Hush Money and Taxes: 7 Things To Know (Shhh!)

Hush money sounds dirty or even illegal. But on some level, nearly all businesses pay it on occasion. And these days, everyone in business should know certain key rules. Consumers should too.

1. Hush Money is Income. If you get paid hush money, is it income you have to report on your taxes? You bet. 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 pretty strict about what qualifies as physical. Even then, that is only for the compensatory damages, not punitive damages or interest.

Once it’s income, it is hard to avoid taxes. Stormy Daniels had income, even if she returned the $130K Trump settlement. So be careful. And attorneys’ fees are often treated as taxable income to the plaintiff, even if the lawyer takes the fees off the top! It’s one way the Trump tax law hurts legal settlements.

2. 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 can encourage other claims from being 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, well until recently.

3. Individual Defendants Usually Can’t Claim a Write-off. Companies routinely pay hush money. Individuals do 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.

4. 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. For exampled Fox settled some suits without confidentiality.

5. 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.

6. 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. In short, the tax law that double-taxes victims needs fixing.

7. 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 actually work. On the plaintiff side, legal settlements with tax indemnities are on the rise

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Serena Williams Fines: At Least They Are Tax-Deductible

Controversially, Serena Williams was fined $17,000 at her U.S. Open Tennis Finals. The fines break down to $10,000 for verbal abuse of chair umpire Carlos Ramos, $4,000 for being warned for coaching, and $3,000 for breaking her racquet. Williams and others have suggested that male and female athletes are treated differently when it comes to run-ins with officials. But one place they seem to be treated the same is when it comes to taxes. Everyone must pay them, and athletes typically pay a lot. But at least fines of this type are generally tax deductible. Athletes are operating a business, and a pretty big one at that. They usually have their own companies. But even if they do not, they can report taxes as the proprietor of a business on Schedule C to their tax return.

Serena Williams argues with the chair umpire during a match against Naomi Osaka, of Japan, during the women’s finals of the U.S. Open tennis tournament at the USTA Billie Jean King National Tennis Center, Saturday, Sept. 8, 2018, in New York. (Photo by Greg Allen/Invision/AP)

Anything that is ordinary and necessary can generally be deducted, and occasional fines and penalties certainly qualify. After all, these are not fines for breaking the law, and they are not paid to the government. Even big fines paid to the NFL or other organizations can be deducted. These professional athlete organizations are not the government. Big companies manage to deduct fines and penalties, often despite what seem to be prohibitions in the tax code. Tax deductible settlements are one reason for the proposed Truth in Settlements Act (S.1109). It would require federal agencies to disclose the tax deductibility of settlements. It would also require corporations to disclose deductible settlements. Most legal settlements in business are tax deductible, of the things you should know about taxes on legal settlements.

However, Section 162(f) of the tax code prohibits deducting ‘‘any fine or similar penalty paid to a government for the violation of any law.’’ That includes criminal and civil penalties, as well as sums paid to settle potential liability for a fine. But many companies can negotiate for smaller nondeductible fines and bigger deductible payments. For example, BP probably could write off a majority of its $20.8 billion out-of-court settlement related to the Gulf Oil spill. The deal designated only about one quarter, $5.5 billion, as a non-tax-deductible Clean Water Act penalty.

One big critic of such deals is U.S. Public Interest Research Group, which often rails against tax deductions claimed by corporate wrongdoers. The organization has a research report here on settlement deductions. But the present tax code allows businesses to deduct damages, even punitive damages. Restitution and other remedial payments are also fully deductible. Only certain fines or penalties are nondeductible. Even then, the rules are murky, and companies routinely deduct payments unless it is completely clear that they cannot.

Explicit provisions about taxes in settlement agreements are becoming more common. For example, the Department of Justice expressly blocked Credit Suisse from deducting its $2.6 billion settlement for helping Americans evade taxes. Ditto for the BNPP terror settlement, which states that BNPP will not claim a tax deduction. Sometimes the government and a defendant split the baby.

Of the $13 billion JP Morgan settlement struck in late 2013, only $2 billion was said to be nondeductible. The DOJ doesn’t always disclose the terms of settlements either.

But that could change. A poll released by the U.S. PIRG Education Fund says most people disapprove of deductible settlements. BP might fuel such sentiments. As for Serena, there’s no controversy about deducting those kinds of fines, which are for tax purposes regarded as a cost of doing business. Notably, though, under the big tax law passed in December 2017, employee business expenses no longer qualify for tax deductions. So you really have to be in business to deduct your expenses.

