Sexual Harassment Taxation After Trump’s Tax Reform
Trump’s tax reform, also known as Tax Cust and Jobs Act of 2017 (TCJA) has made significant changes in the US taxation system, one of which is the tax treatment of settlement related to sexual harassment.
Prior to TCJA individuals who were victim of sexual harassment at their work place could deduct the attorney’s fees related to this lawsuit on their Schedule A itemized deduction as a miscellaneous deduction subject to 2% of AGI (they could deduct any amount that exceeded 2% of their AGI). Employers who paid the settlement also could deduct the lawyer’s fee incurred in the law suit, as well as the settlement amount paid to the victim, as ordinary and necessary business expense.
Current law after enactment of TCJA has changed the deductibility rules. Code Section 162(q) states that “No deduction shall be allowed…for” (regarding payments related to Sexual Harassment and Sexual Abuse)
(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
There are two main points here to look at:
1. If the employer includes a nondisclosure agreement in the settlement (i.e. the victim won’t be allowed to mention that his/her employer settled for sexual harassment or abuse), then the entire settlement amount is not deductible for the employer.
2. The attorney’s fees are not deductible regardless of whether or not an NDA (nondisclosure agreement) is included in the settlement. The language of the code is somehow vague and at first glance it seems that both the settlor and the victim are disallowed from deducting the attorney’s fees that they incurred in this lawsuit. The IRS, however, in an informal guidance, has indicated that recipients of settlements or payments related to sexual harassment of abuse are not precluded by Sec. 162(q) from deducting attorneys' fees related to the settlement or payment (IRS, Section 162(q) FAQ). To make matters more complicated for individuals, TCJA has removed the miscellaneous deduction for individuals on Schedule A. The few miscellaneous itemized deductions that remain were not subject to the 2%-of-AGI limit. These include gambling losses and investment interest. Thus, attorneys' fees are no longer allowed as an itemized deduction. As a result, any portion of the settlement that is taxable is reported net of attorney's fees in the victim's tax return.
For example, A was sexually harassed while working at XXX Co. A decides to file a lawsuit against XXX Co. They settled out of court for $2,000,000 and the company also incurred $300,000 in attorney’s fees. If XXX Co asks A to sign an NDA, the entire $2,300,000 payment ($2M to A and $300K to Attorneys) is NOT deductible for XXX Co. If XXX Co, however, does not include an NDA in the settlement, XXX Co can deduct the $2M payment to A (the $300K payment to attorneys is still not deductible). This clearly gives financial incentive to companies not to hide their sexual harassment and abuse settlement from the public, so that employees can make a better informed decision before joining any company. Please note that the prohibition of deducting the attorney fees is only related to sexual harassment and abuse. In most other cases, the attorney fees are still deductible for businesses.
If you are a victim of sexual harassment or abuse by your current or former employer, or if your business has recently settled a sexual harassment case and you have any question about the tax treatment of this event, please contact us.
Prior to TCJA individuals who were victim of sexual harassment at their work place could deduct the attorney’s fees related to this lawsuit on their Schedule A itemized deduction as a miscellaneous deduction subject to 2% of AGI (they could deduct any amount that exceeded 2% of their AGI). Employers who paid the settlement also could deduct the lawyer’s fee incurred in the law suit, as well as the settlement amount paid to the victim, as ordinary and necessary business expense.
Current law after enactment of TCJA has changed the deductibility rules. Code Section 162(q) states that “No deduction shall be allowed…for” (regarding payments related to Sexual Harassment and Sexual Abuse)
(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
There are two main points here to look at:
1. If the employer includes a nondisclosure agreement in the settlement (i.e. the victim won’t be allowed to mention that his/her employer settled for sexual harassment or abuse), then the entire settlement amount is not deductible for the employer.
2. The attorney’s fees are not deductible regardless of whether or not an NDA (nondisclosure agreement) is included in the settlement. The language of the code is somehow vague and at first glance it seems that both the settlor and the victim are disallowed from deducting the attorney’s fees that they incurred in this lawsuit. The IRS, however, in an informal guidance, has indicated that recipients of settlements or payments related to sexual harassment of abuse are not precluded by Sec. 162(q) from deducting attorneys' fees related to the settlement or payment (IRS, Section 162(q) FAQ). To make matters more complicated for individuals, TCJA has removed the miscellaneous deduction for individuals on Schedule A. The few miscellaneous itemized deductions that remain were not subject to the 2%-of-AGI limit. These include gambling losses and investment interest. Thus, attorneys' fees are no longer allowed as an itemized deduction. As a result, any portion of the settlement that is taxable is reported net of attorney's fees in the victim's tax return.
For example, A was sexually harassed while working at XXX Co. A decides to file a lawsuit against XXX Co. They settled out of court for $2,000,000 and the company also incurred $300,000 in attorney’s fees. If XXX Co asks A to sign an NDA, the entire $2,300,000 payment ($2M to A and $300K to Attorneys) is NOT deductible for XXX Co. If XXX Co, however, does not include an NDA in the settlement, XXX Co can deduct the $2M payment to A (the $300K payment to attorneys is still not deductible). This clearly gives financial incentive to companies not to hide their sexual harassment and abuse settlement from the public, so that employees can make a better informed decision before joining any company. Please note that the prohibition of deducting the attorney fees is only related to sexual harassment and abuse. In most other cases, the attorney fees are still deductible for businesses.
If you are a victim of sexual harassment or abuse by your current or former employer, or if your business has recently settled a sexual harassment case and you have any question about the tax treatment of this event, please contact us.