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March 2019

The Weinstein Tax Update: The IRS Clarifies the Unintended Consequence Directly Affecting Plaintiffs with Sexual Harassment Claims

It has been more than a year since the Weinstein Tax went into effect.  Up until recently there had been no response from Congress addressing a number of issues and concerns related not only to the intended scope and purpose of this legislation and its ambiguous terms, but also the consequences and effects this legislation would have on settlement of claims. 

In an earlier article, “The Weinstein Tax and the Unintended Consequences of Congress’ Response to the #MeToo Movement,” February 2018, we explained that prior to the Weinstein Tax, the Internal Revenue Code allowed employers to deduct ordinary and necessary expenses paid or incurred in carrying on a trade or business, including those expenses used in settling employment disputes. Sexual harassment claims were included in this expense deduction. However, after December 22, 2017, employers were no longer allowed to deduct any settlement expenses related to sexual harassment and abuse claims when there was a non-disclosure term contained in the settlement agreement. 

The Weinstein Tax states that:

No deduction shall be allowed under this chapter 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.

(Emphasis added).

In the February 2018 article, we highlighted a number of unintended consequences identified by legal and tax professionals.  One significant consequence was whether Congress intended for a plaintiff to lose the deduction if a nondisclosure term was contained in the settlement agreement.  The Weinstein Tax clearly identifies that an employer will face tax liability and will be precluded from deducting as a business expense attorneys’ fees related to a sexual harassment claim where the settlement agreement includes a non-disclosure term; however, until now it was unclear whether the same was true for the plaintiff’s attorney’s fees.

The confusion centered around conflicting language where the plain text of the legislation stated, no deductions “under this chapter” which implied this provision was applicable to all of Chapter 1 of the tax code covering businesses and individuals alike. Conceptually, this was confusing because the clear purpose of the Weinstein Tax was to require transparency from employers regarding sexual harassment, but this text directly affected the plaintiff when reporting settlement amounts to the IRS. Before, the plaintiff would include the gross settlement amount as taxable income, and the attorney fee amount would be deducted from the taxable income amount. Thus, the plaintiff would be taxed on his or her net recovery after attorney’s fees rather than the gross amount. However, based on the legislative text, if the plaintiff cannot factor in the deduction for attorney’s fees, the plaintiff is taxed on 100 percent of the settlement, regardless of the fact that the plaintiff’s attorney took a significant portion of the settlement amount.

This unintended consequence caused significant concerns and Congress attempted to clarify this issue in a proposed bill, “Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018.” This bill, however, died as quickly as it was proposed.  Without any further clarification from Congress, the Internal Revenue Service (“IRS”) recently addressed this question in an “FAQ” on its website. 

Q: “Does section 162(q) preclude me from deducting my attorney’s fees related to the settlement of my sexual harassment claim if the settlement is subject to a nondisclosure agreement?” 

A: “No, recipients of settlements or payments related to sexual harassment or sexual abuse, whose settlement or payment is subject to a nondisclosure agreement, are not precluded by section 162(q) from deducting attorney’s fees related to the settlement or payment, if otherwise deductible.”

It is now clear that the tax liability rests solely on the employer.  This is good news for the plaintiffs as they can now deduct attorney’s fees.  Employers should anticipate that since the parties will no longer have similar motives there may be less cooperation from the plaintiffs as to how sexual harassment claims are characterized in a settlement agreement.  Ultimately, unless a plaintiff is resolving a claim pre-litigation and wants to maintain privacy, the plaintiffs should be less invested in the decision as to whether or not a non-disclosure agreement is a term of the settlement agreement. In fact, since only the employer faces tax liability there is an argument to be made that the decision of whether or not a non-disclosure agreement is contained in a settlement agreement should rest solely with the employer.

It is also important to note that the IRS decision only affects federal taxes.  For states that have enacted their own Weinstein Tax prohibition of non-disclosure agreements, the settling parties will have to ensure that the settlement agreement complies with the respective state legislation and be aware that this may result in mutual tax liability.   

For questions regarding the Weinstein Tax, please contact a partner with the Employment Law practice group at Gordon Rees Scully Mansukhani.

Employment Law

Sarah N. Turner

Employment Law