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Do You Have Attorney-Client Privilege With Your Accountant? Here’s A Workaround

Taxes and the IRS can be unsettling, and may cause you to worry over many questions. How aggressive are you being? Are you claiming something the IRS may view as over the top? Do you have exposure for past years, and would amending past returns make the situation better or worse? How much can you safely tell your accountant, and how much can you reveal in writing without fear it will be used against you? What is good planning, what is over the line? What is fraud, and how long do you have to worry?

Think carefully when you come to the penalties of perjury language on your tax return. In the run-up to tax filing season and year-round, government press releases about tax convictions, guilty pleas and indictments help remind you to fly right. But taxes are complex, and the line between creative tax planning and tax evasion isn’t always clear.

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You do not have attorney client privilege with your accountant. In contrast, if you tell a lawyer secrets (say you are hiding money offshore), the IRS cannot make your lawyer talk. The IRS generally can’t even make your lawyer produce documents. The attorney-client privilege is strong precisely so that clients (in both civil and criminal cases) will be forthcoming with their lawyers. Accountants, however, don’t have this privilege. If you make statements or provide documents to your accountant, he can be compelled to divulge them no matter how incriminating

For completeness, it is worth noting that there is a statutory “tax preparation” privilege. It was added in to the tax code (IRC Section 7525(a)(1)) in 1998. But it is quite narrow, and is completely inapplicable to criminal tax cases. That makes it of little value. In contrast, attorney-client privilege is worth a great deal and provides enormous protections under the law. In sensitive tax matters, the answer to this disparity is the Kovel letter, named after United States v. Kovel. You hire a tax lawyer, and your tax lawyer hires an accountant. In effect, the accountant is doing your tax accounting and return preparation, but reporting as a subcontractor to your lawyer.

Properly executed, this end run imports attorney-client privilege to the accountant’s work and communications. It is reasonably safe too, although it is true that there have been a few IRS lawsuits eroding it. For example, in United States v. Richey, the Ninth Circuit refused to protect an appraisal that a taxpayer, lawyer and accountant were trying to keep from the IRS. In United States v. Hatfield, the court forced disclosure of discussions between the lawyer and accountant. On the whole, however, the Kovel letter has withstood the test of time, and probably will for generations to come. The mere fact that a Kovel arrangement in place can make it unlikely that the IRS will push for disclosure around the edges. And having a Kovel agreement can make accountants more comfortable and more responsive as well. 

Pre-existing relationships between the accountant and the ultimate client can be prickly. A Kovel arrangement is premised on the notion that the accountant’s communications were “made in confidence for the purpose of obtaining legal advice from the lawyer.” See United States v. Adlman. The attorney is the client in a Kovel engagement so the accountant should address all correspondence to the lawyer. That means information acquired by an accountant under a Kovel agreement should be distinguished from information collected by the accountant as an auditor or in some other capacity.

Attorney-client privilege is rarely tested in this context. However, you don’t want to end up having to fight about disclosure when it really matters.

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How Sexual Harassment Plaintiffs Are Double Taxed By Trump Tax Law

The tax reform law passed in December 2017 prohibits tax deductions for hush money settlements in sexual harassment cases. Labelled a ‘Weinstein Tax,’ it prevents individuals and companies from writing off the settlements and the associated legal fees. But the law mistakenly says that plaintiffs too cannot deduct their legal fees. If a plaintiff recovers $500,000 but must pay her lawyer 40%, the full $500,000 is income, even though the plaintiff nets only $300,000. The victim is paying tax on money she never receives. Of course, the legal fees are taxable to the lawyer too, who must also pay taxes. That sure sounds like double taxation.

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The “Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018” would change that, making clear that the plaintiffs can deduct their legal fees. But the bill has not yet been passed. The Weinstein provision was meant to stop defendants in sexual harassment cases from being able to deduct their legal fees and settlement payments where confidentiality is required. Of course, virtually all legal settlement agreements have some type of confidentiality or nondisclosure provision. This is so in virtually any kind of legal case, especially with sexual harassment. The double tax problem starts with the strange tax rules for legal fees.

