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Deduction of Attorney Fees – Sexual Abuse

Deduction of Attorney Fees – Sexual Abuse

The law, known as TCJA (Tax Cuts and Jobs Act of 2017), made many important changes to the Federal Tax Code. Among the numerous changes made to the code is a provision on fees associated with sexual harassment agreements if the agreements include a confidentiality agreement.


The Previous Law

Prior to the TCJA, individuals could generally deduct legal fees incurred in legal proceedings, including sexual harassment proceedings against current or former employers, which generated taxable bonuses in the form of various discriminatory deductions subject to a minimum of 2% (i.e., deductible only to the extent that they exceeded 2% of taxpayer's AGI). Employers who paid premiums in sexual harassment cases could usually deduct premiums paid and legal fees incurred in the process as ordinary and necessary business expenses.


The Current Law

Section 162 (q), which deals with the tax deductibility of expenses related to sexual harassment agreements, states: 

(q) Payments related to sexual abuse and sexual harassment.

No deduction is allowed in this chapter for:

1. Any agreement or payment of harassment or sexual abuse where such an agreement or payment is the subject of a confidentiality agreement, or

2. Legal costs associated with any such agreement or payment.

 

The implications of this change in the law are significant, perhaps even for individual taxpayers. (Unlike many individual tax changes to the TCJA, this denial is permanent.)

Please note that Section 162 (q), as adopted, does not distinguish between withholdings by the payer and withholdings by the beneficiary of the agreement; does not allow the deduction of legal fees "associated" with this payment. The Joint Tax Commission said that "not all attorneys' fees borne by the beneficiary or recipient are subject to this rule." Still, it recognized that Congress might need to approve a technical correction "to reflect this intention. 

In informal guidance, the IRS has indicated that recipients of sexual harassment or abuse agreements or payments are not precluded by Section 162 (q) from deducting attorney fees related to the 'agreement or payment. However, as adopted, the provision's plain language appears to apply to both parties to an agreement.

The TCJA also removed all of the various itemized deductions that could be deducted within the AGI limits of 2% (Article 67 (g), which is in effect from 2018 to 2025). Under the previous TCJA law, the discrimination of these expenses allowed the taxpayer to deduct any personal expenses, such as legal fees. The few remaining itemized deductions were not subject to the 2% AGI limit. This includes gambling losses and investment interest. As mentioned above, legal fees are no longer allowed as an itemized deduction.


What Does it Mean?

It is clear that if the lawsuit is a case of aggravated bodily harm and no interest and punitive damages are paid, the legal fees can be deducted down the line. Plus, if a lawsuit is filed against an employer that affects your business or business, legal fees can usually be deducted down the line. However, the attorney's deductibility limitation applies where the case relates to sexual harassment and contains a nondisclosure agreement. As a general rule, any settlement involving punitive damages is assessed at 100% of recoveries. The hard part is how these recoveries are taxed.


What Would Be the Impact on a Company That is Being Sued?

Example: Jane was sexually harassed while working for ABC. ABC knew about the sexual harassment but did not resolve the issue. Jane decided to sue ABC. They made a deal for $ 1 million. ABC also had to pay $ 400,000 in legal fees. If ABC decides not to include a confidentiality agreement, it can all deduct $ 1.4 million ($ 1 million + $ 400,000) from the transaction fee. Since the new corporate tax rate is 21%, it will save $ 294,000 ($ 1.4 million × 21%) in additional tax deductions. However, if ABC understood a confidentiality agreement, it would miss the opportunity to save taxes.

 

How Will Plaintiffs and Companies React?

Due to the significant tax consequences, this new law will encourage complainants and defendants to refrain from including a confidentiality agreement in their sexual harassment agreements. Considering the tax ramifications shown in the examples above, there is an obvious incentive not to have a confidentiality agreement. Only time will tell how this will turn out. Still, an increase in nondisclosure agreements is likely to put more sexual harassment victims into public awareness when they hear more encouraging voices that are not silenced by the agreements' confidentiality.


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