A recent entry on another lawyer’s blog titled Secrecy in Settlement Negotiations discusses a significant issue concerning lawsuit settlements. The issue? Confidential Settlement Agreements. I believe this is an important area of concern. When our firm settles a care, we explain the issue to our clients. We discourage our clients from agreeing to these settlement arrangements.
Why are confidential settlements an issue? Our legal system should work toward several goals. Deterring wrongful conduct. Accountability. Compensation for victims. A secret settlement defeats all these important purposes. When a settlement is secret, the defendant is much less likely to change its dangerous conduct. Others will continue to suffer injuries and damages. And, case after case will also continue to be litigated because the truth was concealed. Everyone suffers except the wrongdoer.
On an individual case level, a confidential settlement can also expose the injured party and his legal counsel to future liability. How? When parties sign a settlement agreement they expect the issues to be completely resolved. Yet, any accidental disclosure of a confidential deal in the future could result in a lawsuit by the original wrongdoer. If you enter a confidential deal, you might get sued for damages or the return of your settlement proceeds. Instead of resolving an injury claim, a confidential settlement can create future litigation.
That’s not the only issue. These confidential agreements can also create income tax problems for the injured person. I am no tax attorney. I certainly do not intend this post to provide specific advice concerning our ever-changing tax laws. However, our tax laws exclude some types of damages from a person’s income, such as those generally received solely for a physical injury. That is, such damages may not be taxable as income. Yet, other types of damages or compensation may be taxable as income. I don’t mean to confuse you. Here is what I’m trying to say — By entering into a confidential settlement, the injured party risks the IRS claiming that he received money not as damages for his personal physical injury, but instead, as payment (and thus income) to stay silent. Why risk making a settlement taxable?
Has the IRS ever made such a claim? Yes, in the case of Amos v. Commissioner. In January, 1997, Eugene Amos was operating a television camera during a professional basketball game. During the game, Dennis Rodman jumped for a ball and landed in a group of photographers. As he returned to the court, Rodman kicked Amos in the groin. Paramedics took Amos to the hospital. Amos later pursued a personal injury claim against Rodman. The case settled with a confidentiality provision. When he later filed his tax return, Amos excluded from his gross income the settlement proceeds as personal injury damages. Unfortunately, the IRS saw the issue differently, concluding the proceeds were not personal injury damages but paid in return for confidentiality. Under the IRS conclusion, the money would be considered taxable income. Amos and the IRS then litigated the issue in the U.S. Tax Court. The Court eventually concluded some of the proceeds were attributable to the confidentiality provision, and thus, taxable.
How do you avoid this potential problem in a settlement of a lawsuit? The obvious and easiest way is to settle without a confidentiality clause. If you do settle with such a clause, don’t simply ignore the risk of tax problems. Carefully consider the settlement language to minimize any risk. We spend extensive time reviewing settlement language for our injured clients. We are able to protect them from many future issues. I am constantly amazed at how often attorneys and their clients will simply sign a proposed agreement with little or no regard for its potential impact in the future. Face it, that guy on television or billboards promising quick checks for wrecks, is NOT going to protect your settlement. That billboard lawyer simply wants a quick settlement.
We are not tax attorneys. However, we have considered a number of approaches to address tax risks in confidential settlement agreements. These suggestions include:
- Mingle the confidentiality terms throughout the agreement so they are not a significant or distinct section.
- Explicitly state in the agreement that all settlement funds are being paid only because of the personal injury.
- Negotiate a separate confidentiality agreement with other money paid for it (which could be taxable). This is often accomplished by allocating a portion of the total settlement proceeds to the confidentiality agreement.
- Include language in the settlement agreement that the defendant will indemnify your client for any adverse tax consequences. After all, they wanted confidentiality. Thus, they should bear the risk of it.
On the whole, I still consider confidentiality clauses in settlement agreements to be a bad idea for my clients. I usually reject them. However, when necessary in some complex case, I ensure the agreement is written as carefully as possible to minimize any future risks. This includes the risk of adverse tax consequences as well as other anticipated future risks. Is your attorney working to protect you? Good lawyers take cases seriously from the very beginning to the very end.
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From its office in Huntsville, the Blackwell Law Firm helps injured people across Alabama. If you have questions about a legal issue, let us know. We are happy to discuss your issues. Consultations are always free and confidential.
(256) 261-1315
