance clarifying this ambiguity, but until then employers and employees need to be aware of the possible tax issues.

The Tax Act also eliminated miscellaneous itemized deductions, which was often a way for taxpayers to deduct legal fees that didn’t qualify for an above the line deduction. This elimination further limits the deductibility of legal fees.

Payments Made to the Government or Governmental Entities

Additionally, the Tax Act amends Code section 162(f). The previous version of this provision denied deductions for amounts actually paid to the government or government entities, unless the payment was established as restitution or amounts required to come into compliance with a law that was violated. These amounts were only nondeductible if paid directly to the government, but were deductible if paid directly to a plaintiff. Under the updated version, deductions are denied for any amount paid or incurred to or at the direction of a government or governmental entity in relation to the violation of any law or investigation of such violation. The section doesn’t apply to private claims, but applies to claims brought by the Equal Employment Opportunity Commission. With this change, payments that represent a fine or penalty, whether paid to the government, a government entity, or to a plaintiff, are not deductible. Therefore, treble or punitive damages are no longer deductible, but damages to come into compliance with a law or restitution damages, such as lost wages or recovery for pain and suffering, are still deductible. However, for these restitution or compliance damages to be deductible, the court order or settlement agreement laying out the damages must specifically identify the damages as restitution or damages paid to come into compliance with a violated law. Therefore, parties to settlement discussions will have to take extra care to ensure that the final settlement agreement includes any necessary language to allow the payments to be deductible.

Call General Counsel PC Today

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 staying 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.