The new tax law disallows previously available deductions for settling government agency enforcements and sexual harassment claims.
It’s enough of a headache for CFOs when their company gets caught up in a costly government regulatory action or an embarrassing sexual harassment claim. But now they have two new worries to contend with when settling such cases.
The Tax Cuts and Jobs Act (TCJA) enacted two provisions that will, in many cases, disallow tax deductions for all or part of the payments to settle these types of controversies and will no longer permit companies to write off investigative costs.
The new tax law greatly expands the deduction disallowance rule for payments relating to government enforcement actions. Before IRS 162(f) was amended by law, only the amount allocated to the payment of fines or penalties was not deductible, meaning where restitution or repayment to the government or a third party was ordered or awarded, those amounts potentially could be deducted.
Under the TCJA amendment, all payments to a government agency with regard to a claim of a violation of law are not deductible unless they are classified as remedial. The TCJA’s disallowance rule also applies to payments made to third parties at the direction of the government agency. In addition, the law disallows any deduction for investigation costs.
This rule applies to a wide variety of government enforcement actions, including securities, employment, environmental, Foreign Corrupt Practices Act, white collar, health-care, government contracts, gaming, and any other regulatory claims.
The only exception to the disallowance rules are for payments made for restitution or remediation of property or to bring the company into compliance with the law. That means settlements may be structured with this in mind, to consider limiting the amount that would not be deductible.
For example, say a company is facing an employment enforcement action where a state labor agency claims that the workers were not paid for the time spent on changing into protective clothing to ready themselves for their shift, and for claims that these workers were subject to verbal harassment from supervisors for not changing fast enough.
The amount allocated to settle the wage/hour claims to bring the company into compliance with wage/hour rules would be deductible, because such payments would be to bring the company into compliance with a specific wage/hour statute.
On the other hand, the amount paid to settle the verbal harassment claims might not be deductible. In addition, any investigation costs the company incurs might not be deductible.
CFOs may wish to consider structuring future settlements in enforcement matters to maximize the amount which would be deductible. Be aware, however, that the IRS can challenge the allocation of the settlement agreement between deductible and nondeductible items.
To improve the likelihood of any structured settlement being enforceable from a tax deductions perspective, it is important that the allocation of the settlement be supported by the pleadings and evidence.
The new law also applies to a whistleblower action brought by a private party under a state or federal false claims act or private attorney general act.
It is not yet clear whether a settlement with the private party who brought the claim would be subject to this disallowance provision. It is possible that the IRS might say that a quick settlement of a whistleblower claim before a government agency decides to intervene would nevertheless still be classified as a payment coming under the scope of this rule.
However, it is likely that once the government agency agrees to intervene in the claim, a settlement will fall under the wide umbrella of this disallowance rule. As a result, a quick settlement before the agency chooses to intervene might be in a company’s best interest.
Sexual Harassment or Abuse Claims
A second tax deduction disallowance provision deals expressly with sexual harassment or abuse claims. TCJA adds new IRS section 162(q), which disallows any deduction for the payment of settlements related to sexual harassment or abuse claims that are subject to a nondisclosure agreement.
This provision is set out in very broad language, so that any amounts paid to settle a sexual harassment claim would be subject to this disallowance rule, even if a portion of the settlement amounts are attributable to lost past or future wages due to the claimant. A decision must be made whether the added after-tax cost of settling a sexual harassment claim is worth including a nondisclosure agreement.
In addition, this new provision disallows a deduction for attorney fees related to the settlement of sexual harassment claims that include a nondisclosure agreement.
One unintended consequence of that: under a literal reading of the statute, the company’s payments of fees to the claimant’s attorney may result in additional tax costs to the sexual harassment claimant. That’s because the attorney fees paid to the claimant’s attorney would be included in her gross income.
Under the general rule for attorney fees in an employment-related action, the claimant is entitled to an above-the-line deduction for attorney fees, but that would be disallowed if the settlement is tied to a nondisclosure agreement. Until this glitch is fixed by IRS guidance, it may increase a claimant’s after-tax cost of settling sexual harassment claims. Accordingly, a claimant might seek additional compensation.
CFOs should consider taking steps to explain the added costs of a nondisclosure agreement to management when settling sexual harassment claims. They also should be involved in determining whether the added cost of a nondisclosure agreement is worth avoiding the unwanted publicity.
These two new deduction disallowance provisions will change the tax-planning landscape in settling actions involving violations of law or sexual harassment claims.
While a company’s legal counsel is typically focused on limiting legal exposure, CFOs must now be concerned with structuring settlements with the aim of minimizing the tax-related impact of
For information, education, and answers to frequently asked questions about Whistleblowers, see the Whistleblower FAQ and Education Page.