In March of 2019 there was a terse announcement by the IRS entitled "Recipient of sexual harassment settlement may deduct attorney fees" (as reported in a tax daily newsletter communication). My initial impression was that the IRS had magically decided to allow the same types of deductions for which plaintiffs in certain enumerated employment & whistle blower claims are eligible, and which can be categorized as "above the line deductions"(IRC sec. 62(20)&(21)). Sadly, this was not the case. The announcements were not complete and probably had the character limitation malady from which Twitter suffers.
Of course, the "whole" of the announcement was expanded and corrected by follow-up language that narrowed the breadth of the announcement. The whole of the announcement stated "the recipient of a settlement of a sexual harassment claim is not precluded, by Code Sec. 162(q)'s disallowance of deductions related to sexual harassment claim payments, from deducting attorney fees related to the payment." I again mistook this to mean that attorney's fees and costs could be deducted from harassment awards.
The IRS finally put out an FAQ on its site that stated: "Question: 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? The somewhat evasive answer: "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 [capitalized emphasis].
This qualifying language "if otherwise deductible"means that for victims, sexual harassment claims are like other personal injury recoveries, generally NOT deductible and therefore are 100% includable in the plaintiff's income unless the damages are due to "personal physical injuries or physical sickness." IRC Sec. 102(a)(2) states:
"(a) In general, except in the case of amounts attributable to (and not in excess of) deductions allowed under section 213 (relating to medical, etc., expenses) for any prior taxable year, gross income does not include: (2) the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness;"
Further any settlement agreement must "spell out" and allocate to the "personal physical injuries or physical sickness" claims separately if the claimant has any hope of having that portion of the settlement be recognized as non-taxable. In the non-published case of Mumy v. CIR (T.C. Summary Opinion 2005-129 of 2005) a $12,000 settlement for harassment and a physical arm pinch "referenced the harassment, personal injury, and emotional distress allegations in a preliminary "whereas" clause...and then specifically stated that "Settlement is made only to buy peace and to compromise disputed claims, and to avoid the expense and inconvenience of trial." All of the $12,000 was found to be income of plaintiff.
If the parties had agreed and made two claims, one claim for $6,000 for the pinch and one claim for $6,000 for the emotional damage, the income would likely have been only $6,000 and the attorney fee of $500 would have been split in accord with the recovery absent some evidence of the amount of attorney time spent on each claim. Only a precise, reasonable amount of detail in the settlement agreement can mitigate the lack of deductibility of costs and attorney fees for "emotional distress."
An example of tax non-deductible of court costs and attorney fees might include a $100,000 settlement with $10,000 of court costs, and $40,000 of attorney fees. All $100,000 is added to the income of the plaintiff, who may pay as much as $15,416 in federal taxes (assuming no other income and excluding state tax). After paying the attorney fee, court costs and taxes, the plaintiff benefits by $100,000 - $10,000 - $40,000 - $15,416 = $34,584. (If the settlement is large enough to push the plaintiff into a higher tax bracket, the final benefit percentage drops further.)
The same example for complete exclusion from income (such as for physical injury) might include a $100,000 settlement with $10,000 of court costs, and $40,000 of attorney fees. All $100,000 is excluded from income, and the plaintiff benefits by $100,000 - $10,000 - $40,000 = $50,000 after paying the attorney fees, & court costs.
Against this tax deductibility system, is the Tax Cuts & Jobs Act. Congress added 26 U.S.C. Sec. 162(q): Payments related to sexual harassment and sexual abuse No deduction shall be allowed under this chapter 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.
The above was the provision that caused so many to mistakenly postulate that no tax deductibility would be allowed to victims who agree to keep their settlements confidential. The IRS FAQ emphasized that "otherwise deductible" referred to the prior state of tax deductibility as it was before section 162(q), but they could have simply interpreted 26 U.S.C. Sec. 162(q) to relate only to payor defendants (though that would have been too clear and easy an announcement) .
The purpose of IRC Sec. 162(q) is to deny a payor defendant a tax deduction when the settlement is made with confidential provisions. The idea might be such that an extra penalty is in order for a company electing confidentiality since confidentiality makes it more likely for a coverup or for the conditions that created the violation to continue. In addition, the extra cost due to inability to tax deduct a payor's damage payment might cause parties to opt for a non-confidential settlement benefitting the public.
Of course, the differential cost between confidential and non-confidential settlement will depend upon the marginal tax rate of the payor. Currently (2019) the top marginal rates are 21% for C corporations, 35% for professional corporations, and 37% for individuals. Using a $100,000 settlement amount, the ability to tax deduct the settlement is worth $21,000 to a C corporation, $35,000 to a professional corporation and $37,000 to an individual sole proprietor employer. It is financially painful enough to pay $100,000.00 as a settlement, but the loss of deductibility amounts to an additional fifth to one third as a penalty because the settlement is confidential.
This appears to be what congress had in mind when they passed Sec. 162(q). However, the use of insurance can severely mitigate this "economic punishment" arising from blocked tax deductibility. Commercial insurance policies typically work from a coverage limit and a policy deductible. The policy deductible is an amount that the insured is responsible for paying, while the insurance policy limits above the deductible is the responsibility of the insurance company.
The policy premiums are typically deducted as ordinary and necessary business expense after purchase and before an insurable event occurs. The policy deductible is typically subtracted from any claim paid. This means that only the deductible is paid by the insured. As such the deductibility or limit of deductibility is controlled by and paid by the insured. The insurance company's payout is related to reserves, and taxation of insurance performance is beyond the scope of this article.
An ELPI (Employment Practices Liability Insurance) policy is the type of commercial liability insurance that insures against employment harassment claims. Continuing the example above, if an insurance policy for $100,000 with a $1000 deductible will cause and enable the insured to deduct $1000 if the claim is non-confidential, and no deduction if the claim is confidential.
At the tax rates above, the inability to tax deduct the $1000.00 policy deductible costs employer payors an additional costs of $210.00 to a C corporation, $350.00 to a professional corporation and $370.00 to an individual sole proprietor. This can be considered to be either (a) a much reduced penalty for keeping the settlement confidential, or (b) a signal for the plaintiff to ask for more compensation to try and capture the "theoretical restored artificial tax deductibility" that comes from having insurance.
Of course, if the case goes to jury, the jury will probably not be allowed to consider insurance. The presence of insurance is likely to benefit the plaintiff even more where the plaintiff presses for some part of the "theoretical restored artificial deductibility" that comes from having insurance. In the example, the additional available benefit of not needing tax deductibility amounts in play (due to the presence of insurance) are $20,790 to a C corporation, $34,650 to a professional corporation and $36,630 to an individual sole proprietor.
Therefore, when an ELPI policy is present, the payor is likely to be insensitive to tax deductibility and thus may always want confidentiality unless the policy deductible amount is very large. When an ELPI policy is present and confidentiality is sought, a savings of roughly 20.8%; 34.65% and 36.6% of the claim results by having bought the insurance policy. These amounts of money were sought by congress as a tax deductibility punishment for non-insured payors, and under proper circumstances may represent percentage additional recoveries for plaintiffs as a starting bid for agreeing to confidentiality.
Other Articles Outside the Tax Debt Approach
Debt Control Extensive Outline (8/14/2019)
Pre-Startup Efficiency – Introduction (Parts 1&2) (2016)
9th Circuit Rejects “One Day Late Rule” for Late Filed Return Tax Dischargeability (2016)
Give My Start-Ups a Break! (2015)