Tax reform put restrictions on business deductions related to sexual harassment damages and settlements as well as impacting the taxability of any award or settlement.
Impact on a Business - Under the Tax Cuts and Jobs Act (TCJA), and effective for amounts paid or incurred after December 22, 2017, no business deduction is allowed for any settlement, payout, or attorney fees related to sexual harassment or sexual abuse if such payments are subject to a nondisclosure agreement (IRC Sec. 162(q)(1) as amended by TCJA Sec. 13307(a)).
Impact on an Award Recipient – Damages for sexual harassment and gender discrimination are not excludable under Code Sec. 104(a)(2) and thus are fully taxable. The issue of sexual harassment qualifying as excludable physical injury or sickness has been in court on several occasions – always with the same result. Here is an
Example: Payment was received to settle a sexual harassment/discrimination law suit against an employer. The employee did not allege physical injury or sickness in his complaint, but the settlement agreement was broad and encompassed all possible causes of action, including physical injuries. However, there was no allocation of a specific amount of the settlement as compensation for physical injuries or physical sickness. Accordingly, without the allocation, no amount of the settlement proceeds was excludable from income (Hellesen, Jon. E., (2009) TC Memo 2009-143),
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. (IRS website; Section 162(q) FAQ)).
However, the deduction for nonbusiness legal fees is a Tier 2 miscellaneous itemized deduction, and these deductions are suspended for years 2018 through 2025, thus not deductible during that period of time.