Eric Swalwell Claims Raise Tax Issues For Swalwell & His Victims

It seems inevitable that Eric Swalwell will face civil suits in addition to government investigations. Civil suits probably mean paying settlements and legal fees, and tax issues in sexual harassment and abuse settlements can be tricky. If you’ve been through an ordeal and eventually collect a settlement or judgment, the last thing you want is uncertainty about taxes and potentially facing an audit and a big bill for taxes, penalties and interest from the IRS or state tax authorities years later.

Taxes on Victims

Most people believe that sexual assault and abuse legal settlements in particular should not be taxed by the IRS. Yet how lawsuit settlements are taxed is nuanced, the tax law has long been unclear, and many sexual harassment plaintiffs have a hard time getting tax-free treatment. Under the tax code, compensatory damages for personal physical injuries or physical sickness are tax free.

In contrast, damages for emotional injuries are fully taxable. It’s confusing, making taxing emotional distress and physical sickness a kind of chicken and egg issue. To have a chance at tax-free treatment, the plaintiff needs to show that she claimed that the defendant caused physical injuries or physical sickness. Medical evidence helps, including statements from medical professionals.

Some plaintiffs claim that harassment gave them post traumatic stress disorder. The IRS has not specifically ruled whether it is physical, but there are good arguments that PTSD is physical for tax purposes. Settlement wording matters but caution is needed as the IRS taxes most lawsuit settlements.

Tax Deductions For Harassers

For defendants in business, legal settlements are almost always tax deductible, as are legal fees. But since 2018, the tax law denies tax deductions for confidential settlements in sexual harassment and abuse cases. Related legal fees are also nondeductible, making the tax treatment of the legal fees here especially harsh. Section 162 of the tax code generally lists business expenses that are tax deductible, but Section 162(q) now provides that:

• “(q) PAYMENTS RELATED TO SEXUAL HARARASSMENT AND SEXUAL ABUSE. — No deduction shall be allowed under this chapter for —(1) any settlement or payment related to sexual harassment or sexual abuse if such settlement or payment is subject to a nondisclosure agreement, or (2) attorney’s fees related to such a settlement or payment.”

The overwhelming majority of legal settlement agreements have a confidentiality or nondisclosure provision. Even so, reports suggest that many defendants still claim tax deductions for settlement payments and related legal fees, despite the seemingly black letter denial of tax deductions.

Sexual Assault Victims

Sexual assault victims could get some relief if a proposed tax bill gains traction in Congress. The Survivor Justice Tax Prevention Act (H.R.10055) was co-sponsored in 2024 by Representatives Smucker and Moore. If it is eventually passed, it would amend the tax code so that survivors of sexual abuse and unwanted and illegal sexual contact do not have to pay taxes on their settlements. Under current tax law, compensatory payments for damages awarded on account of personal physical injuries or physical sickness are exempt from federal tax.

But what constitutes physical injuries or physical sickness is not defined. The IRS likes to see “observable bodily harm” such as bruises or broken bones, but if you are sexually assaulted or abused, you may not have these signs. Sexual assault victims often face uncertainty. The IRS has issued one piece of non-precedential internal guidance in which the IRS’s attorneys advised an IRS agent to presume that a victim of an alleged assault who was a minors at the time of the assault, but was an adults when they brought suit several years later, qualified for an exclusion.

In that ruling, the IRS allowed the exclusion without proof of cuts, scrapes or bruises. Yet it did so by assuming that they existed and had healed due to the passage of time, not by clarifying that they were not needed in the context of a sexual assault in the first place. If passed, this law would exempt sex abuse and assault settlements. Smucker and Moore rightly point out that the observable harm standard can be especially difficult to meet and unfair in circumstances of sexual assault or sexual contact where such physical injuries may not be visible or may have healed.

The proposed legislation narrowly “expands” (or merely clarifies) current law to help survivors of sexual assault or unwanted sexual contact by tying the IRS tax exemption to the definitions of sexual act and sexual contact in federal criminal code.

Needed Tax Relief

Tax legislation is not easy to write, and many tax bills fail to gain traction and fail to pass. In some cases, one reason is the language in the bill itself. But this tax bill—apart from its equity—is extremely specific. It would implement the exclusion by amending Section 104(a)(2) of the Internal Revenue Code to include within the ambit of the existing exclusion amounts (other than punitive damages) received by a taxpayer on account of a “sexual act” or “sexual conduct.”

The definition of sexual act and sexual contact are clearly identified as referring to definitions of the same terms under 18 USC 2246. For example, the term sexual contact means the intentional touching, either directly or through the clothing, of the genitalia, anus, groin, breast, inner thigh, or buttocks of any person with an intent to abuse, humiliate, harass, degrade, or arouse or gratify the sexual desire of any person;

Under the definition in the proposed legislation, the groping of a person’s buttocks, inner thigh, or breast even “through the clothing” is sexual contact, so a settlement would therefore be excludible. The bill also specifically provides that it is enough to qualify for the exclusion if the judgment or settlement agreement states that the damages are for an alleged sexual act or sexual conduct. It goes on to say that the IRS or a court cannot use a lack of medical records about the groping or other incident occurred to deny tax-free treatment.

It would seem difficult for the IRS to be able to impose a cut, bruise, or scrape requirement on sexual abuse recoveries with this language. Cases that are already settled and monies that are already paid are not covered by this tax bill. Getting to an acceptable tax position that their recoveries are excludible as amounts received on account of a physical injury may still be possible in many cases, despite the current ambiguity in the tax law.

Until this tax bill passes, plaintiffs in current sex abuse or sexual assault should be careful with settlement agreement wording and be cautious about whether IRS Forms 1099 will be issued for the settlement. If possible, get tax advice before your settlement is documented. The IRS isn’t bound by the parties’ tax characterization, but lawsuit taxes often hinge on settlement agreement wording and the IRS often will respect it.