Confidentiality clauses are commonly requested by defendants when a personal injury case settles. However, practitioners must be careful because if any of the settlement is allocated to confidentiality it turns a non-taxable settlement into a partially taxable one. Personal physical injury claims are not taxable under Section 104(a)(2) of the Internal Revenue Code. All damages, other than punitive damages, that flow from a personal physical injury are not taxable. In the now infamous "Amos" decision, the tax court held that a portion of the settlement was taxable because it was for confidentiality and not physical injuries.
The Amos case involved Dennis Rodman. Dennis Rodman, upon falling out of bounds during an NBA game, kicked Amos, a photographer in the groin. Amos filed suit, and the dispute settled for $200,000. The settlement agreement contained a confidentiality clause. Amos claimed all of the $200,000 was excluded from income tax as compensation for personal physical injury under IRC Section 104(a)(2). The IRS audited Amos' tax return and declared the $200,000 to be taxable compensation because they determined that the payment was motivated by a desire for confidentiality.
The tax court noted that the 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. "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 (10th Cir. 1995). Thus, the tax court held that 60% of the damages were compensation for Amos' physical injuries, and 40% was payment for confidentiality. Thus, 40% of the damages were taxable.
The lesson is that it is important to pay attention to how damages are allocated in a settlement agreement. This is particularly so with recent developments regarding taxation of damages. If a confidentiality clause is mandated by the defense when the case is settled, the consideration for the clause should be the reciprocal promises of both parties to maintain such confidentiality.
It is hard to imagine the IRS trying to argue that the reciprocal promises are not sufficient consideration. The Rodman case was an extreme example and thus was scrutinized, but it is still an issue that should be addressed. In the typical settlement none of the funds are for confidentiality, they are all compensatory under 104(a)(2) so the mutual promise should be sufficient consideration. Nevertheless, you should consult a competent tax professional regarding these issues.
The cite to the Amos opinion is: Amos v. Commissioner, T.C. Memo 2003-329 (December 1, 2003).
If you would like suggested language for confidentiality clauses, please contact me via e- mail at firstname.lastname@example.org