The Tax Cuts and Job Act passed by Congress on December 22, 2017, includes a surprising provision that may have a significant impact on settlements of sexual harassment and other claims. Under Section 13307 of that Act, the Internal Revenue Code provision relative to the deductibility of expenses in carrying on a trade or business was amended to read:

Payments Related to Sexual Harassment and Sexual Abuse – No deduction shall be allowed under this chapter for (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.

The amendment (which becomes Section 162(q) in the tax code) takes effect immediately.

What this now means is that the standard practice of including a confidentiality provision in employment settlement agreements must be undertaken with caution or not at all. The impact of the tax code amendment can arise in two ways.

Settlement of Sexual Harassment Claims.  First, in a case that directly involves a sexual harassment (or sexual abuse) claim, the inclusion of a provision by which the claimant agrees to keep the existence and terms of the settlement private and confidential will mean that neither the settlement payment amount nor any attorney’s fees related to that settlement may be taken as deductible business expenses.  In such case, the employer should make the determination as to whether the confidentiality of the settlement is of sufficient importance to forego the deductions.

Blanket Releases of all Employment Related Claims.  Second, even in a case in which no sexual harassment (or sexual abuse) claim is made, the amendment can be a trap for the unwary.  If the settlement agreement contains a nondisclosure provision, but is otherwise not carefully drafted, it can potentially have the same ramification.

In virtually every settlement of a claim made by a present or former employee (and even in the documentation surrounding severance payments where no claims have been made), it has been common practice to include a broad release of any and all claims arising out of the employment relationship. In some iterations, the language contains not only a broad release, but also the specific delineation of every possible type of employment-related claim (e.g., release of claims arising under any federal, state, or local law relating to employment, discrimination, retaliation, harassment, breach of contract, fraud, identity theft, tortious interference, emotional distress, or any common law claim).  Certainly the latter and possibly even the former approach may also result in the loss of the deductions.

Express Disclaimer and Attendant Risk.  In such cases, one approach that should preserve the deductions would be to expressly disclaim that the release applies to claims of sexual harassment or sexual abuse.  As can often be the case, fixing one problem may create a different one.  While such a disclaimer would preserve the deductibility of the settlement payment and legal expenses, it could expose the employer to a subsequent claim of sexual harassment.

Exclusion by Omission and Attendant Risk.  Another possible approach would be to use only the broad form release or omit “sexual harassment,” “sexual abuse,” “harassment,” “abuse” or similar words from the litany of specific types of claims.  If the Internal Revenue Service takes an aggressive approach, however, either form of release (broad or specific) could potentially jeopardize the employer’s deductibility of the settlement payment amount and attorney’s fees.

Questions, Questions and More Questions. Will the IRS take an aggressive approach to this exclusion?  How will it interpret the phrase “any settlement or payment related to sexual harassment or sexual abuse?”  Will this provision apply to agreements required in return for the payment of severance?  Must a claim first be made by the employee?  If so, must that claim be for sexual harassment or sexual abuse?  How will the phrase “related to” be interpreted in practice?  Will “nondisclosure” be specific to the terms of the settlement?  Will a non-disparagement provision prohibiting the disclosure of negative statements about the employer also trigger the non-deductibility penalty?

Is Clarification Forthcoming?  By the enactment of the Tax Cuts and Job Act, Congress has dramatically increased the workload of the IRS.  Any clarification from that agency on how this relatively obscure provision will be interpreted is not likely to be coming soon.  Employers should therefore discuss the risks and potential ramifications with counsel in deciding the form of their concluding agreements.

The recent tax bill has certainly stirred considerable debate about its economic merits. It is probably safe to say, however, that not many of us anticipated that the current revelations about sexual harassment would also become part of that tax bill’s landscape.