Though most news coverage about the Tax Cuts and Jobs Act of 2017 (the Act), signed into law on December 22, 2017, has focused on its effect on corporate and individual taxpayers, it also has important implications for employers and HR professionals. Notably, the Act eliminates previously available tax deductions related to confidential settlements of sexual harassment claims. The Act also creates a new tax credit opportunity for eligible companies that voluntarily offer paid family and medical leave for their lower-wage workers. In light of these changes, employers should evaluate their current policies and procedures and prepare for more complicated risk analyses when settling certain employment-related claims. Below is a discussion of these two important changes.
I. SETTLING SEXUAL HARASSMENT CLAIMS
With the recent wave of complaints and allegations of sexual harassment in the news, and efforts such as the #MeToo and Time’s Up campaigns encouraging victims to come forward, employers are likely to face – and potentially settle – an increasing number of sexual harassment claims. Under Section 162 of the Internal Revenue Code (IRC), employers have been permitted to deduct litigation and settlement costs as ordinary and necessary business expenses paid or incurred in connection with an employer’s profit-seeking activities. With implementation of the Act, Congress has significantly limited employers’ ability to deduct confidential settlement payments and attorney’s fees incurred that are “related to” sexual harassment or sexual abuse claims.
As modified by the Act, Section 162 of the IRC, now states:
“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 settlement or payment.”
It is common to include confidentiality provisions in settlement agreements for the benefit of all parties, but now employers must weigh the value of deducting settlement payments against the cost of any potential reputational damage if the settlement is disclosed. Unfortunately, claims leading to larger settlements often include egregious allegations and facts that may increase an employer’s interest in maintaining confidentiality. The direct relationship between these factors may present employers with a Hobson’s choice, and little option but to forfeit the deduction.
More Questions Than Answers
Because the IRS has not issued guidance on the new exception, many unanswered questions remain.
- What does settlement or payment “related to” sexual harassment or sexual abuse really mean? Employees often bring multiple claims stemming from one set of operative facts. Interpreting “related to” broadly could render virtually all employment-related settlements nondeductible (if confidential) if any allegation of sexual harassment or sexual abuse is included in the plaintiff’s complaint. By using the broad qualifier “related to,” arguably Congress did not intend the new limitation to apply only to settlements that are actually pled as “sexual harassment.” For instance, a claim for retaliatory discharge, based on a former employee’s allegation he or she was terminated for reporting sexual harassment, could fall within the new limitation.
- What about confidential severance payments to a terminated employee who was the target of allegations of sexual harassment? Although it appears the purpose of the new rule is primarily to prevent employers from secretly “paying off” victims while retaining the alleged abuser or harasser, the new exception may also prevent deduction of confidential severance agreements made with terminated employees, if their separation was in some way related to alleged sexual harassment or abuse. Employers should consider whether such severance payments could be made pursuant to an established severance policy versus a confidential severance and release agreement, which the IRS could characterize as a “settlement.”
- Can employers preserve deductibility of a portion of the total settlement amount by entering into separate settlement agreements, segregating sexual harassment claims from non-sexual harassment claims? There is no IRS guidance on this point, although it would seem permissible. Employers should be careful, however, to ensure any allocation of settlement funds among the various claims remains in proportion to the allegations of the complaint. Even if the plaintiff alleges numerous claims, only one of which is entitled “sexual harassment,” yet virtually all the plaintiff’s allegations center on instances of sexual harassment, an employer may be hard-pressed to argue that some of the claims were not “related to” sexual harassment. The IRS (or a court) could closely scrutinize any settlement that appears to allocate a disproportionate amount of the total settlement to the non-sexual harassment claims. Such settlement could be considered “not at arm’s-length” and ultimately ignored when construing the agreement for tax purposes.
