by: Begley Law Group

by Thomas D. Begley, Jr., CELA

Frequently, large personal injury settlements contain confidentiality agreements. Unless these agreements are handled properly, they can result in a significant income tax liability to the plaintiff. As a general rule, recoveries in personal injury actions are excluded from federal income tax under §104 of the Internal Revenue Code. However, the exception only applies to damages received on account of personal physical injuries or physical sickness. This exclusion is not available to monies attributable to medical deductions allowed in any prior taxable year. As a general rule, punitive damages are considered taxable income. If a Trial Court has awarded compensatory and punitive damages and the case settles on appeal, there is always an issue as to the allocation between compensatory and punitive damages. The determining factor as to how a litigation settlement or award will be treated for tax purposes is the origin of the underlying claim. This is known as the “Origin of the Claim Test.” If the claim is for physical injuries or sickness, the recovery will qualify for an exclusion. Otherwise, the recovery is taxable. Cases often arise for a mixture of employment claim, claim for emotional distress and a claim for physical injury and sickness, and also contain a confidentiality agreement. Treatment of claims in that situation will depend on the origin of the underlying claim.

The taxation of Confidentiality Agreements in personal injury settlements is becoming an increasing concern to plaintiffs and to personal injury lawyers. The issue arises out of a United States tax court case.[1] This case involved an incident in which Dennis Rodman, a basketball player for the Chicago Bulls, during the course of a game against the Minnesota Timberwolves landed on a group of photographers and twisted his ankle. Mr. Rodman then kicked one of the photographers, Eugene Amos. Mr. Amos was immediately taken to a local hospital and the next day sought medical treatment from the Veterans Affairs Medical Center. The medical reports from the local hospital and the VA Medical Center did not disclose any serious injuries. Nevertheless, Amos filed a Complaint against Rodman seeking damages for personal injury. The case was settled for $200,000.

The Confidential Settlement Agreement and release stated that the amount of the settlement was $200,000 and that Rodman would be released from any and all claims by reason of any damage, loss or injury sustained by Amos as a result of the incident. The Release went on to say that part of the consideration was that the terms of the agreement and release be kept confidential. The Release also contained a liquidated damages clause to the effect that if there was a material breach of the Confidentiality Agreement, Rodman would be entitled to $200,000.

Amos excluded from his gross income the $200,000 he received claiming that it was non-taxable under I.R.C. § 104(a)(2) as a physical injury. However, the tax court held that the determination of the nature of the claim is factual. The court stated that the character of the settlement payment hinges ultimately on the dominant reason [emphasis added] of the payer in making the payment. Amos contended that the entire amount of the settlement was excludable from gross income. The Service contended that, except for a nominal amount, the settlement was compensation for Amos’ agreement to the confidentiality provision. The court held that Rodman’s dominant reason in paying the settlement was the petitioner’s claimed physical injuries, but that there was a separate payment for Amos’ acceptance of the confidentiality clause. The court determined that $120,000 of the settlement amount was for Amos’ claimed physical injuries and $80,000 was on account of the non-physical injury provisions of the Settlement Agreement. The court noted that the Settlement Agreement lacked an express allocation between the physical and non-physical injury.

How should plaintiffs and plaintiff’s personal injury lawyers address confidentiality agreements? There are a number of possibilities:

  • Do not agree to a confidentiality clause; however, this may preclude settlement.
  • Make a specific allocation of consideration between the physical injury and the confidentiality clause. Such an allocation should be reasonable, because it is likely that the Service will look beyond any nominal consideration and make a determination based on the substance of the transaction.
  • Include reciprocal promises of confidentiality without additional consideration. Again, the Service may look to substance over form. Clearly, the defendant would have an interest in keeping confidential either the existence of his conduct or the amount of the settlement. The plaintiff’s motive for confidentiality may be more difficult to prove, but it could include a desire not to have friends and neighbors know that he has received money or, if so, how much money.
  • Allocate $1 to each party as consideration for reciprocal promises of confidentiality.
  • Include an indemnity provision compelling the defendant to indemnify the plaintiff for adverse or unforeseen tax consequences. It is unlikely that a defendant will agree to this.
  • Seek a private IRS ruling in advance of finalizing the settlement. Such a ruling would take a long period of time and could cost $30,000 to $40,000. In most instances, this will not be practical strategy.

[1] Amos v. Commissioner of Internal Revenue, T.C. Memo. 2003-329 (Dec. 1, 2003).