Confidentiality Clauses Are Taxable

From time to time, a defendant or its insurer will submit a settlement agreement that contains a confidentiality clause. Typical wording would be the following:

The parties agree that neither they nor their attorneys nor representatives shall reveal to anyone, other than as may be mutually agreed to in writing, or as compelled by law or legal process, any of the terms of this Settlement Agreement or any of the amounts, numbers or terms and conditions of any sums payable to Plaintiff hereunder.

There are two problems with such a clause. First, it deprives the plaintiff and defense bars from important knowledge about settlements, thereby interfering with the judicial branch’s task of resolving disputes. Second, it can result in a partially taxable settlement. 

Normally, personal injury settlements are not taxable. IRC section 104(a)(2). However, the taxpayer has the burden of proving that damages are on account of personal physical injuries or sickness. 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). 

In Amos v. Commissioner, T.C. Memo 2003-329 (December 1, 2003), the U.S. Tax Court ruled that a confidentiality clause in a personal injury settlement made 40% of the settlement taxable as ordinary income. The court reasoned that the defendant (Dennis Rodman) not only was compensating the victim for his injuries, but also was buying the victim’s silence and paying extra for it. That payment was held to be ordinary income and therefore fully taxable. 

Plaintiffs therefore should insist on deleting such provisions from personal injury settlement documentation. If the defendant insists, then confidentiality can be made mutual and the agreement can recite that the consideration is limited to the mutual promise. Additionally, the victim should insist on defense and indemnification for all resulting tax liability, interest, penalties, attorneys fees and costs.