Many businesses pay hush money on occasion, with important tax rules at play. Every payment, whether to the recipient or the one paying the money, has tax consequences. Legal claims of all sorts are settled to avoid bad publicity or lawsuits, with confidentiality typically required in settlement agreements. While most legal settlements paid by businesses are tax deductible, there is an exception for confidential legal settlements for sexual harassment or abuse, which are no longer deductible. Companies have found ways around this rule, such as settling without requiring confidentiality or splitting the money into different categories.
Individuals paying hush money must be conducting a trade or business, and the hush money must relate to that trade or business to be eligible for a deduction. Legal fees for businesses are generally tax deductible, but since 2018, if hush money is paid for sexual harassment or abuse and confidentiality is required, even legal fees cannot be deducted. Recipients of hush money must report it as income on their taxes, as the IRS considers almost all legal settlements to be income. Exceptions are made for compensatory personal physical injury damages, but in most cases, settlement money is taxable.
Some plaintiffs argue that harassment led to conditions like PTSD, which could qualify as physical for tax purposes. However, the IRS is strict on what qualifies as physical for tax purposes, and exact wording of settlements can have a significant impact on how much a plaintiff keeps after legal fees. The U.S. Supreme Court ruled in 2005 that plaintiffs generally have income equal to 100% of their recoveries, even if legal fees are taken out by their lawyers. A tax law enacted in 2017 by then-President Trump restricts many plaintiff deductions for legal fees, further impacting legal settlements.
