Confidentiality: But At What Cost?

A 2003 tax court case has recently been making the rounds among plaintiffs’ lawyers and causing concern regarding the tax consequences of confidentiality provisions. It has long been accepted that settlements involving physical injuries or sickness are excluded from gross income for tax purposes. It is not uncommon for settlement agreements to contain confidentiality provisions. However, those confidentiality provisions may now subject the plaintiffs to adverse tax consequences. In Amos v. Commissioner of Internal Revenue, 86 T.C.M. (T.C.C.H. 663 2003), a cameraman, who was kicked during an NBA basketball game by Chicago Bulls forward Dennis Rodman, filed suit against Mr. Rodman for the injuries received as a result of the altercation. Shortly thereafter, he reached a $200,000 settlement that contained a confidentiality provision. When Amos filed his tax return for that year, he excluded from his gross income the $200,000 he received from Rodman as personal injury damages. After an audit, the IRS determined that except for a minimal amount, Amos was not entitled to exclude the remaining proceeds from his gross income because the payment was almost exclusively for the confidentiality provision and not for personal injuries. Amos appealed the decision to the U.S. Tax Court which determined that $80,000 of the $200,000 was attributable to the confidentiality provision and was therefore taxable income.

The Tax Court focused on the fact that it was Amos’ burden to prove that the IRS had been erroneous in its assessment that the income excluded by the claimant under Section 104(a)(2) was actually taxable income. The court noted that, “the taxpayer must demonstrate that the underlying cause of action giving rise to their recovery was based upon tort or tort type rights; and the taxpayer must show that the damages were received on account of personal injuries or sickness.” The Amos court then noted that where damages were received pursuant to a confidential settlement agreement, the following factors should be considered in determining whether such damages are excludable from gross income:

1. the name and character of the claim that was the actual basis for the settlement and its factual basis;
2. the existence of any express language in the settlement agreement stating what amount was paid by the defendant to settle the plaintiff’s personal injury claim;
3. the defendant’s dominant intent in making the payment, which is a critical factor; and
4. the belief of the plaintiff in receiving the payment.

The Amos court held that though Rodman’s dominant purpose for paying the settlement amount was to compensate Amos for his personal injuries, the fact that the settlement agreement expressly provided a portion of the settlement proceeds were paid by Rodman for Amos’ promise not to defame Rodman, disclose the terms of settlement agreement, publicize facts related to the accident or assist in any criminal prosecution against Rodman was evidence that an amount was also paid to Amos for non-physical injuries. Id.

This holding and its recent notoriety is causing great concern among the plaintiffs’ bar with regard to confidentiality provisions in settlement agreements. More and more plaintiffs’ lawyers are either refusing to allow their clients to sign settlement agreements with confidentiality provisions or are requiring a premium be paid for such provisions. Alternatively, a number of plaintiffs’ counsel are currently requesting that an amount that is paid for the confidentiality agreement be specifically set forth in the settlement agreement so that their client’s tax liability is fixed. Finally, a segment of plaintiffs’ lawyers are also requesting indemnification for their clients from the defendants when the defendants are insistent upon the confidentiality provisions but refuse to provide additional safeguards.

However the parties choose to deal with the issue, one thing is for sure. The costs of confidential settlements has just gone up.