Robert W. Wood Forbes Contributor
Even though Hush Money sounds dirty or even illegal nearly all businesses pay it on occasion. So, these days everyone in business and consumers should know certain key rules.
- Hush Money is Income If you get paid hush money, is it income you have to report on your taxes? Yes! The IRS says everything is income. That certainly applies to hush money, whatever the circumstances. In fact, almost all legal settlements are income. There are a few exceptions, mainly for personal physical injury damages. But the IRS is strict about what qualifies as physical. Even then, that is only for the compensatory damages, not punitive damages or interest.
- Defendants Deduct It Businesses routinely settle legal claims of all sorts to keep claims and amounts quiet. No business wants bad publicity, and lawsuits are bad for business. So are settlements, especially if amounts are publicized. Settlements that become public can encourage other claims to be brought. So just about every legal settlement agreement requires confidentiality. It’s part of the deal. You can say that the business is paying the claim or paying for silence. It might be a bit of both. If the company paying the money is in business, it is almost always tax deductible, until recently.
- Individual Defendants Usually Can’t Claim a Write-off Companies routinely pay hush money. Individuals do so less frequently, even though individual conduct at companies probably leads to most of the liabilities the hush money is intended to cover up. To claim a write off, an individual would have to be conducting a trade or business. Plus, the hush money would have to relate to that trade or business. For an individual, that can be a tall order.
- Hush Money for Sex Harassment Starting in 2018, a new tax law says businesses and individuals can no longer write off confidential legal settlements for sex harassment or abuse. The restrictions only apply if confidentiality is required. So, if you just pay hush money but do not expressly call for nondisclosure or confidentiality, companies can still write it off. Some companies are doing that now (settling without requiring confidentiality) to get around the new rules. But most companies seem willing to forgo a tax deduction to keep the settlement quiet.
- Legal Fees Can Be a Problem For businesses, legal fees are almost always tax deductible, even if the legal fees are very expensive. They are just one of numerous business expenses. But starting in 2018, if you are paying hush money for sex harassment or abuse, and if you require confidentiality, not even the legal fees can be deducted.
- Recipients of Hush Money Have Tax Problems Too If you a receiving money and your claims were for sex harassment or abuse, you will probably be asked to sign a confidentiality provision. You might think only the defendant would face tax restrictions from this. But plaintiffs can have tax problems too, perhaps not being able to deduct their legal fees. A plaintiff in a $500,000 sex harassment settlement might pay her lawyer $200,000, netting only $300,000. But she may be taxed on the full $500,000. There’s currently a movement to change this unintended and harsh result
- Be Careful of End Runs With many sex harassment claims settled all the time, parties are already attempting to get around these rules. For example, in a $1M settlement, how about saying that only $50,000 is for ‘sex harassment? No one know yet whether these workarounds will work. However, legal settlements with tax indemnities are on the rise.