Foran Glennon Palandech Ponzi & Rudloff

December 2014

Possible Tax Implication From Confidentiality Clause

Michael Errera

Congratulations – you’ve just successfully settled a lawsuit.  With settlement reached, attention turns to the settlement agreement’s terms.  Depending on the type of claim and damages sought, and how the settlement agreement’s terms are written, there may be an unintended tax liability.  As a result, the decision of which terms to include in a settlement agreement is important and should not be taken lightly.

Whether you are the party making the settlement payment, or the party receiving the settlement funds, there may be a desire to include a confidentiality clause in the settlement agreement.  The inclusion of a confidentiality clause may, at first consideration, not be seen as onerous.  But, in today’s tough economic times, government taxing authorities are exploring new opportunities to expand the tax base.  Based on the guidance offered by a tax suit arising from the settlement of a personal injury claim against a professional basketball player, the inclusion of a confidentiality clause, if not appropriately drafted, could lead to a tax liability.

The tax ramification of including a confidentiality clause in a settlement agreement was explored in Amos v. Commissioner of Internal Revenue, T.C. Memo. 2003-329 (Dec. 1, 2003).  This case arose from the settlement of a personal injury claim by Eugene Amos, a television cameraman, who was kicked by Dennis Rodman during a basketball game.  In settlement of the claim, Mr. Amos received a payment of $200,000.  Part of the settlement agreement included a confidentiality clause.  Significantly, because the settlement agreement did not identify the amount of consideration paid for the inclusion of the confidentiality clause, an unanticipated tax liability arose after Mr. Amos elected to not list any of the $200,000 as taxable income.  Federal Income Tax Rules define gross income as, “all income from whatever source derived.”  I.R.C. § 61(a) (1994).This broad definition results in the taxing of payments for salary, back pay, severance, benefits, punitive damages, and pre/post judgment interest.  See Department of the Treasury, Internal Revenue Service, Settlements – Taxability, Publication 4345 (Rev. 11-2011).  Mr. Amos contended all of the $200,000 was properly excluded as taxable income because it was compensation recovered under the exemption for either personal physical injury or sickness.  I.R.C. § 104(a)(2) (1994) and 26 C.F.R. § 1.104-1(c) (2012).  Disputing Mr. Amos’ tax return, the IRS argued the entire $200,000 settlement was paid as consideration to include the confidentiality clause and subject to taxation.  Ultimately, the Tax Court determined $80,000 was paid for inclusion of the confidentiality clause and subject to tax.

Practice Pointers.  To avoid a potential tax liability from settlement of a claim, consider excluding a confidentiality clause provision in the settlement agreement.  Alternatively, consider specifically identifying what types of damages are covered by the settlement, such as the entire settlement relates to a recovery of property damage.  Allstate Ins. Co. v. United States, 936 F.2d 1271, 68 AFTR 2d 91-501 (Fed. Cir. 1991)(Due to application of the tax benefit rule, an insurer’s property damage subrogation recovery is not considered taxable income).  Consider stating in the agreement the specific amount of the settlement payment, if any, is being paid to include the confidentiality clause.  If the paying party demands the confidentiality clause’s inclusion, ask that the payer also provide for indemnity of any tax liability.  Finally, consider negotiating a separate supplemental payment as consideration for including a confidentiality clause.