The TCJA (Tax Cuts and Jobs Act of 2017), PL 115-97, made many important changes to the Internal Revenue Code. Among the many changes to the Code, there is a provision on costs associated with sexual harassment agreements if the agreements include a confidentiality agreement.
Prior Law
Prior to the TCJA (Tax Cuts and Jobs Act), individuals could generally deduct attorney fees incurred in litigation, including sexual harassment claims against current or former employers, which generated taxable bonuses, such as various itemized deductions subject to a 2% floor (for instance, they were deductible only to the extent that it exceeded 2% of the adjusted gross income of the taxpayer). Employers who paid damages in sexual harassment proceedings could generally deduct damages paid and attorney fees incurred in litigation as routine and necessary business expenses.
Current Law
Section 162(q), which deals with the tax deductibility of expenses related to sexual harassment contracts, provides:
(q) Payments related to sexual abuse and sexual harassment.
No deduction will be allowed in this chapter for:
Any agreement or payment for sexual harassment or sexual abuse, if such agreement or payment is the subject of a confidentiality agreement, or
Legal costs associated with any such agreement or payment.
The implications of this legislative change are significant, perhaps even for individual taxpayers. (Unlike many individual tax changes in the Tax Cuts and Jobs Act, this disallowance is permanent.)
Please note that Section 162(q), as adopted, does not distinguish between payer deductions and agreement beneficiary deductions; it does not allow the deduction of legal costs "associated" with this payment. The Joint Fiscal Committee held that "any legal costs borne by the beneficiary or the recipient of the agreement are not subject to this rule" but recognizes that Congress may need to approve a technical correction "to reflect that intention."
And the IRS, in unofficial guidance, has indicated that recipients of agreements or payments for harassment or sexual abuse are not excluded from Section 162(q) of the attorney fee deduction related to the settlement or to pay. However, at present, the provision's plain language appears to apply to both parties to an agreement.
The TCJA has also removed all miscellaneous itemized deductions that could be deducted subject to the AGI's 2% limit (Article 67 (g), which will take effect from 2018 to 2025). Under the old TCJA law, listing these expenses allowed the taxpayer to deduct 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, attorney fees are no longer allowed as itemized deductions.
What does it mean
Obviously, if the lawsuit is a qualified personal injury case and no punitive interest or damages have been paid, the legal fees can be deducted down the line. Plus, if a lawsuit is brought against an employer that affects their business or trade, 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 confidentiality agreement. As a general rule, any transaction involving punitive damages is taxed at 100% of collections. The hard part is how these collections are taxed.
How will companies and plaintiffs respond?
Due to the significant tax consequences, this new law will cause plaintiffs and defendants to refrain from including a confidentiality agreement in their sexual harassment agreements. There is an obvious incentive not to have a confidentiality agreement regarding the tax consequences shown in the examples above. Only time will tell how this plays out, but a wave of non-disclosure agreements is likely to reveal more victims of sexual harassment in the public eye when they hear more encouraging rumors that were not hushed up by non-disclosure agreements.
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