The Tax Cuts and Jobs Act (the "Act") was signed into law by President Trump on December 22, 2017, and, for the most part, took effect on January 1, 2018. As employers undertake tax planning efforts and assess the impact of the Act on their businesses for 2018, they should be aware of some significant changes impacting employment-related business deductions and tax credits.
In a nod to the recent proliferation of high-profile sexual harassment claims that have been in the public sphere, the Act eliminates the ability of companies to deduct from their taxable income any "settlement or payment related to sexual harassment or sexual abuse" (including attorneys' fees) if the settlement is subject to a nondisclosure agreement. In addition, the Act provides a new tax credit for employers who provide up to 12 weeks of paid family leave in certain circumstances. It is important for employers to understand both of these changes and how they impact company policies and practices.
Deduction Eliminated for Confidential Settlements Related to Sexual Harassment or Abuse
As noted above, the Act eliminates tax deductions for settlements and other payments related to sexual harassment and abuse if those settlements are subject to a nondisclosure agreement. While relatively straightforward in some circumstances, the change requires significant attention for settlements where sexual harassment allegations are being resolved in conjunction with additional claims.
Limit on Business Deductions Added as Section 162(q) to the Internal Revenue Code
Payments to settle claims and lawsuits ordinarily are deducible business expenses under Section 162 of the Internal Revenue Code. The new law, which adds subdivision (q) to Section 162, eliminates the deduction for any payment or settlement related to sexual harassment or sexual abuse that is subject to a confidentiality or nondisclosure provision:
(q) Payments Related to Sexual Harassment And Sexual Abuse—No deduction shall be allowed under this chapter for—
(1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney's fees related to such a settlement or payment.
The common practice of employers including a nondisclosure clause in a settlement for sexual harassment claims is strongly disincentivized by Section 162(q). Thus, at first glance, and without the benefit of regulations or rulings from the Internal Revenue Service, employers must choose between keeping such settlements confidential without a tax benefit or deducting the settlement and related attorneys' fees as business expenses.
Broad Application for Business or Trade Expenses
The Act applies to all taxpayers. Section 162(q), unlike many state and federal employment laws, does not limit its application to certain subsets of employers or entities. All employers, regardless of revenue, size or number of employees, who wish to deduct an applicable settlement or fee payment as business expenses must therefore proceed carefully when settling such claims.
Bar on Deductions Applies to Conduct "Related to" Sexual Harassment or Abuse
Section 162(q) specifies that the business expense deduction is not allowed for any settlement or payment "related to" sexual harassment or sexual abuse. Clearly articulated sex and gender harassment claims under state, federal and local law will fall squarely within the scope of this prohibition. As but one example, however, the tax implication of inserting a nondisclosure provision into a settlement agreement for whistleblower allegations is not certain, based on the text of Section 162(q).
Employers should be aware that the Internal Revenue Service likely will take a broad view of the provision and businesses will need to assess their risk tolerance with respect to tax liability and confidentiality as they structure their settlement agreements. Accordingly, companies should work with counsel and their tax advisor to defend and structure the settlement of employment claims in light of the broad "related to" language of the law.
Bar on Deducting Payments for Attorneys' Fees
Section 162(q) further eliminates the ability of employers to deduct from their taxable income the payment of attorneys' fees relating to a settlement for sexual harassment or abuse if the settlement is subject to a nondisclosure agreement. In other words, in such cases neither the settlement payment to the claimant nor the attorneys' fees incurred to investigate, negotiate, litigate and resolve the claim would be deductible under Section 162. This further incentives companies to forgo nondisclosure provisions in settlement agreements for sexual abuse and harassment, although businesses should work with their legal service providers to ensure that legal tasks are billed and apportioned correctly.
Settling Comingled Claims
A difficult situation will arise for employers who wish to confidentially settle a lawsuit, administrative proceeding or other claim where sexual harassment is alleged in conjunction with one or more other employment-based claims. Due to the broad language of the prohibition on deductions, the IRS may take the position that the entire action will fall within the purview of Section 162(q). This may be the case even if a separate discrimination or wage claim predominates over ancillary sexual harassment allegations. Employing tax-efficient resolution strategies is imperative under such conditions.
