Section 13307 of the Tax Cuts and Jobs Act added a section titled “Denial of Deduction for Settlements Subject to Nondisclosure Agreements Paid in Connection with Sexual Harassment or Sexual Abuse," designated 162(q). The addition was in response to the recent flood of allegations related to sexual harassment. At this time, this tax provision is still unclear and leaves many questions to be resolved. The principal language in the provision is as follows:
SEC. 13307. DENIAL OF DEDUCTION FOR SETTLEMENTS SUBJECT TO NONDISCLOSURE AGREEMENTS PAID IN CONNECTION WITH SEXUAL HARASSMENT OR SEXUAL ABUSE.
(q) PAYMENTS RELATED TO SEXUAL HARASSMENT AND SEXUAL ABUSE.—No deduction shall be allowed under this chapter for—
But what exactly does the provision allow or disallow? It seems clear that a payment that falls within this provision is nondeductible. This would include any activities for the production of income under Section 212. Since most employee claims involve multiple issues, can careful planning and drafting minimize the disallowance of this provision by allocating settlements and payments to issues other than sexual harassment or sexual abuse?
It also seems that the disallowance is tied to the use of Nondisclosure Agreement (NDA), but what about the deduction of attorney’s fees that don’t involve an NDA? While the Conference Committee Report suggests that the disallowance applies if such payments for sexual harassment or sexual abuse only if there is an NDA, it is not clear since the disallowance for attorney’s fees is tied to “such settlement or payment”. It could be that all attorney’s fees related to a settlement or payment for sexual harassment or sexual abuse are disallowed. As for defendants, they will need to choose between the non-deductibility of the payment and nondisclosure of the settlement.
The next question is which attorney’s fees are disallowed? It’s apparent that the defendant’s attorney’s fees are disallowed, but what about the plaintiff’s if there is an NDA? If there is no exclusion for the plaintiff because the settlement was not on account of physical injuries or sickness, the plaintiff may be disallowed the deduction of any attorney’s fees since the provision does not explicitly refer only to payor’s attorney’s fees. While this may not be the intent of the provision, it is the likely impact. This would result in the plaintiff paying tax on 100 percent of the settlement while up to 40 percent is paid to the attorney. Until there is a statutory change to this provision or IRS guidance to the contrary, the loss of the plaintiff’s deduction could complicate settlement negotiations.
Until there is further clarification of this provision through a statutory change, IRS guidance, and case law, taxpayers will have to proceed using their best judgment while many questions for this provision remain unanswered.