Confidentiality subjects settlements to income tax liability

It is not uncommon for a confidentiality clause to appear unannounced in the settlement papers even where confidentiality was never discussed during the settlement negotiations.  BEWARE! There is serious exposure to income tax liability associated with confidentiality clauses in bodily injury cases.

Confidentiality clauses in settlement agreements lead to tax consequences in personal injury cases under the landmark tax case, Amos v. Commissioner, 2003 Tax Ct. Memo, LEXIS 330 (2003).  The decision in Amos created a new law allowing the IRS to tax personal injury settlements which include confidentiality provisions.  Before Amos, the parties in a bodily injury claim believed that the settlement was not subject to income tax liability as long as no claim for punitive damages was asserted. 26 U.S.C.A. section 104(a)(2).

26 U.S.C.A. section 104(a)(2) provides that "gross income does not include the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sum or as periodic payments) on account of personal physical injuries or physical sickness."  Under section 104(a)(2), the injured party assumes that the settlement proceeds are not subject to income taxes.

Here's the facts of Amos v. Commissioner: On January 15, 1997, Dennis Rodman, a professional basketball player known as the "Worm", kicked a TV cameraman, Eugene Amos, in his groin while on the courtside during the course of a NBA game in Minnesota. Amos sustained a mild groin injury and his lawyer settled with Dennis Rodman less than a week later for $200,000. 

The release agreement drafted by Dennis Rodman had language keeping the settlement confidential and imposing harsh consequences on Amos should he disclose such information.  The settlement imposed additional obligations on Amos including: (1) keeping the settlement terms confidential; (2) not publicizing the settlement; and (3) not granting any interviews or making any statement regarding the assault.

When Amos filed his 1997 tax returns, he excluded pursuant to section 104(a)(2) the full $200,000 he received in settlement from Dennis Rodman.  Unfortunately for Amos, the IRS claimed that he was not entitled to exclude any of the settlement amount under section 104(a)(2) because Amos had failed to introduce any evidence of his injuries.

The IRS, after audit, attempted to tax all but one dollar of the $200,000 confidential settlement amount, contending that the settlement was really about confidentiality to settle a nuisance claim and not about any true injury.  Amos's attorney claimed that the entire amount of the settlement was paid due to physical injuries.  However, the court found that position "belied by the terms of the settlement agreement."  The court also considered other things for which Amos was compensated, including Amos's agreement not to: (1) defame Dennis Rodman, (2) disclose the existence or terms of the settlement agreement, and (3) publicize facts relating to the incident.  The Commissioner of Internal Revenue determined that Amos owed income taxes on the entire $200,000 settlement in the sum of $61,668.

On appeal, the United States Tax Court held that $120,000 of the settlement was excludable from gross income as the ordinary proceeds of a bodily injury settlement, but the remaining $80,000 was subject to income taxes.  The tax court allocated 60% of the settlement as monies paid for physical injuries sustained by Amos, and the other 40% as monies paid in consideration for the other requirements stipulated in the settlement agreement. The tax court's allocation resulted in 40% of the settlement proceeds (for non-physical injuries) included in Amos's gross income and not exempt from income taxes.

The U.S. Tax Court found that the settlement was in consideration of several requirements above and beyond monies for physical injuries--mainly a confidentiality clause in the settlement agreement.  The court found that the parties did not intend all of the settlement proceeds to be allocated to the component for payment on account of personal physical injuries.

The lesson learned from Dennis Rodman: Based on the Amos case, confidentiality provisions lead to tax consequences in personal injury cases.  The best way to avoid this potential problems is simple: DON'T AGREE TO CONFIDENTIALITY!  A confidentiality provision leads to tax problems, so you should beware that all sums allocated to confidentiality are taxable.  Also, beware that the IRS may challenge the allocation of the settlement contained in the settlement agreement and seek more taxes.  My advice to avoid the tax bite: simply avoid confidentiality agreements.

If you make the mistake of agreeing to confidentiality as part of a settlement agreement, you must insist that the defendants who demand confidentiality hold the plaintiff harmless from income tax liability in bodily injury cases.  Of course, the defendants will never agree to such a hold harmless clause relating to income tax liability and if they will not agree, why should you?