Business & Insurance Litigation Newsletter for Indiana

Confidentiality in Personal Injury Settlements May Cause Tax Issues

There is a small but growing issue concerning the inclusion of confidentiality requirements in settlement agreements. It is generally assumed by defendants that a settlement agreement will contain some provision concerning confidentiality. Such confidentiality requirements are enforceable because a settlement agreement is a contract and is enforceable just like any other contract. However, many plaintiffs are becoming aware of the serious tax consequences arising from confidentiality provisions in settlement agreements and are refusing to sign any agreement that contains such a provision. This creates a significant problem for a defendant who is willing to settle a personal injury matter, but who also does not want the amount or the terms of the settlement to be made public.

Under the Internal Revenue Service Code, compensation for injuries or sickness is usually excludable from a taxpayer's gross income. The general rule under the Code is that the amount of any damages received by a taxpayer on account of "personal physical injuries or physical sickness" may be excluded from his calculated gross income. I.R.C. §104(a)(2). However, this rule is read strictly by the courts and can result in unexpected tax liability if not followed closely.

A somewhat famous case, Amos v. Commissioner of Internal Revenue, 86 T.C.M. (CCH) 663 (2003), illustrates how a personal injury settlement agreement can cause serious tax consequences under the general rule. The Amos case arose from an incident during a 1997 NBA game when Dennis Rodman of the Chicago Bulls fell into a group of photographers and then kicked cameraman Eugene Amos in the groin. A settlement agreement was eventually reached concerning Amos's physical injury claims against Rodman, and Rodman was required to pay Amos $200,000 per that agreement. Included in the settlement agreement were significant and distinct confidentiality provisions. Based on the terms of the settlement agreement, the U.S. Tax Court determined that the inclusion of the confidentiality provisions required that $80,000 of the $200,000 settlement be considered payment for Amos's contractual agreement of confidentiality. Since that amount was not compensation for Amos's physical injuries or sickness, Amos could not exclude it from his calculation of gross income, and it was subject to income tax. In light of the Amos case, plaintiffs are now balking at otherwise acceptable settlement agreements, simply because they contain a confidentiality provision. As a result, defendants are faced with the unfortunate choice of agreeing to a non-confidential settlement or continuing to litigate a case that could otherwise be settled.

With careful planning, there are quite a few ways that both parties can get what they want. First, the terms of the settlement agreement requiring confidentiality can be mingled throughout the agreement instead of appearing as a significant and distinct section of the agreement. The fact that the confidentiality provisions in the Amos settlement agreement were so significant and distinct from the remainder of the agreement was a factor in the Tax Court's decision to declare a portion of the settlement amount taxable.

Second, the settlement agreement can contain a confidentiality provision as well as a provision such as, "All sums set forth herein constitute damages on account of personal physical injuries or sickness, within the meaning of §104(a)(2) of the Internal Revenue Code," thereby explicitly stating that all settlement funds should be excluded from calculated gross income and not taxable. However, if such an explanatory provision were to be used, the settlement agreement would also need to include a mutual promise of confidentiality, or some other promise on the part of the defendant, or the confidentiality provision in the agreement may not be enforceable due to lack of consideration.

Third, the parties to the settlement agreement could negotiate a separate agreement concerning confidentiality only. Of course, any money paid as a part of the separate agreement would likely be considered taxable gross income, but this amount could be minimal in comparison to the amount of the settlement payment for physical injury.

Fourth, if warranted, the parties could prepare a settlement agreement that contained a confidentiality provision and then obtain a private ruling from the IRS on whether the inclusion of the confidentiality provision would create any unacceptable tax issues for the plaintiff.

Finally, the defendant could agree to indemnify the plaintiff for adverse tax consequences arising out of the terms of the settlement agreement. However, this is the most risky option for the defendant and should only be used if the defendant is completely sure in his position that no adverse tax consequences will arise for the plaintiff, or if the defendant is willing to pay plaintiff's increased tax liability due to a determination by the IRS.