John A. McCreary Jr., Babst Calland

The Tax Cuts and Jobs Act of 2017 inserted a new subsection (q) into Section 162 of the Internal Revenue Code which denies deductions for payments made in settlements of sexual harassment or sexual abuse cases, and “related” attorney fees, when those settlements are subject to a confidentiality agreement: “(q) Payments related to sexual harassment and sexual abuse. No deduction shall be allowed under this chapter for:

• Any settlement or payment related to sexual harassment or sexual abuse if such a settlement or payment is subject to a nondisclosure agreement, or
• Attorney fees related to such a settlement or payment.”

This provision was added by amendment in the Senate and accepted by the House in the final enactment.

The Conference Committee Report (the report) on the amendment does not disclose the rationale for the change, but it is safe to infer that it was inspired by the sordid revelations about widespread sexual harassment that were making headlines when it was passed on Dec. 20, 2017. See, e.g., https://www.ajc.com/news/world/from-weinstein-lauer-timeline-2017-sexual-harassment-scandals/qBKJmUSZRJqgOzeB9yN2JK/ (published on Dec. 19, 2017). The report contains no interpretive guidance on the meaning of “related to” as used in the statute, nor does it define what is meant by a “nondisclosure agreement.” The report simply notes that while Section 162 generally allows for the deduction of “ordinary and necessary” business expenses, various subsections disallow deductions for certain payments, such as portions of damages awarded under antitrust laws, illegal bribes or kickbacks, and criminal fines. In reaction to the headlines Congress has concluded that confidential payments resolving sexual harassment claims can no longer be considered “ordinary and necessary.”

As with many efforts by Congress to provide quick fixes to perceived problems, the unintended consequences of this quick fix will likely create more uncertainty and controversy than will be resolved. A moment's reflection about the practical effects of Section 162(q) reveals a number of concerns that Congress does not appear to have contemplated.

When is a settlement payment or legal expense “related to” a claim of sexual harassment? The term “related to” is extremely broad. The U.S. Supreme Court has held that “in the normal sense of the phrase” it means “has a connection with or reference to” another thing, as in Shaw v. Delta Airlines, 463 U.S. 85, 96-97 (1983) (construing the term “relates to” as used in ERISA's pre-emption provision, 29 U.S.C. Section 1144(a)). Consider in the light of the Shaw court's definition, the problems arising from settlement of a case involving claims of harassment as well as breach of contract and Equal Pay Act violations. It is common when resolving employment cases to allocate settlement payments to different claims to minimize the tax consequences to both parties. In the hypothetical case it would be relatively easy to craft a settlement agreement allocating all payments to claims other than the harassment claim, thereby eliminating “reference to” it, but the payments would still arguably have a “connection to” the claim of harassment since that claim was part of the original suit. Do payments made to resolve other claims “relate to” the harassment claim that was part of the original suit? If they do, can any of those payments be deducted? What portion of the employer's legal fees incurred in defense of the action will it be able to deduct? Will the employer's attorneys be required to record the time spent working on each discrete issue? It would appear that such a practice is certainly advisable—it may even become a requirement imposed by the employer's auditors. Moreover, and absurdly, the statute does not distinguish between legal fees incurred by employers and plaintiffs; a plaintiff who agrees to a confidentiality agreement is seemingly also unable to deduct his or her fees. IRC Section 62(a)(20) allows a deduction for attorney fees and court costs paid by an individual taxpayer in connection with any action involving a claim of unlawful discrimination. Section 162(q) disallows deductions “under this chapter.” Both Section 62 and Section 162 appear in Chapter 1 of the Internal Revenue Code. What factors will the Internal Revenue Service (IRS) use to evaluate whether a payment is “related to” a harassment claim? Will the IRS adopt the Supreme Court's expansive definition, which after all was determined by the Court to be “the normal sense of the phrase”? There is no guidance for any of these issues.

Second, confidential settlements have long been used by employment lawyers on both sides to resolve litigation privately, thereby avoiding the publicity often attendant to salacious claims. It is not just employers concerned about public reputation who benefit from such privacy. With the notable exception of the controversies that stoke the headlines, privacy and confidentiality are typically valued by the parties to employment litigation, especially in sexual harassment claims, which frequently create emotional impacts on the families of victim and perpetrator alike. The victims of sexual harassment (and their families) in many cases want to put their experiences behind them. A confidential resolution permits them to move on with their lives and careers, either with the settling employer or elsewhere. Elimination of confidentiality therefore potentially exposes the employer to adverse publicity (which presumably was at least part of the motivation for including this provision in the tax code), but at the expense of subjecting the plaintiff and the plaintiff's family to unwanted publicity about his or her claims.

Additionally, although the disallowance of deductions for confidential settlements is presumably targeted at “guilty” employers, not all employers who settle these types of claims are guilty. Cases settle for reasons other than the defendant's actual culpability, such as the comparative cost of mounting a successful defense as opposed to resolving the case, or to avoid the disruptions to routine business caused by litigation. Marginal claims are often settled because it is cheaper and more convenient than litigating to conclusion. Confidentiality and the deductibility of the expense are factors that makes settlement of the marginal claim more likely. Removing these two advantages to the employer may mean that the marginal case gets litigated since the costs of resolution are now higher.

Another issue is presented by the ambiguity of the term “nondisclosure agreement.” What is required to be disclosed, or at least not kept confidential, in order to retain the deduction? Is it the details of the harassment claim itself, or the amount of settlement, or both that must be exposed? Can the deduction be preserved if the parties agree that every settlement provision except those that “relate to” the harassment claim will be confidential? Will a limited nondisclosure agreement, such as one that precludes the plaintiff from telling his or her co-workers but which permits plaintiffs counsel to disclose the fact of settlement (or vice versa), run afoul of Section 162(q)? Again, we are left to speculate and wait for the IRS and Treasury Department to weigh in with their guidance.

A final observation: the amendment to the Tax Code addresses the wrong issue. The problem that required remedy was not the deductibility of settlements for one type of discrimination claim, it was the complete failure of management oversight at the various organizations caught up in the harassment scandals of 2017. Section 162(q) will do little to improve the moral compass of those who lead these organizations. Section 162(q) also paints with too broad of a brush. The headlines to which Congress was responding were generated by conduct occurring at enterprises where the deductibility of a particular settlement will not materially impact tax liability. The same is not true for the vast majority of employers impacted by the change, who also are not likely to continue employing serial sexual harassers. For these employers, resolution of harassment claims just got more expensive.

John A. McCreary Jr. is a shareholder in the employment and labor and litigation groups of Babst Calland. Contact him at 412-394-6695 or [email protected].