United States: New Tax Reform Brings Changes To Taxation Of Settlements

Last Updated: January 17 2018
Article by William P. Zimmerman, Mary B. Hevener and Frances Emmeline Babb

Settlements with the government and those related to sexual harassment claims, as well as certain attorney's fees, will be impacted by newly disallowed deductions.

The taxation of settlements with the government has seen some recent changes with US Supreme Court cases, Internal Revenue Service (IRS) pronouncements, and, of course, with the monumental tax reform of P.L. 115-97, also known as the Tax Cuts and Jobs Act. We review how these all interact. Additionally, the new tax legislation includes a provision disallowing deductions to defendants for settlements or payments relating to or allocated to sexual harassment claims.

Settlements with the Government

The new tax law has created a major change in taxation of settlements with the government, governmental entities, and nongovernmental entities that (i) exercise self-regulatory powers (including imposing sanctions) in connection with a qualified board or exchange (as defined in section 1256(g)(7)), or (ii) to the extent provided in regulations, exercise self-regulatory powers (including imposing sanctions) as part of performing an essential governmental function (the Government). Previously, under section 162(f), if a payment was considered a fine or penalty, then the payment would not be deductible. However, if the payment was compensatory in nature to make a victim whole, then such payment was not a "fine or penalty" and would be deductible under section 162. Typically, the US Department of Justice (DOJ) and some other Government agencies have been very reticent to label any payment in a settlement, thus putting the burden on the taxpayer to prove under facts and circumstances how such settlements with the Government should be allocated. This all changes under the new tax law.

The new law changed Section 162(f) to state as a general rule that no deduction is allowed for any amount paid (whether by suit, agreement, or otherwise) to, or at the direction of, the Government in relation to the violation of any law or the investigation by the Government into the potential violation of any law. This general rule does not apply to private claims, but instead applies to cases brought under the False Claims Act, Foreign Corrupt Practices Act, and other investigations by the DOJ, the US Securities and Exchange Commission (SEC), or the Equal Employment Opportunity Commission. There is then an exception to the general nondeductible rule for amounts that the taxpayer establishes are either (i) restitution (including remediation of property) for damage or harm that was or may be caused by the violation of any law, or (ii) are paid to come into compliance with any law that was violated. Additionally, these amounts must be identified in the court order or settlement agreement as such. In other words, in order for the taxpayer to be able to take a deduction under 162, the identification must be made in the settlement agreement as a restitution amount or amount paid to come into compliance with the law. Any amount paid or incurred as reimbursement to the Government for the costs of any investigation or litigation are not eligible for the exceptions and are nondeductible.1

Additionally, the new tax law adds Section 6050X, which requires the Government to issue and file an information return setting out any amount paid over $600 in a suit or agreement, to, or at the direction of, the Government in relation to the violation of any law or the investigation by the Government into the potential violation of any law. The information return must set forth such amount that constitutes (1) the amount paid because of such violation, (2) any amount that constitutes restitution or remediation of property, and (3) any amount for the purpose of coming into compliance with any law that was violated or involved in the investigation. The IRS information return must be filed with the IRS and furnished to each person who is a party to the suit or agreement, at the time the settlement is entered into. Thus, it is impossible for the Government to remain silent on the settlement allocation. It must agree to label amounts under one of the categories for reporting purposes of section 6050X, thus going to the deductibility of such payments.2

CCA 201748008

The new legislation overrides any Chief Counsel Advice interpreting previous statutory language; however, CCA 201748008 (November 17, 2017) may still have some relevance in IRS reviews of settlement. CCA 201748008 concluded that amounts paid as disgorgement for violating a federal securities law were nondeductible under old Section 162(f). The flush language of new section 162(f)(2) notes that just because amounts are designated as restitution or otherwise in the settlement agreement, does not mean that they are successfully established as such by the taxpayer. In other words, the IRS can still challenge such an allocation written in a settlement agreement. CCA 201748008 relies on the Supreme Court decision of Kokesh v. SEC, 137 S. CT. 1635 (2017), that any SEC disgorgement is a consequence of violating a public law and is intended to deter, not to compensate. Thus, the IRS has stated its position that any amount paid as disgorgement for violating a federal securities law inherently cannot be an amount that is restitution and compensatory in nature.

While the reporting requirements of section 162(f)(2)(A)(ii) and section 6050X will likely add much needed clarification and transparency to settlement agreement allocation, they still leave a gap for the IRS to challenge such allocations. Questions remain how these new reporting requirements will affect settlement negotiations and whether the Government will be willing to allocate the settlement amount in a way that will be favorable to taxpayers for deductibility purposes. Additionally, we still are waiting to see what the IRS information return will look like under section 6050X.

Settlements Related to Sexual Harassment Claims

The new tax law also added a new section 162(q) that states no deduction is allowed 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."

Given the broad general scope of this language, taken literally, this would not permit defendant employers to deduct payments made to their own counsel to defend sexual harassment claims or for attorney's fees awarded to the plaintiff in a settlement related to sexual harassment, as well as forbidding a plaintiff to deduct their own attorney's fees related to the claim. This surely was not the intent.

Another lack of clarity is whether the non-deduction of attorney's fees provision also requires that the settlement be subject to a nondisclosure agreement. In other words, does the statute forbid the deduction of attorney's fees related to sexual harassment even if there is no nondisclosure agreement for the sexual harassment claim? If we are to interpret the language of "such settlement or payment" as meaning the same thing in both paragraphs (1) and (2), then attorney's fees are not deductible even if there is no nondisclosure agreement. In contrast, the language in the Joint Committee of Taxation Report has the nondisclosure agreement stipulation after a list of payments that includes attorney's fees. It says "no deduction is allowed for any settlement, payout, or attorney's fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement." This latter Joint Committee of Taxation interpretation better aligns with the history and policy of the statute.

Regardless, in settlements or cases where many claims are brought forth, this provision incentivizes parties to make clear, specific allocations in a settlement/judgment for the amount paid for claims related to sexual harassment or abuse. It also will inherently complicate the negotiations because it now costs defendants more to obtain nondisclosure agreements as part of settlements, and may lower the amount at which defendants are willing to settle.

Effective Elimination of Miscellaneous Itemized Deductions

Section 62(a)(20) allows above-the-line deductions for attorney's fees attributable to discrimination claims and other employment related claims listed in Section 62(e). However, attorney's fees for employment claims not specifically enumerated or that are used in the production of income not as an employee (i.e., under a section 212 deduction), are only deductible as a below-the-line miscellaneous itemized deduction. With the suspension of miscellaneous itemized deductions subject to the 2% floor until 2026, these attorney's fees that would have been taken below-the-line are no longer deductible.

Footnotes

1 Section 162(f)(2)(B).

2 While the Government must report such amounts on a return for purposes of Section 6050X, there is no indication in the legislation that reporting under section 6050X satisfies the requirement that amounts be reported as "restitution" or "coming into compliance with the law" in the settlement agreement or court order in order to be deductible under section 162(f)(2)(A)(ii).

This article is provided as a general informational service and it should not be construed as imparting legal advice on any specific matter.

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