Why are confidentiality clauses in personal injury settlements dangerous?

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Personal Injury

5/27/2008
James R. Carroll, Jr., Esquire
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Why are confidentiality clauses in personal injury settlements dangerous?

Settlement agreements and releases in personal injury cases are increasingly containing confidentiality provisions that may potentially result in adverse tax consequences to the unwary.

The little known tax court decision of Amos v. Commissioner, T.C. Memo 2003-329 (December 1, 2003), is a cautionary tale for Plaintiff's counsel. The relevant facts of the Amos case are condensed as follows:

- Professional athlete, Dennis Rodman, kicked a photographer in the groin upon falling out of bounds during an NBA game.

- The photographer commenced a lawsuit, which eventually settled for the sum of $200,000.00.

- A settlement agreement was executed between the parties which contained a confidentiality clause.

- The photographer treated the entire amount of the settlement as compensation for a personal physical injury under IRC Sec. 104(a)(2) and excluded same as income.

- Possibly as a result of the publicity of the incident, the photographer's income tax return was audited. The IRS sought to treat the entire sum of $200,000.00 as taxable compensation, reasoning that the settlement amount was motivated by a desire for confidentiality, as opposed to compensation for a personal physical injury.

The Tax Court analyzed the facts as follows:

- A taxpayer has the burden of proving that damages are on account of personal physical injuries or sickness, under IRC Sec. 104(a)(2), citing Commissioner v Schleir, 515 U.S. 323, 328 (1995), and United States v. Burke, 504 U.S. 229, 248 (1992).

- "The nature of the claim forming the basis for the settlement controls whether such damages are excludable under IRC Sec. 104 (a)(2)." Burke, supra, 504 U.S. at 237 [emphasis added].

- "The intent of the payor is critical" and "the character of the settlement payment hinges ultimately on the dominant reason of the payor in making the payment." Knuckles v. Commissioner, 349 F.2d 610, 613 (10^th Cir. 1995).

The Court's decision was to treat 60% of the damages as compensation for the photographer's physical injuries and 40% as payment for confidentiality. Thus, 40% of the damages were taxable. The impact of the ruling was an acknowledgment that despite the dominant reason Mr. Rodman paid the photographer was to compensate him for his physical injuries, the court still held that a portion of the award represented taxable damages. The holding in Amos provides justification for the IRS to treat all personal injury damage awards as part taxable and part non-taxable if the settlement agreement contains a confidentiality provision.

Therefore, counsel must be cautious during settlement negotiations and insist on striking such confidentiality provisions from personal injury settlements that fall within the purview of IRC Sec. 104(a)(2). If confidentiality is non-negotiable, any such clause should be drafted so as to contain express language that confidentiality is mutually beneficial to both parties and that no consideration is being paid or intended for that purpose.

Also be sure to strike the phase "in settlement of a doubtful and dubious claim" which is frequently inserted into settlement agreements. In the worst case scenario, the settlement agreement and/or release needs to be clear as to the percentage of the total settlement that is being allocated to confidentiality and the percentage allocated as compensation for personal physical injury. It could thus be argued that additional consideration must be paid to offset any such potential tax implications for such apportionment.

Here is a .pdf of the Amos case if you want to review the specific language of the tax court.

Labels: case law confidentiality personal injury settlement

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