- Can an employer negotiate with a plaintiff to dismiss sexual harassment claims with prejudice and settle the remaining claims to preserve the deduction? This is unclear. Such an arrangement could raise a red flag with the IRS, although there may be practical limitations on the IRS’ ability to discover the underlying facts given that they would not be part of the settlement agreement. Without a live sexual harassment claim, confidential settlement of remaining claims may not be considered “related to” sexual harassment and therefore may be deductible.
Without IRS guidance or case law to shed light on the scope of the new provision, employers are left with a tax risk calculation—interpret the statute narrowly and risk unexpected tax liability, or interpret the statute broadly and sacrifice potentially viable tax deductions. What is clear, however, is that the culture’s increased focus on victims of sexual harassment and abuse now has corporate tax implications. And employers must now further adapt their approach to sexual harassment and abuse allegations.
II. TAX CREDITS FOR PAID FAMILY AND MEDICAL LEAVE
The Act also created a two-year business tax credit, beginning in 2018, for eligible companies that voluntarily offer paid family and medical leave for their lower-wage workers.
Eligibility for Tax Credit
The tax credit is available to employers who have a written policy in place that provides at least two weeks of paid family and medical leave at a compensation rate that is at least 50 percent of the wages normally paid to the employee. Specifically, the written policy must satisfy the following requirements:
- Both full-time and part-time “qualifying employees” must be offered paid leave. An employee is a “qualifying employee” if he or she is employed by the employer for at least a year, and paid no more than $72,000 (for 2017). Full-time employees must be offered at least two weeks of annual paid “family and medical leave” (discussed further below). The policy must offer part-time employees a commensurate amount of paid leave on a pro rata basis.
- The policy must require a compensation rate for paid family and medical leave that is not less than 50 percent of the employee’s regular wages.
- For any eligible employees who are not covered under the federal Family and Medical Leave Act (FMLA), the policy must include a non-retaliation provision that states that the employer will not (a) interfere with, restrain or deny the exercise of (or attempt to exercise) an employee’s right to paid leave under the written policy, or (b) discharge or in any other manner discriminate against any individual for opposing a practice that is prohibited by the policy.
Amount of Tax Credit
Eligible employers may claim a general business tax credit equal to 12.5 percent of the wages paid to qualifying employees for family and medical leave if the leave benefit amount equals 50 percent of normal pay. The 12.5 percent credit increases incrementally by 0.25 percent for each percentage point that exceeds the 50 percent rate of normal pay for up to 12 weeks of paid leave per employee per year, up to a 25 percent maximum credit.
Ineligible Leave for Purposes of Tax Credit
Any leave that is paid by a state or local government or required by state or local law is excluded in determining the amount of paid family and medical leave provided by the employer.
The tax credit only applies to “family and medical leave” under the federal FMLA, regardless of whether the leave is offered under the FMLA or an employer’s leave policy. “Family and medical leave” refers to leave for a reason permitted under the FMLA. If the paid leave is provided for other purposes (such as vacation leave, personal leave, or other medical or sick leave), then it is not taken into consideration for purposes of the tax credit.
FMLA qualifying reasons include:
- The birth of a child of the employee and the care of a newborn child.
- The placement of a child with the employee for adoption or foster care.
- A serious health condition that makes the employee unable to perform the functions of his or her job.
- The care of the employee’s spouse, son, daughter or parent with a serious health condition.
- Any qualifying exigency arising out of the fact that the employee’s spouse, son, daughter or parent is a military member on covered active duty or has been notified of an impending call or order to covered active duty.
- The care of a covered service member with a serious injury or illness who is the employee’s spouse, son, daughter, parent or next of kin.
Pending issuance of IRS guidance, employers that want to take advantage of the new tax credit should review their leave policies to ensure that they meet the above eligibility requirements, and amend or restate them as necessary for compliance with the new law.
For more information about how the new tax act may impact your business, contact Julianne P. Story, Stacey Bowman, Joel Thomason or another member of Husch Blackwell’s Labor & Employment team.