Tax Consequences of Confidentiality Clauses in Settlement Agreements

In a recent issue of Trial Briefs from the Illinois Bar's Section on Civil Practice and Procedure, Michael J. Marovich reported that confidentiality clauses in personal injury settlements might trigger tax consequences for the plaintiff.

Here's the rationale. A confidentiality clause is normally something that benefits the defendant--that is, something the defendant would be willing to pay for in a settlement. Though personal injury settlements normally aren't taxable, 26 U.S.C. 104(a)(2), this might not be true of income received as consideration for a confidentiality agreement. See Amos v. Commissioner of Internal Revenue, T.C. Memo. 2003-329, 2003 WL 22839795, 86 T.C.M. (CCH) 663, T.C.M. (RIA) 2003-329 (U.S. Tax. Ct. Dec. 01, 2003) (No. 13391-01),

In Amos, the court found that $80,000 of a $200,000 personal injury settlement was taxable as consideration for a confidentiality clause in a settlement agreement. There was no discussion of how the court arrived at the $80,000 figure. In his note, Marovich concluded:

It would appear that Plaintiffs have a strong argument for refusing to allow confidentiality agreements to be present in any settlement. In the alternative, the Amos case may provide a strong basis that the settlement amount of a case should be increased in order to compensate Plaintiff for the increased tax liability he or she incurs if a confidentiality agreement is made a part of the terms of any settlement. In addition, the Amos case seems to require that any Plaintiff's attorney advise their client of the tax consequences of including a confidentiality agreement in any settlement agreement. If a confidentiality agreement is made a part of any settlement, counsel for Plaintiff should, at least, make sure that a specific dollar amount is indicated in the settlement agreement as representing the worth of the confidentiality clause. This way the client has a specific dollar amount to claim on their year-end taxes versus having the IRS magically come up with one like they did in Amos.

Members of the Illinois State Bar Association can view Trial Briefs online. Details here.