The Minnesota Legislature has advanced legislation that, if enacted into law, will further complicate the way sexual harassment cases are settled. This legislation, touted as a measure to close “a loophole in the law that benefits companies at the cost of victims of sexual harassment,” does no such thing.
The Complications of Minnesota’s Proposed Law on Sexual Harassment Settlements
The legislation appears in three bills being advanced in the Minnesota House and Senate: HF 1056, SF 1258, and SF 3035. All three bills would mandate that, “In a sexual harassment or abuse settlement between an employer and an employee, when there is a financial settlement provided, the financial settlement cannot be provided as wages or severance pay to the employee regardless of whether the settlement includes a nondisclosure agreement.”
This mandate, however, would purportedly force the parties involved in the settlement agreement to violate the U.S. Internal Revenue Code as well as IRS regulations and guidance governing how settlements in employment cases are to be characterized.
The intent of the legislation is to render settlement payments for sexual harassment and sexual abuse cases exempt from Minnesota Income Tax. The draft legislation further provides that the amount of damages received in a sexual harassment or abuse lawsuit or settlement is a subtraction from federal taxable income per Section 290.0132 of the Minnesota Statutes. However, this end can be accomplished without the wage designation mandate.
Current Minnesota and Federal Law on Taxation of Settlements
Regarding Claimant Employees
Current federal and state tax law provides that amounts paid in settlement or pursuant to judgments entered in employment law cases, including sexual harassment cases, that do not involve an actual physical injury, are considered ordinary income to the claimant. The Internal Revenue Code is clear that all such payments, regardless of whether the payments are intended to compensate the claimant for lost wages, lost profits, damages for emotional distress, damages for breach of contract, punitive damages, interest, or attorney’s fees, all must be reported as ordinary income, unless the claimed compensation is for an actual physical injury. For a more in-depth description, see How IRS Taxes Employment Settlements and page 32 of IRS Publication 15.
Sexual harassment cases, like other employment discrimination cases, typically arise out of circumstances that result in the termination of the claimant’s employment. In most such cases, an element of the claimed damages is compensation for lost wages and benefits of employment caused by or arising out of the harassment and the termination of employment related to the harassment. The lost wages claimed can be a significant factor in determining the settlement value of the case.
Regarding Settling Employers
Payments in settlement of lawsuits are deductible from state and federal income tax liability as business expenses. In 2017, Congress enacted a notable exception to the deductibility of such payments. As a result of the Me Too movement, Congress included in the Tax Cuts and Jobs Act (TCJA) a provision that prohibited defendants from deducting settlement of sexual harassment or abuse payments on their income tax returns if the settlements are subject to a nondisclosure agreement (NDA). The purpose was to penalize employers that insisted on settling such claims confidentially.
Minnesota law currently conforms to the TCJA. Settlements are subjected to Minnesota income tax as ordinary income and may be taken as deductions on the employer’s income tax returns as long as the settlement agreements do not include a confidentiality requirement.
Characterizing Settlement Payments as Wages
In settling employment claims, including sexual harassment cases, if the settlement includes, even in part, compensation for lost wages, salary, bonuses, commissions, etc., that portion of the settlement must be reported to the IRS and Minnesota Revenue as wages, subject to mandatory state and federal income tax, social security, and Medicare withholdings. The parties cannot agree to “call it something else” if in fact wage loss factored into the settlement discussions and the ultimate settlement payment.
For this reason, unless there is no claim for lost wages asserted, employers should always require that at least a portion of the settlement be characterized as wages. For their part, settling employees rarely object because they are ultimately liable to pay those taxes, and they would just as soon get that money out of their bank accounts so they don’t spend it before the tax bill comes due.
Minnesota’s Proposed Law on Sexual Harassment Settlements: A Potential Violation of the Internal Revenue Code?
The proposed legislation would expressly prohibit the parties from characterizing financial payments in sexual harassment or abuse case as wages in a settlement agreement regardless of whether there is a nondisclosure agreement. The purpose of prohibiting the parties from characterizing these payments as wages is not clear.
Regardless of whether the payments are characterized as wages, damages for emotional distress, or anything else, the settlement amount must still be reported to the IRS as ordinary income. The employers will report the payments one way or the other, whether on a W-2 Form or a 1099 Form and under the Code, the employees will pay income tax on the settlement or the award.
The IRS position does not change simply because the underlying claim is a sexual harassment claim and it certainly is not going to change if Minnesota passes a law requiring that the parties not characterize any portion of the payment as compensation for lost wages.
As a result, the proposed legislation would actually do more harm than good. It would compel the parties to enter into an agreement that puts both of them, potentially, in violation of the Internal Revenue Code. Alternatively, the parties could follow the requirements of the Code, but that would put them in violation of the proposed Minnesota law.
If the Minnesota Legislature desires to make sexual harassment and abuse case settlement amounts exempt from state income tax, then they should craft legislation that says simply that, without mandating the language to be used to characterize the payment. Section 2 of HF 1056 standing alone, accomplishes that outcome. It states:
Minnesota Statutes 2022, section 290.0132, is amended by adding a subdivision
to read:Subd. 34.
Damages for sexual harassment or abuse.
The amount of qualifying damages received is a subtraction. For purposes of this subdivision, “qualifying damages” means:
- damages received under a sexual harassment or abuse claim that are not excluded
from gross income under section 104(a)(2) of the Internal Revenue Code because the injury or sickness for which the damages are paid are not physical; or- severance pay received under a financial settlement of a sexual harassment or abuse
claim that does not include a nondisclosure agreement.
