Avoiding the confidentiality tax bite: the proceeds of your client's settlement for physical injury are free from income tax, right? Not necessarily, if the settlement contains a confidentiality provision. Enter into such settlements carefully and be aware of potential tax consequences.

Plaintiff attorneys have long known that personal injury settlements for physical injuries or sickness can be excluded from the plaintiff's gross income for tax purposes. But what if the settlement contains confidentiality provisions?

Lawyers commonly agree to enter into settlement agreements that contain confidentiality provisions--sometimes being paid a premium for confidentiality. But the holding in Amos v. Commissioner--a 2003 case that generally has flown under most practitioners' radar--means that if you allow your clients to sign settlement agreements with confidentiality provisions, you may be unknowingly subjecting them to income tax liability. (1)

Federal income tax rules provide a sweeping definition of taxable gross income: "Except as otherwise provided in this subtitle, gross income means all income from whatever source derived." (2) In 1995, the U.S. Supreme Court stated in Commissioner v. Schleier that any exclusions from gross income must be narrowly construed. (3)

Section 104(a)(2) of the Internal Revenue Code provides one such exclusion for damages received due to personal physical injuries or sickness. It states that gross income does not include "the amount of any damages (other than punitive damages) received (whether by suit or agreement and whether as lump sums or as periodic payments) on account of personal physical injuries or physical sickness." (4) Damages received by suit or agreement means "an amount received (other than workmen's compensation) through prosecution of a legal suit or action based upon tort or tort type rights, or through a settlement agreement entered into in lieu of such prosecution." (5)

While it is axiomatic that the exclusion requires a personal injury or physical sickness, "not all recoveries growing out of an action based on a personal physical injury are excludable under section 104(a) (2)." (6) And a claimant who seeks to exclude settlement proceeds from his or her gross income carries the burden of proving the IRS wrong in its assessment that the income excluded is actually taxable as gross income. (7)

Many reported cases address whether the [section] 104(a)(2) exclusion applies to different claims, causes of action, and injuries. (8) To determine whether your client's damages are excludable, you need to understand the potential tax consequences of confidentiality provisions in a settlement agreement.

Amos v. Commissioner

On January 15, 1997, Eugene Amos was operating a handheld television camera during a basketball game between the Minnesota Timberwolves and the Chicago Bulls. During play, Bulls forward Dennis Rodman jumped for a ball over the end line, landing in a group of photographers and twisting his ankle. As he returned to the court, Rodman kicked Amos in the groin. An ambulance took Amos to the hospital with nonspecific complaints of pain in the groin, neck, and back.

Shortly after the incident, Rodman and Amos settled Amos's personal injury claim for $200,000. Not surprisingly, it contained confidentiality provisions.

When Amos filed his tax return for that year, he excluded from his gross income the $200,000 he received from Rodman as personal injury damages. The IRS investigated and concluded that, except for a minimal amount ($1), Amos was not entitled to exclude the settlement proceeds because the payment was made almost exclusively for the confidentiality provisions, not for personal injuries.

Amos appealed to the U.S. Tax Court. After a detailed discussion of both the settlement agreement's confidentiality provisions and the facts of the case, the Tax Court concluded that $80,000 of the $200,000 was attributable to the confidentiality provisions and was taxable under Amos's gross income. (9)

The Amos court quoted at length from the confidential settlement agreement and release:

   [P]art of the consideration for this agreement
   and release includes an agreement that
   Rodman and Amos shall not at any time from
   the date of this agreement and release forward
   disparage or defame each other....

      [T]he terms of this agreement and release
   shall forever be kept confidential and
   not released to any news media personnel
   or representatives thereof or to any other
   person....

      Amos agrees not to make any further
   public statement relating to Rodman or the
   incident or to grant any interviews relating
   to Rodman or the incident....

      To discourage any breach of the terms of
   this agreement and release, and to compensate
   Rodman should any such breach
   occur, it is understood and agreed that
   Amos shall be liable for liquidated damages
   in the amount of [$200,000] in the event
   such a material breach occurs....

      Amos further represents, promises, and
   agrees that, as a part of the consideration
   for this agreement and release, he has communicated
   to the Minneapolis Police Department
   that he does not wish to pursue a
   criminal charge against Rodman, and that
   he has communicated that he will not cooperate
   in any criminal investigation concerning
   the incident. (10)

In its legal analysis, the Amos court cited the Supreme Court's decision in Schleier, which summarized the two independent requirements the taxpayer must meet before a recovery can be excluded under [section] 104(a) (2): First, the taxpayer must demonstrate that the underlying cause of action giving rise to the recovery is "based upon tort or tort-type rights"; and second, the taxpayer must show that the damages were received "on account of personal injuries or sickness." (11)

The Tax Court then noted that when damages are received under a confidential settlement agreement such as the Amos-Rodman agreement, the following factors should be considered in determining whether they are excludable:

* the nature and character of the claim that was settled and its factual basis (this does not include an inquiry into the claim's validity, which is irrelevant)

* any express language in the settlement agreement stating what amount the defendant paid to settle the plaintiff's personal injury claim

* the defendant's dominant intent in making the payment (a critical factor)

* the plaintiff's belief in the reason for receiving the payment (although this is of ancillary importance to the defendant's intent in making the payment). (12)

To meet his burden of proof, Amos introduced the following evidence to connect his proceeds from the confidential settlement agreement with his potential claims for physical injury:

* a provision from the agreement itself, which expressly provided that Rodman's payment to Amos released Rodman "from any and all claims and causes of action of any type" that Amos held in connection with the incident

* a declaration that Rodman signed, stating that he entered into the settlement agreement "to resolve any potential claims and that the settlement agreement was intended to resolve Amos's claim without having to expend additional defense costs"

* testimony from Amos's attorney attesting that Rodman paid the entire settlement amount to Amos on account of his physical injuries

* Amos's medical history, which showed that he had potential claims against Rodman for possible physical injuries resulting from the incident. (13)

The court held that although Rodman's dominant reason for paying the settlement amount was to compensate Amos for his claimed physical injuries, he paid part of it for other reasons. The settlement agreement expressly provided that Rodman would pay a portion of the proceeds in return for Amos's promise not to defame him, disclose existing terms of the settlement agreement, publicize facts related to the incident, or assist in any criminal prosecution against Rodman. The court determined that these provisions were evidence enough that part of the settlement payment was not related to physical injuries.