Tax-Efficient Resolution Strategies
Businesses have a number of options to settle claims for sexual abuse or harassment. If a claim is not based on allegations that reasonably meet the legal standard for sexual harassment or abuse, counsel may meet and confer in an attempt to have the claimant voluntarily dismiss the claim before settling the lawsuit. Litigants may also move the court to dismiss or summarily adjudicate the claim.
Another option is for businesses to settle claims in parts, where only allegations not of a sexual harassment or abuse nature are subject to a nondisclosure agreement or where the settlement payment is appropriately attributed to each claim according to its value. For example, in a situation where the plaintiff refuses to dismiss a sexual harassment claim, or where litigating the case to summary judgment motion or trial is cost-prohibitive, the parties could apportion the settlement into two agreements so that the employer may be able to avail itself of a tax deduction for at least a portion of the total settlement payment.
Importantly, employers must keep in mind that under the IRS's "origin of the claim" test and general tax doctrine, the IRS will look at the underlying nature of the claim to determine if expenses and fees were properly apportioned.
Of course, the structure of the settlement will depend on the facts and circumstances of the particular case. Companies are advised to consult with counsel and their tax advisor to ensure that the settlement meets their legal and tax planning goals.
Severance Agreements
The Act does not address whether a severance agreement for a departing employee would fall within the scope of Section 162(q). However, the IRS may take the position that the severance payment is nondeductible if the departure is related in any way to a sexual harassment or abuse allegation. Unless and until the IRS provides guidance on this and other issues, employers and their counsel and tax advisor will need to make the best decision considering all possible tax and employment implications in light of the specific facts and circumstances of the situation.
Employer Tax Credit for Paid Family and Medical Leave
Addressing another topic that has been the subject of increased public discussion—paid family leave—the Act also adds Section 45S to the Internal Revenue Code, which provides a tax credit for businesses that voluntarily provide up to 12 weeks of paid family leave to qualifying workers pursuant to a written policy. The tax credit is equal to 12.5 percent of wages paid to the employee on leave, so long as the wages are at least 50 percent of what the employee normally would have earned had he or she been working. The credit increases in intervals of 0.25 percentage points (up to 25 percent of wages) for each percentage point by which the employee's payment under the policy exceeds the 50 percent minimum threshold.
Employers are eligible only if they have a written policy that provides not less than two weeks of annual paid family and medical leave for full-time employees and a prorated equivalent for part-time employees. The leave policy must also satisfy other criteria set forth in the Act. The tax credit is temporary and will automatically terminate after December 31, 2019.
Employers have two full years to take advantage of this new tax credit. Congress is expected to revisit the credit upon its expiration.
What This Means for Employers
The Tax Cuts and Jobs Act made significant structural reforms to the way that businesses across the country plan for, and pay, their taxes. While much of the focus in the media has been on corporate tax rates, employers should be aware of the restrictions on deductions for payments made in connection with sexual harassment and abuse claims, as well as the availability of a new tax credit for providing paid family leave to employees. With the increased reporting of sexual harassment allegations, the fact that a tax deduction for payments made in connection with such claims is no longer available can play a significant role in how employers approach the defense and resolution of sexual harassment claims. Similarly, employers who are contemplating adopting family leave policies would be well-served to factor into their decision-making process the newly available tax credit for payments to employees pursuant to such policies.
In each case, the changes made by the Act are both new and nuanced, and it is recommended that employers seek legal and tax advice when making decisions involving these changes.
For Further Information
If you have any questions about this Alert, please contact any of the attorneys in our Employment, Labor, Benefits and Immigration or any member of our Tax Practice Group.
Disclaimer: This Alert has been prepared and published for informational purposes only and is not offered, nor should be construed, as legal advice. For more information, please see the firm's full disclaimer.
