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Be Careful with Confidentiality

Are Your Clients Getting Kicked While They’re Down?

Settlement agreements in personal injury cases commonly contain confidentiality provisions. Based on a U.S. Tax Court decision from 2003, plaintiffs who sign settlement agreements containing confidentiality provisions put themselves at risk for future tax liability.' In 1997, Dennis Rodman landed on a group of photographers while trying to save a ball during an NBA basketball game. "The Worm" exacerbated the unfortunate incident by kicking an injured photographer in the groin. Not surprisingly, the photographer sued Mr. Rodman.

On January 21, 1997, the parties entered into a "Confidential Settlement Agreement and Release" requiring Mr. Rodman to pay the photographer $200,000 to settle all claims.  The settlement agreement contained a fairly involved confidentiality provision.  Following settlement, the photographer did not report any taxable income from the settlement, reasoning that it was for compensatory damages and the origin of the claim was certainly personal physical injury.2 The Internal Revenue Service took issue with this classification due to the confidentiality provision.

Ultimately, the U.S. Tax Court agreed with the IRS stating in the above-referenced published memorandum finding that 40% of the $200,000 settlement ($80,000) was paid as the underlying consideration for confidentiality provision. Thus, $80,000 of the recovery was classified as taxable income and taxes and penalties were assessed on that amount.

Plaintiff attorneys settling cases should be careful anytime a confidentiality clause is added to a settlement This is especially true when there are questionable or minor physical injuries or when the defendant or incident is highly visible. If possible, plaintiffs should insist on striking confidentiality provisions from personal injury settlements falling within IRC Sec. I04(aX2). If such a provision must be included, consider allocating a specific portion of the settlement proceeds to the confidentiality provision, making it clear how much of the total settlement allocated to confidentiality, and the amount allocated to 104(a)(2) damages. However, be aware that allocating a negligible portion of the settlement to confidentiality opens the door for the IRS to contest it and could do more harm than good for your client. The defendant and its liability carrier could be asked to indemnify the plaintiff against adverse tax consequences arising from including the confidentiality clause. Another option is to agree to add express language to the settlement agreement staling that confidentiality is in the mutual best interest of the parties and to require the defendant to also pledge confidentiality. It is definitely not recommended to agree to tie liquidated damages to a breach of the confidentiality clause.  Any time confidentiality is included in a settlement agreement, it should be addressed even if it is just to say that none of the damages are paid for confidentiality.
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