Plaintiffs who use contingent fee lawyers are treated as receiving 100% of the settlement amount, even if their lawyer takes 40% off the top. So ruled the U.S. Supreme Court in Commissioner v. Banks, 543 U.S. 426 (2005). That means plaintiffs must figure a way to deduct the fees, which can be as high as 50%. In 2004, Congress enacted an above the line deduction for legal fees in employment cases. Since then, plaintiffs in employment cases have been taxed on their net recoveries, not their gross, but only if they properly claim this above the line deduction. In sex harassment cases, that is now on hold.

However, one positive development is this letter by several Senators to the Treasury Secretary and head of the IRS. The Senators say they want to fix this. But that is hardly the same as actually getting the correction through Congress. In the meantime, plaintiffs are understandably worried about taxes. Some legal settlements include tax indemnities, if the plaintiff can get the defendant to go on the hook for that risk. But most defendants are likely to say no to such a request. Some plaintiffs try to cut the risk by allocating nothing or close to nothing to the sex harassment claims.

Legal settlements are routinely divvied up between claims, and there could be more of this now. The IRS is not bound by an allocation in a settlement agreement, but the IRS often respects them. The parties might allocate $50,000 of a $1M settlement to sexual harassment, or perhaps even less. But whether that might work is debatable. Keep in mind that the case does not have to be 100% sex harassment to trigger the provision. Many non-sex harassment cases could be covered by mentioning such claims in a release.

Hopefully a technical correction, such as the Repeal the Trump Tax Hike on Victims of Sexual Harassment Act of 2018 will be passed swiftly. But in the meantime, there is understandable worry. Of course, being taxed on your net after legal fees may not be such a good deal either. Some sexual harassment litigants may be able to claim at least some of their recovery as tax free under Section 104 of the tax code. That section excludes damages for physical injuries and physical sickness. Yet exactly what is “physical” isn’t so clear. And arguably, the tax law doesn’t treat sexual harassment plaintiffs too well, quite apart from the Weinstein provision.

After all, if you make claims for emotional distress as is typical in sexual harassment cases, your damages are taxable. If you claim the defendant caused you physical injuries or caused you to become physically sick, those can be tax free. But most sexual harassment plaintiffs will have a hard time doing that. Of course, the plaintiff does not necessarily have to prove that the defendant caused the sickness. But she needs to show that she claimed it. In addition, she needs to show that the defendant was aware of the claim and considered it in making payment.

To prove physical sickness, the plaintiff should have evidence of medical care, and evidence that she actually claimed the defendant caused or worsened the condition. The more medical evidence the better, including statements from medical professionals. As with so many other rules in the tax law, it turns out that the taxation of legal settlement payments can make a huge difference in how much money a plaintiff actually gets to keep.

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Like Prince, Aretha Franklin Died Without A Will. Why You Should Have One

Aretha Franklin, the Queen of Soul, died without a will. Papers have already been filed in court by Franklin’s four sons and niece. That means there will be public proceedings. There could be court battles too, depending on who claims what. Unexpected celebrity deaths can make the rest of us think about what documents we need to have in place. The tax and financial hassle of probate or intestacy can be huge, even for normal sized estates. When you add the extra zeros that go with a successful entertainer, the failures can seem much more palpable. Franklin is not the only star who neglected estate planning. In 2016, Prince died without a will, echoing estate planning gaffes by Philip Seymour HoffmanJames Gandolfini, Amy Winehouse, Heath Ledger, and others. All of these celebrity estates had issues of one sort or another.

Singer Aretha Franklin performs the song “Respect” during the opening night tribute to Althea Gibson, former professional tennis player, at the U.S. Open at the Billie Jean King National Tennis Center in Flushing Meadows, New York, on Monday, Aug. 27, 2007. Photographer: Rick Maiman/Bloomberg News.

Franklin had been ill, so writing a will would have been logical. But even people with Wills do not always think through the tax and other implications. For example, Seymour Hoffman had three children with Marianne O’Donnell, but the couple never married. Plus, he mentioned only one child in his will, not all three. Like Prince, Amy Winehouse didn’t have a will. That means we do not know what either one of them would have wanted to have happen to their assets. Amy Winehouse’s parents inherited her estate, while her ex-husband got nothing.

Heath Ledger had a will, but it was five years old. It gave his parents and sisters his $20 million estate, failing to mention Michelle Williams or their child. And after James Gandolfini died at 51, reports said his will clumsily sent $30 million of his $70 million to the IRS. The stories should make tax advisers and estate planners cringe.

