For those litigating cases involving alleged sexual harassment or sexual abuse, the Tax Cuts and Jobs Act of 2017 (“the Act”) made an important change that might easily be overlooked.  In pertinent part, Section 13307 of the Act amends Section 162 of the Internal Revenue Code (relating to the deductibility of trade or business expenses) by denying any deduction for “any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement” or “attorney’s fees related to such a settlement or payment.”  Although the Act does not specify, in any particular terms, the definition of a nondisclosure agreement or related attorney’s fees, regulations will ultimately be issued for clarification.  These changes could have a major impact on victims of sexual harassment and abuse as well as employers, attorneys, and other related parties.

An unintended consequence of the legislation is that employers or other defendants may be less inclined to settle matters involving alleged sexual abuse or harassment.  The goal of the legislation was to curb a perceived tax handout for those who could hide sexual harassment or abuse via nondisclosure agreement.  Employers will now bear a higher after-tax burden for settling disputes involving sexual harassment and/or abuse where a nondisclosure agreement is used.  While this goal may be honorable, in many situations where a nondisclosure agreement has some value to the employer (or another defendant) – value that could have been shared with the victim in a settlement – the defendant may be inclined to pursue increased litigation to protect its reputation and to reduce costs.  Since employers may have deeper pockets than those being harassed or abused, this could actually harm victims in cases where victims could be outspent.  Furthermore, in situations where settlement agreements are necessary (or have a great value), employers may choose to settle a case for less than they might otherwise (in order to offset the inability to deduct their settlement costs).  In either event, defendants and corporate counsel will need to account for the changes in deductibility as part of their risk management strategy.

On the other hand, in situations where victims of harassment or abuse may be required to agree to a nondisclosure agreement in order to resolve a matter before trial, they may no longer be able to claim attorney’s fees as potentially deductible expenses.  (While legal fees for personal matters are not generally deductible, such fees could be deductible if they relate to the production of income – for example, if an employee sues an employer in connection with alleged harassment and subsequent termination.)  This could drive up the after-tax cost of pursuing vindication of their rights.  Moreover, some victims may be persuaded to proceed to trial – rather than settle the matter – in order to claim deductibility.  This may not be in the victims’ interest and may unnecessarily burden the legal system.  For some of these individuals, where a matter may persist for multiple years, it may leave doubt as to deductions claimed in prior years.  And, at least in marginal cases, it could cause some victims not to seek vindication of their legal rights.  All of these items need to be considered by victims and their attorneys before proceeding with a sexual harassment or abuse lawsuit.

Finally, this change in deductibility could have a negative effect on attorneys and could jeopardize their ability to represent clients without conflicts of interest.  To start, in order to diligently represent their clients, it may be incumbent on attorneys to now advise their clients of the disparate after-tax outcomes of settling a matter with or without a nondisclosure agreement.  As mentioned previously, such tax considerations may convince some clients to proceed to trial when the proper strategy may be to settle (if tax considerations were not relevant).  On the other hand, in situations where the attorney’s fees are contingent upon the amount of recovery, attorneys may selfishly advocate against a nondisclosure agreement.  That is, if their client may stand to receive less from a settlement that requires a nondisclosure agreement (on an after-tax basis), attorneys may be inclined to advocate against inclusion of a nondisclosure agreement or to proceed to trial.   Since attorney’s fees may not be commensurate with the amount of the potential deduction for either the plaintiff or defendant, it is not clear what effect this change may have to the resolution of these types of cases.

With these concerns in mind, there still may be ways to minimize the effects of this legislation.  For instance, it may be possible to structure a settlement where all or a portion of the payment stems from something other than the nondisclosure agreement.  If done correctly, this could theoretically preserve the deductibility of a significant amount of the payment.  Also, to the extent that a nondisclosure agreement is necessary, it may be possible to structure payments as being in satisfaction of other claims (e.g., discrimination or unlawful termination) in order to avoid the denial of deductions relating to sexual harassment and sexual abuse expenses.  Affected parties may also be able to qualify these types of expenses under a different category of deduction in order to work around the prohibition in Section 13307.  Attorneys should be careful to properly document the nature of such agreements and payments in order to preserve the likelihood of deductibility, should their client be subject to a later audit.  Still, no matter what planning is done, litigants and practitioners will have to wait until further guidance is issued by the Internal Revenue Service before having any certainty on the application of this legislation.

These descriptions are intended for informational purposes only and should not be taken as legal advice on any particular set of facts or circumstances.  Rosenberg Martin Greenberg, LLP is experienced in all aspects of federal and state tax laws, including tax planning, tax audits and appeals, tax litigation, and more.  Please contact Brandon N. Mourges at 410.951.1149 or or Seth J. Groman at 410.649.1244 or for a free consultation.