Confidentiality May Cost Plaintiffs Plenty in Taxes

A buzz has been raised on both sides of the tort-litigation bar regarding the tax consequences of confidentiality agreements.

The discussion was kicked off, literally and figuratively, by former basketball player Dennis Rodman, who followed an errant ball into the stands. After the play, he kicked a photographer in the groin; the photographer was taken by ambulance to a local hospital for medical treatment. Subsequently, he filed a lawsuit against Rodman and later settled the matter for $200,000.

The money came under question upon an audit of the photographer’s tax return, on which he sought to have the entire amount excluded as income based upon the Internal Revenue Code that allows a taxpayer to exclude any damages received on account of personal physical injuries or sickness. Internal Revenue Code section 104(a)(2). The taxpayer bears the burden of proving this, and exclusions "must be narrowly construed." Commissioner v. Schleier, 515 U.S. 323, 328(1995).

In the Rodman case, a confidentiality agreement was signed by the parties, wherein Rodman stated that the "dominant reason in paying the petitioner the settlement amount at issued was to compensate him for his claimed physical injuries." Amos v. Commissioner, T.C., Memo 2003-329 (Dec. 1, 2003). The Tax Court ruled in a memorandum opinion that a $200,000 settlement was partially taxable because it was not fully intended to serve as compensation for physical injuries – despite the defendant’s stated intent – but rather was for purpose of keeping the matter quiet.

It is established that the court is allowed to examine the intent of the payor, and "the character of the settlement payment hinges ultimately on the dominant reason for the payor in making the payment." Agar v. Commissioner, 290 F.2d 283, 284 (2d Cir. 1961), aff’d per curiam, T.C. Memo, 1960-21.

Here, the court found that a dominant reason for Rodman’s payment to the photographer was for its confidentiality. The court bifurcated the amount that was taxable, treating 40 percent of it as taxable income.

This significant decision shows that plaintiffs must be very cautious before signing confidentiality agreements.

In receiving compensation, the plaintiff is responsible for any tax due on the amount, which generally is nothing in a tort case. Thus, a confidentiality agreement may raise a tax issue for which the defendant pays nothing while acquiring something that may be more valuable to the defendant than the plaintiff. The defendant receives all the benefit while the plaintiff may ultimately be held accountable for non-payment of a taxable event.

I wrote about confidentiality just two years ago, and I find that it is rearing its ugly head more and more – in medical malpractice cases, aviation matters, sexual assault lawsuits and mass tort litigation.

Although defense attorneys use the excuse of sealing agreements for "proprietary informational" reasons, it is clear that it is over money. Defendants simply don’t want the next plaintiff to know how much a previous plaintiff received for his or her injuries. Despite defendants’ contentions, there is nothing "proprietary" about that. It is about duping the next guy or taking advantage of the civil justice system.

The competing public versus private interests were catapulted onto the national scene last May when the South Carolina Supreme Court adopted a rule that prevented parties from negotiating court-approved confidentiality settlements as a condition for settling cases. In other words, the court must approve the settlement before hearing arguments regarding sealing it.

That rule followed a South Carolina federal district court’s action in November, 2002 that prohibited sealing "information concerning matters that have a probable adverse effect upon the general public health or safety, or the administration of public office, or the operation of government." Judges there, however, may still approve confidentiality settlements if good cause is demonstrated.

The issue is discussed more thoroughly in the May issue of the South Carolina Law Review following a symposium last October called "Court-Enforced Secrecy: Formation, Debate and Application of South Carolina’s New Secrecy Rules." (S.Car.L.R., May 2004).

Michigan’s eastern district federal court adopted a similar local rule that provides for sealed settlement agreements to remain secret for two years from the date of sealing. After the two-year period, the documents must be unsealed and placed in the court file.

The Ford/Firestone controversy is a recent example of the abuse of confidentiality agreements. The tire manufacturer continued to produce the defective product, and Ford was allowed to put it on SUVs that allegedly caused fatalities while secretly settling wrongful-death lawsuits. The settlements prevented disclosure of information that arguably could have saved lives.

In its wake, more than a half dozen states have considered legislation that would ban confidential settlements in cases that compromised public safety. Illinois was among then. H.B. 1191, sponsored by state Rep. James Brosnahan (D-Evergreen Park), passed the Illinois House, but the state Senate has failed to act. That bill would prohibit secrecy agreements where a public hazard is involved in a product-liability case.

Attorneys must be mindful of the potential tax consequences that confidential settlements may mean in light of the recent decision in the Rodman case. Until the tax courts or Internal Revenue Service provide greater clarity on this issue, it would behoove the smart plaintiff to include an indemnification provision against any adverse tax consequences that result from the defendants insisting on secrecy.

Attorneys may even consider the posting of a bond or; under certain circumstances, obtain a private letter ruling from the IRS regarding a particular factual scenario until a tax court can examine the settlement agreement.