What happens on your death isn’t an easy subject for anyone to discuss. But a few key points about Aretha’s Franklin’s situation deserve mention. A will would have been clear as to what she wanted, but a will is public. There is no reason the public has to know about who you benefit and who you may disinherit. Probate is public, expensive, time consuming and unnecessary. It is even worse not to have a will. With no will, the state has to decide who gets what, usually be statute. It is far better to make those decisions yourself. A will would have been simple and better. The simple way to keep it private?

Use a revocable trust. For very little money you can create a revocable trust that calls for the disposition of your assets. You still write a will. But the will just says that everything you own goes via the revocable trust. It’s called a pour-over-will, since it pours all assets into the trust. The trust is private. Using a trust does not necessarily mean saving taxes. No one wants to pay taxes unnecessarily, but you first want your assets to go how you want them to go. That can change frequently during life. Another advantage of a revocable trust is that you can change it easily at any time.

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Tax Tips From Manafort Conviction That Might Keep IRS Away

The conviction of former Trump campaign chairman Paul Manafort on eight counts of financial crimes nets the first conviction for Special Counsel Robert Mueller.

Political commentators on both sides are jabbering over this. They also have the guilty plea by former Trump fixer Michael Cohen to talk about. But aside from politics, there are some serious tax lessons here for everyone. And they are surprisingly simple.

The IRS wants you to report your worldwide income on your taxes, and (separately) to report your foreign accounts. That sounds simple, but there has long been temptation with hidden accounts. FBARs, the foreign bank account reporting form Manafort failed to file, have been required by law since 1970, so the requirement is hardly new. It is very easy for the government to win FBAR cases, and the penalties–both civil and criminal–are steep, worse than tax evasion.

Protester Bill Christeson holds up a sign saying “guilty” as the first count of guilty comes in at he trial of former Donald Trump campaign chairman Paul Manafort, at federal court in Alexandria, Va., Tuesday, Aug. 21, 2018. (AP Photo/Jacquelyn Martin)

Much of the scrambling started about ten years ago. The IRS and Justice Department took on Swiss banking, and in 2008, started to win big in court. With huge potential exposure for helping Americans, UBS settled with the U.S. government in 2009 for $780 million. Since then, vast numbers of Swiss and other banks faced criminal charges or made big civil settlements. And American taxpayers have too, with the IRS offshore account collections haul topping $10 billion. For ten years, the IRS has run its Offshore Voluntary Disclosure Program (OVDP), a type of tax amnesty. This program will formally close on September 28, 2018. The IRS Streamlined program will still exist, but Streamlined cases are subject to audits. For the protection of the OVDP, there’s not much time left. 

I’ll bet Manafort wishes now that he had cleaned up his accounts voluntarily before he was in the cross hairs. Another lesson from Manafort is about IRS access to information. Often, they get it. Consider FATCAthe Foreign Account Tax Compliance Act. It penalizes foreign banks if they don’t hand over Americans. The vast majority of foreign countries and their banks comply, so don’t count on bank secrecy anywhere. On top of FATCA, the U.S. has a treasure trove of data from 50,000 voluntary disclosures, whistleblowers, banks under investigation and cooperative witnesses. So the smart money suggests resolving your issues. You can have money and investments anywhere in the world as long as you disclose them.

The biggest lesson from Manafort? Declare all your income and your foreign accounts, and don’t obscure or cover up the facts. Sure, you can make mistakes. But your mistake must be credible. If there are too many oversights or glitches, you might just appear to be willful. Negligence, inadvertence, or mistake is OK. Intent to conceal or to evade taxes is not. Consider that the IRS’s offshore Streamlined program requires one to:

Provide specific reasons for your failure to report all income, pay all tax, and submit all required information returns, including FBARs. If you relied on a professional advisor, provide the name, address, and telephone number of the advisor and a summary of the advice. If married taxpayers submitting a joint certification have different reasons, provide the individual reasons for each spouse separately in the statement of facts.”

If you knew you were supposed to report, the IRS may say you were willful. What’s more, the IRS uses a concept of “willful blindness.”
Essentially, it is a conscious effort to avoid learning about the IRS or FBAR reporting. Willfulness involves a voluntary, intentional violation of a known legal duty. In taxes, it applies for civil and criminal violations. The failure to learn of filing requirements, coupled with efforts to conceal the facts, can spell willfulness.

