Caveat: This summary has absolutely nothing to do with estate planning or the administration of trusts. The topic is still timely, however, in light of today’s headlines. It also addresses one of the overlooked provisions of the 2017 Tax Act that have not gotten much attention unlike IRC 199A or the doubling of the standard income tax deduction which affects all of us.

Take-Away: One product of the “Me Too” movement is the filing of more sexual harassment claims. While such claims may be validated with substantial jury awards, the taxation of a sexual harassment award and the deduction to pay such an award has dramatically changed. The change has much less to do with raising revenues as it does ‘punishing’ bad behaviors.

Background: The “Me Too” movement has brought to the national headlines the prevalence of sexual harassment in the workplace. Consider- Harvey Weinstein, Matt Lauer, Charlie Rose, James Franco, and Kevin Spacey, just in the past year. More and more claims are being filed in court asserting sexual harassment. It is likely that there will be substantial jury awards that will arise from such claims if they are litigated to judgment. Some claims will be settled out of court, also for significant amounts. The payment of a sexual harassment claim, or a nondisclosure agreement when such a claim is settled, may be subject to varying income tax treatments for both the payer and the recipient. The 2017 Tax Act changed many of the ‘old’ tax rules with regard to sexual harassment verdicts and settlements, thus implicating Congress in what is normally a state created and controlled remedy.

Old Tax Law: Employers were generally permitted to deduct not only the payment for a settlement or judgment that involved allegations of sexual harassment at their place of business, they were also able to deduct the legal fees they incurred in the defense of those complaints, as ordinary and necessary expenses incurred in the carrying on of a trade or business. [IRC 162.] If the plaintiff paid attorney’s fees and court costs in connection with a recovery in connection with the cause of action for sexual harassment, as a general rule, the plaintiff would be entitled to an ‘above the line’ income tax deduction, unless the legal fees were allocable entirely to a non-taxable award or settlement. [IRC 62(a)(20 and IRC 265(c).]

New Tax Act: Consider how the 2017 Tax Act has changed the ‘old’ tax rules:

  • IRC 62(a)(20) and (21) allow a taxpayer to deduct the costs incurred in unlawful discrimination suits and attorney’s fees that relate to whistleblower awards. IRC 62(e)(18) defines unlawful discrimination to include: “any provision of Federal, State, or local law, or common law claims permitted under Federal, State or local law… regulating any aspect of the employment relationship, including claims for wages, compensation or benefits, or prohibiting the discharge of an employee, the discrimination against an employee, or any other form of retaliation or reprisal against an employee for asserting rights or taking other actions permitted by law.” A plaintiff’s tax deduction for legal fees incurred in employment discrimination and qualifying whistleblower cases cannot exceed the income that the plaintiff receives from the litigation in the same tax year.
  • IRC 162(q) provides that under this chapter income tax deductions for settlement of payments in sexual harassment or sex abuse cases are denied, including attorney’s fees, if such settlement or payment is the subject to a nondisclosure agreement (uncharitably referred to in the press as the Harvey Weinstein tax.)
  • Some civil rights statutes permit an award of attorney’s fees to the prevailing party. The Tax Act provides that a successful plaintiff does not need to include that statutory attorney fee award, i.e. money damages awarded to pay for attorney’s fees, in their taxable income.
  • Excludable fees from the plaintiff’s taxable income will include: (i) compensatory damages awarded in a pure physical injury case with no interest and no punitive damages; (ii) court awarded fees; and (iii) statutory attorneys fees.

Thus, a summary of these ‘new’ tax rules includes:

  • Reporting: Lawsuit settlements are now subject to W-2 and 1099 reporting to the IRS.
  • Emotional Distress: An award for emotional distress incurred by the victim will not treated as a physical injury (see above.)
  • Nondisclosure Agreement: If a payment is made in settlement of a claim that is subject to a nondisclosure agreement, then any payment for the sexual harassment claim will be non-deductible by the payer. It is no surprise that most payers will want a nondisclosure agreement to settle this kind of litigation, so the loss of the income tax deduction is an expensive trade-off in exchange for the nondisclosure agreement.
  • Attorney’s Fees: Attorney fees must now be identified and allocated. The attorney’s fees that are related to a settlement agreement or judgment for the plaintiff’s injuries that arise from sexual harassment or sex abuse are non-deductible. Several forms of attorney’s fees are tax deductible but these attorney’s fees incurred to resolve harassment claims are excepted from the deductibility.

Disturbing Example: The plaintiff receives a $1.0 million jury award for her sexual harassment claim. The plaintiff agreed to pay her attorney a 40% contingent fee from any recovery that she might receive, either in court or through settlement. The attorney is paid $400,000 pursuant to that contingent fee agreement. The plaintiff will be taxed on the full $1.0 million award, not her net take-home amount of $600,000. The plaintiff could be left, after-tax, with about $200,000 from her $1.0 million jury award after she has paid her attorney and her taxes. Note, her attorney will still have to pay income taxes on the $400,000 legal fee he/she earned in the representation of the claimant. Double taxation of the $400,000?

Lingering Questions: No guidance has been provided by Treasury on several questions that these new income tax rules create:

  • What is a payment related to sexual harassment or sexual abuse?
  • What does related to actually mean?
  • What happens if the plaintiff and the defendant bring numerous claims against each other, which is often the case in current jurisprudence where the ‘best defense is deemed to be a good offense?’
  • What happens when the plaintiff’s sexual harassment complaint is filed in conjunction with several other causes of action, e.g. age discrimination, breach of employment contract, intentional infliction of mental suffering, often asserted to avoid some claims that might otherwise be dismissed due to a statute of limitations bar?
  • By using the phrase under this chapter did Congress intend to eliminate the income tax deduction for attorney’s fees for both the payer and the recipient where the settlement payment is subject to a nondisclosure agreement? Or, was the intent that this limitation on deductibility applies solely to the payer in such situations?

Conclusion: These new rules that pertain to the taxation of sexual harassment or sex abuse awards create a disincentive to classify any settlement as a result of being sexually harassed if a nondisclosure agreement is required to reach a settlement. It could be a long time before Treasury provides Regulations in answer to some of the questions raised earlier. But these rules demonstrate that more often than we think, the tax laws of this country are put in place, not so much to raise revenues, as they are to change behaviors.