Confidential Settlement Agreements Present a Host of Problems
I often read the entries on another blog titled Plaintiff Trial Lawyer Tips. A recent entry on this blog titled Secrecy in Settlement Negotiations by Paul Luvera discusses a significant issue concerning the settlement of lawsuits. The issue, confidential settlement agreements, is one our firm has long considered an area of concern. In his entry, Paul writes clearly why he is against secret settlements. I agree completely with Paul's reasons for not favoring secrecy. Like Paul, I try to explain to my clients the issues surrounding confidentiality. I discourage my clients from agreeing to these settlement arrangements but will honor their decision if they choose to do so.
Why are confidential settlements an issue? Our tort system should work to provide accountability, to assess just compensation to victims, and to deter wrongful conduct. A secret settlement defeats all these purposes. By making a settlement confidential, a defendant is much less likely to actually change their dangerous conduct. Others may also be injured because the problem has now been concealed from the public. When injured, these other individuals will then not benefit from the information gained in the earlier claim that could assist them in seeking justice. As a matter of public policy, these secret settlements harm society as a whole.
On a case-by-case level, entering into a confidential settlement can also expose both the injured party and their legal counsel to future liability. When parties enter into a settlement agreement they expect the issues to be completely resolved. Yet, any accidental disclosure of the deal in the future could result in both the injured party and their counsel being sued for a return of the confidential settlement proceeds or other damages. Instead of resolving the initial litigation, a confidential settlement can create future litigation. In his blog entry, Paul notes several actual instances when such agreements have resulted in future litigation.
To all of the issues expressed by Paul, I would add that confidential settlements 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. However, other types of damages or compensation may be taxable as income. By entering into a confidential settlement, the injured party risks the IRS claiming that he received money not as damages for his personal injury, but instead, as payment (and thus income) to stay silent.
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. An ambulance took Amos to the hospital. He later pursued a personal injury claim against Rodman which was 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 that 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 reached a conclusion that 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 simply to settle without a confidentiality clause. However, if you do settle with such a clause, don't simply ignore the risk of tax problems. Instead, carefully consider the settlement language to minimize the risk. Although it is very important to carefully review the language contained in settlement papers for a number of reasons, 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.
We are not tax attorneys. However, our office has considered a number of recommended approaches to address the tax risk in confidential settlement agreements. Several of these approaches are also suggested in an article by the law firm of Mallor, Clendening, Grodner & Bohrer, LLP. These suggestions include:
- Mingle the confidentiality terms throughout the agreement so that they do not appear as 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 would be taxable). This is often accomplished by simply 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.
On the whole, I still consider confidentiality clauses in settlement agreements to be a bad idea for my clients. When allowed by my client, I will simply reject them completely. However, when they become necessary, you must then see that 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.