The court reviewed the entire record and noted that Amos had the burden of proving that the whole settlement amount was intended to compensate him for physical injuries. Because the agreement did not allocate specific amounts of the $200,000 to physical injuries and other factors, the court determined that Rodman paid $80,000 for the confidentiality provisions in the settlement agreement that did not pertain to physical injuries, so this amount was taxable as gross income. The court's allocation of $80,000 apparently was arbitrary.

After Amos, plaintiff lawyers who do not address these issues may be improperly advising their clients on the net recovery they will receive after taxes and other considerations.

Tax tips

Rather than face unwelcome tax consequences--or an unwelcome legal malpractice lawsuit--consider these options and, if necessary, discuss them with your client before you complete your next settlement.

Do not enter into a confidentiality agreement. Far too often, confidentiality provisions are part of the standard forms defense lawyers use when preparing a release and settlement agreement. But confidentiality often is unnecessary.

Expressly disclaim any consideration for confidentiality. If none of the settlement is being paid for confidentiality, the agreement should expressly state that. Both the express statement that no money is being paid for a confidentiality provision and another that all consideration is being paid to the plaintiff for physical injuries and sickness will help defeat any claim by the IRS that the money was received for the confidentiality provision.

Get an express statement from the defendant that payment is not for confidentiality. Although the release/settlement agreement could include this language, a separate statement or affidavit from the payer setting forth his or her dominant purpose and intent for the payment would be better.

Create a causal connection between injury and settlement. Expressly set out the claims that create a causal connection between the physical injury and the settlement. Whether the settlement payment is excludable from gross income depends on the nature and character of the claim asserted. To ensure that proceeds will be excluded, they should be traceable to the physical injury claim. The release should describe the injuries the plaintiff suffered and how they are connected to the settlement. Use clear, unambiguous language to avoid any misinterpretation. For example: "The plaintiff's injuries include brain damage and spinal in juries, and settlement is for those injuries and loss of earning capacity."

Segregate the amount paid for confidentiality. If the defendant is paying some consideration for the confidentiality provision, the release should expressly state what amount of the proceeds is allocated for the plaintiff's physical injuries and what amount is for confidentiality. Of course, you should advise the client of the related tax consequences and direct him or her to consult with a tax adviser (as is probably a good practice in all cases).

Demand extra money for including a confidentiality provision. The confidentiality provision often does not come up until the plaintiff attorney receives the release and settlement papers. If this occurs and the defendant demands confidentiality, it is not unreasonable to request that additional consideration be paid to include the confidentiality provisions.

Make a claim for physical injury early in the settlement process. Many claims allow recovery for both taxable and nontaxable damages. The settlement proceeds are more likely to be excluded under [section] 104(a)(2) if the plaintiff asserts his or her physical injury claims before the settlement process begins--which is ideal--or as early in the settlement process as possible. If the plaintiff asserts a claim late in the process, he or she faces the chance that a court will strike down the exclusion and allocate all the proceeds to gross income. (14)

Include an indemnification provision. Plaintiffs routinely indemnify defendants for later claims. But if the defendant insists on a confidentiality provision and refuses to provide some of the additional safeguards noted above, it is not unreasonable to ask the defendant to indemnify the plaintiff for the unforeseen tax consequences he or she may face later.

Obtain a private IRS ruling. Although it typically is not practical, the plaintiff could consider obtaining a private IRS ruling based on his or her specific factual situation in the proposed settlement agreement to determine whether the IRS will require the plaintiff to allocate some or all of the proceeds to gross income.

Amos v. Commissioner spotlighted a previously unaddressed tax liability issue in settlements--and highlighted the dangers of entering into settlement agreements with confidentiality provisions. If your client's settlement agreement requires a confidentiality provision, consider your options carefully. Ignoring potential tax liability may leave your client with less than he or she anticipated--and may leave you exposed to an unnecessary malpractice claim.

Notes

(1.) 86 T.C.M. (CCH) 663 (2003).

(2.) 26 U.S.C. [section] 61(a) (2001).

(3.) 515 U.S. 323, 328 (1995).

(4.) 26 U.S.C. [section] 104(a)(2) (2001).

(5.) 26 C.F.R. [section] 1.104-1(c) (2006).

(6.) Institute on Federal Taxation, USC Law School, Major Tax Planning for 2004 56-13, at 1308.1 (2004).

(7.) See U.S. Tax Ct. R. 142(a) (200-65).

(8.) See Institute on Federal Taxation, supra note 6.

(9.) Amos, 86 T.C.M. (CCH) 663.

(10.) Id. at 663-65.

(11.) 515 U.S. 323, 337.

(12.) Amos, 86 T.C.M. (CCH) 663, 664-65.

(13.) Id.

(14.) See, e.g., King-Knoll v. Comm'r, 86 T.C.M. (CCH) 396 (2003).

RANDALL O. SORRELS is a partner in Abraham, Watkins, Nichols, Sorrels, Matthews & Friend in Houston. NEEL CHOUDHURY is a recent graduate of the University of Houston Law Center.