New Tax Law Targets ‘Hush Money’ But Creates New Issues for Workplace Sexual Harassment Settlements

The collision of the #MeToo movement and the new tax law has resulted in ramifications for both employers and employees looking to engage in settlement of a sexual harassment claim.

While intended to disincentivize “hush money” payments by removing a tax benefit – under the new law employers are no longer able to deduct the settlement as a business expense – the law creates potentially difficult choices for sexual harassment victims looking to remain anonymous.

The New Law

The Tax Cuts and Jobs Act took effect on December 22, 2017. It is designed to prevent employers from deducting, as a business expense, any payments to individuals who allege sexual harassment if the settlement requires the individual to sign a nondisclosure agreement (NDA). The goal was to expose alleged sexual harassers to the public eye by imposing such a financial penalty for confidential sexual harassment claim settlements.

Prior to the new law, employers were able to deduct payments for a settlement involving sexual harassment, as well as the legal fees incurred in the defense of a complaint as ordinary and necessary expenses incurred in the carrying on of a trade or business. Under the language of Internal Revenue Code Section 162(q), the federal government will no longer permit employers to deduct “(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.”

Impact on the Employees

Unfortunately, the law may have negative implications for victims of harassment.

First, the Act’s prohibition on the deduction of attorney’s fees is not limited to just the employer’s attorney’s fees. Previously, a victim’s attorneys’ fees were not taxed as income because that money was not retained by the victim, but allocated to his or her attorneys. Because the law does not state whose legal fees cannot be deducted, employer or victim, both are subject to this provision. This means that the victim will be taxed for the entire settlement, including the money the victim would give to his or her attorneys.

Second, some victims of harassment may want to keep their sexual harassment claims confidential through a nondisclosure agreement for personal privacy reasons, as a result of trauma, or to prevent any negative stigma that could affect the victim’s finding another job. In such a case, an employer could potentially use the victim’s desire for confidentiality as leverage to lower the settlement offer, i.e., to offset the additional cost in taxes due to the victim’s desire to include a non-disclosure provision.

Unanswered Questions

There remain unanswered questions:

  • Is the intent of the law to apply the loss of deductibility to both the victim and employer’s attorneys’ fees or is solely the employer subject to the elimination of this deduction?
  • What about costs which are not technically part of a confidential settlement? For example, are costs associated with the investigation of the case or any other payments made to the victim also subject to the Act and therefore not deductible?
  • If the victim makes other discrimination claims, along with the sexual harassment claim, would a portion of the settlement still be deductible?
  • If the employer maintains Employer Professional Liability Insurance (EPLI) and the EPLI carrier pays the settlement, would the EPLI carrier also be denied a deduction?

Hopefully, Congress or the IRS will issue guidance to answer remaining questions.

Ultimately, employers and victims must carefully weigh the costs and benefits of confidentiality of sexual harassment settlement agreements.

Julie Reddig is an employment attorney who represents management in workplace employment matters. For more information on the impact of the new tax law on workplace sexual harassment settlements, contact Julie at [email protected].