The Tax Cuts and Jobs Act that was passed by the House of Representatives and the Senate, and subsequently signed into law at the end of 2017 brings sweeping changes to the U.S tax landscape. One of the lesser-known changes involve the deductibility of expenses related to lawsuits and the judgements and settlements resulting from them. Below, we will take a look at amended IRC Section 162(f) relating to the deductibility of payments made to governmental entities and the newly-created IRC Section 162(q) relating to the deductibility of legal expenses and payments made in connection with sexual abuse and harassment allegations. Whether you are a party involved in a lawsuit, a business owner that may be (or become) a party to a lawsuit, or a litigation attorney, this posting is a must-read.
IRC Section 162(f) disallowed taxpayers a deduction for payments that constituted a “fine or penalty”. Payments that were compensatory in nature (made to make the payee whole), were not considered to be a fine or a penalty and would therefore be deductible under Section 162. While the prior iteration of IRC Section 162(f) was in force, the Department of Justice was reluctant to classify payments to the government as fines, penalties, or otherwise. Instead, taxpayers were responsible for proving out what type of payment their settlement constituted.
IRC Section 162(f) as amended by the Tax Cuts and Jobs Act provides that deductions are not available for any amount paid or incurred to, or at the direction of, a government or governmental entity in relation to the violation of any law or the investigation or inquiry by such government or entity into the potential violation of any law. IRC Section 162(f) indicates that it matters not whether the amount paid is in the form of a judgement or a settlement.
The new deductibility restrictions under IRC Section 162(f) may be trying to achieve a similar result to the pre-Tax Cuts and Jobs Act rules. IRC Section 162(f)(2) provides an exception for (1) payments constituting restitution or (2) payments that are made to come into compliance with a law. If you recall, payments that were meant to make a victim whole were previously deductible under IRC Section 162 as they were not deemed to be fines or penalties. It appears that the same result would be reached under the new law.
It should be noted that the payment of amounts considered to be “taxes payable” to the IRS are not subject to IRC Section 162(f). That is not to say that penalties or fines related to the investigation and the litigation that follows are deductible, as such expenses must be analyzed under the new IRC Section 162(f) rules.
The Tax Cuts and Jobs Act also added IRC Section 6050X, which mandates the issuance of an information return identifying any amount paid in excess of $600 in a suit or agreement to, or at the direction of, the Government in relation to any law or the investigation by the government into the potential violation of any law. As mentioned above, the government has historically been reluctant to classify the type of payment that it received. IRC Section 6050X requires the government to not only identify the amount paid, but also set forth any amount that constitutes restitution or remediation of property and any amount that was paid for the purposes of coming into compliance with any law that was violated or involved in the investigation. This requirement forces the government to take a position on the classification of payments made to it.
IRC Section 162(f) was not the only amendment relating business expense deductibility as a part of the Tax Cuts and Jobs Act. IRC Section 162(q) was added to address the wave of sexual misconduct allegations that have plagued some of the nation’s executives and public figures. IRC Section 162(q) provides that no deduction is allowed for any settlement or payment related to sexual harassment or sexual abuse if the settlement or payment is subject to a non-disclosure agreement. Further, attorney’s fees related to such settlement or payment are also not deductible.
Because nearly all settlements relating sexual misconduct include non-disclosure agreements, this addition to IRC Section 162 is likely to affect most settlements made between employers and the employees bringing suit for sexual harassment or abuse. IRC Section 162(q) appears to disallow the deduction for employer-provided legal representation for both the employee being accused and the employer, itself.
Interestingly enough, the broad language of IRC Section 162(q) appears to disallow the plaintiff in a sexual harassment and/or abuse case to deduct attorney’s fees related to a settlement or payment.
Whether you are personally involved in litigation or are an attorney that is representing a client in litigation, it is critical that you understand the key provisions of the tax code (the “Code”), as amended, relating to the deductibility of legal costs and payments made in (or out) of litigation. Although most litigators may have a general understanding of the tax implications of expenses incurred in litigation, the new complexity of the Code demands that a resource with extensive tax experience be brought in to ensure there are no surprises come tax time. An experienced tax attorney can provide guidance as to the deductibility of expenses related to litigation.
The tax and accounting professionals at the Tax Law Offices of David W. Klasing have extensive experience in representing taxpayers from all walks of life in a myriad of tax situations. Whether you are engaged in litigation and are unsure of the tax consequences to you or your client or are at the center of an IRS audit, our team of attorneys and tax professionals are ready to zealously advocate for your best interests. Do not lose sleep because of the uncertainty surrounding tax laws. Contact the Tax Law Offices of David W. Klasing today for a reduced-rate consultation.
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