Sexual Harassment: Deductibility of Sexual Harassment Expenses

Sexual harassment lawsuits against employers are increasing with no end in sight, especially considering the United States Supreme Court ruling which makes it easier for an employee to sue an employer. In Burlington Industries v. Ellerth, (1998), the Supreme Court held that an employee is able to recover against an employer without a showing that the employer was negligent or at fault for the actions of a supervisor.

Employers are spending a great deal of money defending these sexual harassment lawsuits. One of the issues each entity faces is whether the legal fees and payments to settle such lawsuits are a deduction for federal income tax purposes.

Origin of the Claim Test

An analysis of whether a deduction for legal fees would be allowed starts with an origin of the claim examination. The Supreme Court articulated the "origin of the claim" test in United States v. Gilmore, (1963) 372 U.S. 39.

In the Gilmore case, a husband sought to deduct the legal fees spent in a divorce proceeding where his wife was seeking half of the stock in companies that her husband had controlling interests. The Supreme Court held that litigation costs are deductible only if the claim arises in connection with the taxpayer's profit-seeking activities. (See 26 U.S. Code § 162). The court found that the husband's expenditures were personal and therefore not deductible.

However, as long as the origin of the claim, sexual harassment, is related to the employer's business, then the legal fees and any payout is likely to be tax deductible under Section 162. For instance, if an employee rejects the president of corporation XYZ sexual advances at the workplace and later the president takes employment actions against such employee, i.e., denying a promotion or a decrease in salary, the legal fees and costs to defend and settle a sexual harassment claim by such employee should be deductible.

No Deduction for Personal, Living or Family Expenses

Sexual harassment claims usually involve verbal or physical conduct at the workplace. However, such claims can arise outside the workplace. For instances, harassment claims may arise from conduct on business trips, at business meetings or at a client's or customer's work location.

In these situations deductibility of legal fees and settlement payments of a corporate defendant or other entity will depend upon whether its employee charged with harassment committed the action within the course and scope of his/her employment. If the action is based on a personal activity the legal fees may not be tax deductible. (26 U.S. Code § 262).

For example, if an employee and her supervisor attend a private party and he assaults her. The IRS may see this as a personal matter, not in the furtherance of the business. Therefore, would disallow a deduction for legal fees and settlement monies, even though an employer may have to defend a suit and pay a settlement.

In Conclusion

There is no clear answer as to when the IRS will view a deduction for attorney's fees or settlement monies as arising in the furtherance of the employer's business. Each case is based upon the facts and circumstances of that case. Before settling any sexual harassment lawsuit and taking a deduction a qualified tax attorney should be consulted.