If you don’t want to end up like Manafort, what other things do you want to avoid? Avoid setting up trusts or corporations to hide your ownership. Avoid filing some tax forms and not others. Avoid keeping two sets of books. Avoid telling your bank not to send statements. Avoid using code words over the phone. Avoid cash deposits and cash withdrawals. You get the idea. Even if you can explain one failure to comply, repeated failures can morph conduct from inadvertent neglect into reckless or deliberate disregard. That may have been part of Manafort’s problem.

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Receive An IRS Summons? Here’s What To Do

The vast majority of IRS audits involve the big agency telling you what they want to see, and you handing it over. This is most frequently done with what the IRS calls Information Document Requests, IDRs for short. But sometimes matters escalate to an IRS summons. And sometimes the IRS issues a summons to a third party, trying to get information about someone else. If you are issued a summons, in many cases you probably will want to comply. If you don’t, the government can actually sue you. In the vast majority of cases, the government wins these disputes. The government usually gets the data, and it does not like to have to sue to collect it. In that sense, fighting over the data is usually not where taxpayers (or third parties) want to spend their money. Eventually, the merits of the tax dispute must be addressed, and that is generally be the real fight, not the documentary preliminaries.

(AP Photo/J. David Ake, File)

Many tax disputes end up getting compromised. Of course, there can be times when it is appropriate to clam up and stop cooperating. There may be privilege issues, for example. Third parties often must protect the privacy of their account holders, customers, etc. But for most taxpayers it can be worth considering voluntary compliance. Almost any IRS correspondence is stressful, but when a request for substantiation or documents looks like legal process, stress levels go higher. Usually, the IRS asks for information in an IDR, on IRS Form 4564. You are under no legal obligation to respond, but you generally should. Otherwise, your case with the IRS will escalate. The first way an IRS probe usually escalates is from an IDR to a summons.

An IDR is informal, a list of items the IRS requests from you. The fact that you do not have all the items—or perhaps might not want to provide them all—does not mean you should not respond. If you respond to an IDR with 4 out of 6 requested items, maybe that will satisfy the IRS. Sometimes they may not keep asking, or may accept an explanation why the other items are not included. If you don’t respond at all, you are almost guaranteed to provoke another IRS response. After one or more IDRs, next comes a summons, which the IRS has the power to issue.

When the IRS issues a summons, you can comply, refuse, or ignore it. Alternatively, you can go to court and attempt to quash it. That involves showing you have legitimate legal reasons not to disclose the information. If you refuse or ignore the summons, the Justice Department can get a court order to enforce it. If you still refuse, you could face sanctions for criminal or civil contempt. In all of these ways, a summons to hand over books, records or other data is more potent than an IDR, since it carries the threat of court enforcement. In fact, the mere fact that the IRS issues a summons rather than an IDR sends a stern message. A summons ups the ante, showing that the IRS is playing tough and is willing to go to court.

What grounds can you cite for not complying with an IRS summons? Common grounds are attorney-client privilege or work product protection, but the standards are high. The IRS uses its summons power frequently today, and court fights are becoming more common. Taxpayers generally lose these cases, which means the IRS generally gets the documents in the end. There are some sobering statistics. According to the U.S. Taxpayer Advocate Service, there were only 44 such disputes in 2005. Then, by 2012, the number ballooned to 153. While the number of cases has decreased since 2012, summons enforcement continues to be a significant source of litigation.

The Taxpayer Advocate Service says that the IRS has won 96% of its summons cases during June 1, 2014 through May 31, 2015. With that many cases litigated, many more were probably resolved short of litigation. You should consider those odds when you decide whether and how to fight. With a normal summons, the IRS seeks information about a specific taxpayer whose identity it knows. But the IRS also has the power to issue a ‘John Doe summons.’ A John Doe summons allows the IRS to get the names of all taxpayers in a certain group. The IRS needs a judge to approve it, but recent IRS success that the IRS has had with offshore bank matters may to lead to even more of these blanket IRS summonses in the future.

A John Doe summons is ideal for pursuing tax shelter investors, or account holders at a financial institution. The IRS can claim major successes on this front. The IRS was able to sniff out thousands of American taxpayers with Swiss accounts at UBS with a John Doe summons. The IRS has done the same with other banks (such as HSCB in India). Also, the IRS mostly won its fight for Coinbase customer data. Crypto investors with more than $20,000 generally had their data disclosed to the IRS.

Sometimes, big companies can and do play hardball with the IRS. But for most people, the IRS is eventually going to get the information, at least statistically speaking. As such, fighting over such issues can end up being unwise. It can sometimes even make an IRS dispute on the merits tougher when you get to it.

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