Negative Tax Consequences of Confidentiality Provisions in Injury Settlements
UNEXPECTED INCOME TAX CONSEQUENCES IN SETTLEMENT AGREEMENTS By Bobby L. Bollinger, Jr. Bollinger Law Firm, PC, Charlotte, NC Board Certified Specialist In NC Workers' Compensation Law
A frequent feature of workers' compensation and personal injury settlements is a confidentiality agreement or a confidentiality provision in the primary settlement agreement. The confidentiality provision may be included in a clincher agreement, a general release, or in a separate wholly contained confidentiality agreement.
This paper will discuss a Federal income tax issue of which practitioners should be aware when dealing with confidentiality provisions or confidentiality agreements. A 2003 Tax Court Memorandum decision sets forth a nightmare for plaintiffs' lawyers. This 2003 decision arose when the plaintiff, Eugene Amos, was working as a TV cameraman at a 1997 NBA game. NBA player Dennis Rodman went after a loose ball. Mr. Amos was sitting down behind the basket, on the floor, and when Rodman went after the loose ball, he ended up tripping over Mr. Amos. Rodman, in a fit of anger, kicked Amos, notably in the groin, causing Mr. Amos to suffer some injuries. He eventually sued Rodman for damages. The case was settled for $200,000.00. Rodman, being the NBA star and celebrity, naturally wanted a confidentiality agreement and a confidentiality provision was placed into the settlement agreement. The settlement agreement was entitled "Confidential Settlement Agreement and Release" and it stated that the consideration for the settlement was $200,000.00, but did not specifically state how much of the consideration was attributable to the confidentiality agreement. The two parties agreed not to "defame or disparage" each other, and that the terms of the agreement "shall forever be kept confidential and not released to any news media . . . or any other person . . . for any reason except to the extent necessary [for taxes or subpoenas.]" But the agreement provided that if Amos violated it, the liquidated damages would be $200,000.00.
The Internal Revenue Service took the position that the entire consideration was taxable, as consideration paid for confidentiality agreements is taxable income under the Internal Revenue Code. Consideration paid to settle personal injury and sickness claims, including workers' compensation claims, is not taxable under Internal Revenue Code Section 104(a)(2). However, money paid to settle most other claims is income taxable. Here, the government cited a regulation under that Section and argued the consideration paid to support the confidentiality agreement would be subject to income tax. I.R.C. 1.104-1(c), Income Tax Regulations. Mr. Amos and the Internal Revenue Service could not agree on how much should be taxed so they ended up litigating the matter in Tax Court.
The Tax Court, in a memorandum decision, determined that a portion of the $200,000.00 settlement was indeed consideration for the confidentiality agreement, and that portion was taxable. The court assigned $80,000.00 out of the $200,000.00 as consideration for the confidentiality agreement, and Mr. Amos had to pay taxes on that amount. The court reasoned that a 1996 amendment required that non-taxable settlement proceeds must be paid only for personal injuries or sicknesses that are physical. Pub. L. 104-188, Sec. 1605, 110 Stat. 1755, 1838-1839. Therefore, the nature of the claim that was the actual basis for the settlement controls whether the damages are excludable from income for tax purposes. If the agreement is silent, then the intent of the payor is critical to the question. The character of the payment hinges on the dominant reason for the payment. The validity of the underlying claim is irrelevant. Amos v. Commissioner, 2003 TC Memo 329; docket # 13391-01