Impact of Tax Reform on Confidentiality Provisions in Sex Harassment Cases

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A repercussion of the #MeToo movement is a new provision in the recently enacted amendments to the Federal Tax Code. Section 13307 of the newly revised tax code denies tax deductions for settlements and attorney’s fees subject to nondisclosure agreements paid in connection with sexual harassment or sexual abuse. While the proposition seems simple on its face, it raises a multitude of questions.

First, what is meant by a nondisclosure agreement (“NDA”)? In the employment setting, NDAs typically refer to not disclosing trade secrets or confidential business information. If the new provision is read literally, does that mean a company that settles a sex harassment complaint which includes a NDA but not a confidentiality provision in the settlement agreement is no longer able to deduct the settlement as a business expense? In all likelihood the provision is aimed at confidentiality of sexual harassment complaints, and a NDA just focusing on trade secrets will probably not invoke this provision.

Second, what does sexual harassment encompass? While clearly the intent is to cover the two types of sexual harassment – quid pro quo and hostile environment – does this new provision have a broader application? For instance, sexual discrimination also includes pregnancy discrimination and sexual orientation discrimination. Is the same true for sexual harassment? Is the provision equally applicable to pregnancy harassment and sexual orientation harassment claims?

Third, does any type of confidentiality invoke this provision? While clearly hushing up a victim such that (s)he cannot talk about the underlying facts would invoke this new provision, what about merely keep the amount of the payment confidential? Because NDA is not defined in the legislation, the more cautious interpretation would be that even making the amount paid confidential would invoke this provision and make the settlement payment nondeductible. This creates a dilemma for employers. If victims can talk about how much money they have recovered from their lawsuit, it might inspire copycat lawsuits. In such circumstances it might behoove employers to just not take the deduction. A related problem is what if the sex harassment is just one of many causes of action. A work around might be to enter into two separate agreements. The first agreement would be for the harassment cause of action and a de minimis amount of money could be allocated to the harassment claim. Because the amount of money would be so small in this agreement, the fact that it would not be deductible would not have a significant tax consequence. The second agreement would be for the remainder of the causes of action and a confidentiality provision for such a settlement should have no tax detriment. Perhaps anticipating this reaction, the California Senate has introduced a bill SB 820 that would declare void any provision that prevents the disclosure of factual information in sexual harassment, assault, or discrimination cases. Not only is this bill broader as to the claims that would be included, but also it would not limit the punishment to tax deductions but rather would be a broad ban on all such confidentiality clauses.

Fourth, in today’s employment environment, many companies have procured Employment Practices Liability Insurance. After an employer satisfies a deductible, the insurance company becomes wholly liable for the payment of covered claims including sex harassment. The new tax provision is not limited to employers so presumably an insurer risks the same loss of deduction if it pays the settlement amount and requires a confidentiality clause. In such circumstances if the employer wants the settlement confidential, does the insurer violate its duty to defend by refusing to agree to a confidential settlement agreement to maintain its tax deduction?

Fifth, the law makes clear that attorney’s fees incurred by employers are not deductible if a settlement agreement contains a NDA. What is not clear is whether attorney’s fees for the victim are deductible if the settlement agreement contains a confidentiality provision. While an employer may be willing to forego the deductibility of its attorney’s fees to maintain confidentiality, there is little to no incentive for an employee to lose the deduction. Also, if the settlement agreement provides for confidentiality, does an employer lose the deduction for all of its attorney’s fees or just those amounts attributable to defending the sex harassment cause of action?

These are just a few questions raised by this new provision. As the courts work their way through these issues, they will have to grapple with such policy issues like if the employer does not choose to lose deductibility of settlement payments, does this discourage fast resolution of sex harassment cases? As companies wade through these issues in the coming months, it will be important to have both competent tax counsel and employment counsel helping them navigate there murky waters.