Tax law raises questions for sexual harassment settlements

Harvey Weinstein, Kevin Spacey, Bill O'Reilly, and many other figures in the business and entertainment world have been accused of serious acts of sexual harassment. The torrent that was unleashed came to be known on social media as the #MeToo movement. With tax reform being discussed, many people seem shocked that settlements and legal fees are nearly always tax deductible by businesses.

The recently passed tax bill includes what some have labeled a Harvey Weinstein tax. The idea is to deny tax deductions for settlement payments in sexual harassment or abuse cases if there is a nondisclosure agreement. Notably, this "no deduction" rule applies to the lawyers' fees, as well as the settlement payments.

New Section 162(q) of the tax code provides:

(q) 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.

Most legal settlement agreements have some type of confidentiality or nondisclosure provision. There has been speculation that sexual harassment settlements may start breaking this normal confidentiality mold. Moreover, some commentators have suggested that the IRS might read the law as a denial of a tax deduction for legal fees related to sexual harassment or abuse, even without a nondisclosure agreement.

Even worse, what about legal fees paid by the plaintiff in a sexual harassment case in which a confidential settlement is reached? It is shocking to think that the plaintiff's fees might not be deductible. In 2005, the U.S. Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005), held that plaintiffs in contingent fee cases must generally recognize gross income equal to 100 percent of their recoveries.

Being treated as receiving 100 percent means that the plaintiff must figure a way to deduct the 40 percent fee. A few months before the Supreme Court's Banks decision, Congress provided an above the line deduction for legal fees in employment cases. Since then, plaintiffs in employment cases have been taxed on their net recoveries, not their gross.

Now, though, there is real concern that the legal fee deduction rules are going backwards. On its face, the new law would seem to prevent any deduction for legal fees in this context. One answer to this surely unintended result might be to revisit the 2004 above the line deduction.

However, the new Weinstein provision says that it trumps the above the line deduction. Surely Congress would not want a sexual harassment victim to pay tax on 100 percent of her recovery when 40 percent goes to her lawyer! But we do not yet know how this will be read by the IRS.

Before the 2004 change, many employment plaintiffs had to be content a below the line deduction. Such miscellaneous itemized deductions face limitations, so are not too valuable. But even these deductions were eliminated by the new tax law.

This is not a feature of the Weinstein tax, but of other significant changes in the new tax law. With higher standard deductions, the law eliminates these deductions. Thus, for the sexual harassment plaintiff, the choice may be an above the line deduction or nothing.

This arguably suggests a broader tax problem. Outside of the employment context, plaintiffs who do not qualify for an above the line deduction for legal fees may now pay tax on 100 percent of their recoveries, not merely on their post-legal fee net. Only employment and certain whistleblower claims are covered by the above the line deduction.

Sexual Harassment Questions

Will any mention of sexual harassment claims trigger the Weinstein provision? If it does, will it bar any tax deduction, even if the sexual harassment part of the case is minor? Plaintiff and defendant may want to agree on a particular tax allocation, attempting to head off the application of the Weinstein tax.

In a $1 million settlement over numerous claims, could one allocate $50,000 to sexual harassment? This figure may or may not be appropriate on the facts. However, legal settlements are routinely divvied up between claims. There could be good reasons for the parties to address such allocations now.

The IRS is never bound by an allocation in a settlement agreement. But the IRS pays attention to allocations and often respects them. I expect that we will start seeing such explicit sexual harassment allocations. We may see them where sexual harassment was the primary impetus of the case, and where the claims are primarily about something else.

Suppose that the parties allocate $50,000 of a $1 million settlement to sexual harassment. That amounts to 5 percent of the gross settlement. If $400,000 is for legal fees, 5 percent of those fees ($20,000) should presumably be allocated to sexual harassment too.

One other possible answer might be for the parties to expressly state that there was no sexual harassment, and that the parties are not releasing any such claims. Yet defendants want complete releases. Perhaps a complete release might state that the parties agree that no portion of the settlement is allocable to sexual harassment.

These are big and worrisome tax changes, and they may complicate already difficult settlement discussions. Whoever you represent, get some tax advice and try to be prepared for the new dynamics these issues may raise. When it comes to attorneys' fees for plaintiffs, this may be a sea change.

For many types of cases involving significant recoveries and significant attorney fees, the lack of a miscellaneous itemized deduction could be catastrophic. There may be new efforts, therefore, to explore the exceptions to Supreme Court's 2005 holding in Banks. The Supreme Court in Banks laid down the general rule that plaintiffs have gross income on contingent legal fees.

The court alluded to various contexts in which this general 100 percent gross income rule might not apply. We should expect taxpayers to more aggressively try to avoid being tagged with gross income on their legal fees. It is a troubling new tax world.