Confidentiality Can Be Taxing: Negotiating Tips to Help Protect Your Clients from Taxation of their Settlement

Confidentiality Can Be Taxing: Negotiating Tips to Help Protect Your Clients from Taxation of their Settlement

Confidentiality provisions in settlement agreements can often come back to haunt plaintiffs. As discussed in a previous post, an inadvertent breach of confidentiality could cost a plaintiff his/her settlement. Similarly, a confidentiality clause could result in tax liability for the plaintiff effectively reducing his/her recovery. In Amos v. Commissioner of Internal Revenue, T.C. Memo. 2003-329 (Dec. 1, 2003), the Internal Revenue Service held that a confidentiality provision in a settlement agreement can trigger tax liability in certain circumstances.  Generally, funds paid as compensation for personal injuries and economic damages are not taxable. I.R.C. §104(a)(2). However, when a defendant demands confidentiality in addition to settlement of the lawsuit, the IRS takes the position that some portion of the settlement proceeds are consideration for the confidentiality clause as opposed to the injuries. The consideration for the confidentiality would be taxable income.

The famous Amos case involved Dennis Rodman when he was still playing for the World Champion Chicago Bulls. In a game against the Minnesota Timberwolves, after scrambling for a loose ball, Rodman fell into a group of photographers on the sidelines. While television cameras rolled, Rodman kicked a cameraman, Eugene Amos, in the groin. Amos retained a lawyer to file a personal-injury lawsuit against Rodman. Before the lawsuit was filed, the attorneys for Amos and Rodman negotiated a $200,000 settlement agreement. That agreement contained a confidentiality clause providing that Amos had to keep the nature and amount of the settlement secret.

Relying on well-settled law that settlements for personal injuries were not taxable, Amos did not claim the $200,000 as part of his gross income on his tax return. Much to his chagrin, the IRS claimed that he should have claimed the money as income because his injuries were minor and the monies were really paid for the confidentiality clause. The Tax Court determined that the $200,000 settlement had to be allocated between the amount paid for the personal injuries, which was exempt from taxation, and the amount paid for the confidentiality clause, which was taxable. Arbitrarily, the court allocated $120,000 to the personal injuries and $80,000 to the confidentiality clause.

What should a personal injury attorney do when faced with defendant’s demand for confidentiality?

  • If possible, do not agree to confidentiality. To avoid misunderstandings, be sure to indicate in all settlement demands that no confidentiality will be agreed to without additional consideration and terms regarding tax issues.
  • If defendant cannot be dissuaded on the confidentiality issue, get more money for the settlement. If a defendant requires confidentiality, it should come with a price.
  • If money is being paid for injuries and confidentiality, make sure that a written settlement agreement allocates the money between the two. Also, be specific about the injuries that are being compensated. Keep in mind that all sums allocated to the confidentiality are taxable. The IRS may challenge the allocation and seek more taxes.
  • If possible, have defendant indemnify your client for any and all tax consequences occasioned by the confidentiality clause.

Protect your clients and be careful about accepting confidentiality provisions in any settlement agreement.

Read more about the dangers of confidentiality provisions.