Generally, under Sec. 162, a taxpayer can deduct any ordinary and necessary expenses that they pay or incur during the tax year in carrying on any trade or business. Under the TCJA, however, a new exception to this general rule was added, denying taxpayers a tax deduction for settlements or payment they make relating to claims of sexual harassment or sexual abuse if the payment is subject to a nondisclosure agreement. A nondisclosure agreement generally bars the victim from discussing the allegations or the settlement with others. Such forced confidentiality can create a culture of secrecy in which other employees are kept unaware of their employer’s past indiscretions, and Congress may therefore have felt motivated/pressured to discourage their use. The new provision, in a separate subsection, also prohibits tax deductions for the payment of attorney’s fees related to such a settlement or payment. This disallowance provision is applicable for amounts paid after 12/22/17.
As with most of the new tax law’s provisions, there are unanswered questions surrounding this new provision, such as:
- How to handle a settlement where the origin of the claim relates to both sexual harassment or abuse as well as other employment-based claims, such as discrimination or wage claims. If the full settlement payment is deemed to be tainted because a portion is attributable to a sexual harassment or abuse claim, it might be advantageous for the employer to bifurcate the settlement into two settlements, so that at least a portion of the employer’s payment might be tax-deductible.
- Whether the disallowance of a tax deduction for legal fees is independent from or contingent upon the existence of a nondisclosure agreement.
- Whether victims will still be able to deduct their own legal fees or if the disallowance of the legal fee deduction applies only to the employer. (An employee is generally allowed an above-the-line deduction for attorneys’ fees that are related to their employment claims.)
Despite these unanswered questions, however, it seems clear that employers and their attorneys must be aware of this new provision so they can structure the settlement in the most tax-efficient manner. It remains to be seen whether employers are going to continue the common practice of requiring the sexual abuse victim to sign a nondisclosure agreement in return for the receipt of a settlement or payment, in which case the employer will forfeit their tax deduction. It also remains to be seen how this will impact the dollar amounts employers are willing to pay for victims for such settlements, since they will now be paid with the employer’s after-tax dollars rather than pre-tax dollars.