If an employer settles a claim made by an employee (or former employee), the employer may generally claim a deduction for the amount that is paid to the employee to resolve his/her claims. The expense is treated as an ordinary and necessary business expense and a deduction may be claimed pursuant to Section 162(a) of the Internal Revenue Code.
For example, if an employer pays an employee $25,000 to settle the employee’s claims for back wages, emotional distress, and age discrimination, the employer may deduct the $25,000 on its tax return (the employer’s tax reporting obligations with respect to the $25,000 payment and how the payment should be allocated among the claims made by the employee are topics for a different article).
Change Made by the Tax Cuts and Jobs Act.
Now comes the Tax Cuts and Jobs Act (the “Act”). The Act was signed into law by President Trump on December 22nd. One of the more peculiar provisions in the Act addresses the deductibility of certain settlement payments made by one taxpayer (typically an employer) to another taxpayer (typically an employee).
Section 13307 of the Act amends Section 162(q) of the Internal Revenue Code to deny a deduction for any settlement or payment (or related attorneys’ fees) paid or incurred after December 22, 2017 if it is “related to sexual harassment or sexual abuse” if the settlement or payment is subject to a nondisclosure agreement. Although the language is fairly simple, there is quite a bit of uncertainty as to how it will be applied. There also appears to be a significant unintended consequence of this provision.
