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U.S. Tax Court decision may influence terms of settlement
agreements
Amos v. IRS 2003 (January 29, 2008) |
In response to a client’s request, I took a look at the United
States Tax Court’s decision in Amos v. Commissioner of Internal
Revenue (Dec. 1, 2003) No. 13391-01. Though the decision is several
years old, recently plaintiff’s attorneys have been citing its
effect on settlement agreements, and in particular, confidentiality
clauses. Specifically, defense attorneys have been asked to either
remove the confidentiality clause altogether, or to specify that
only $1 of the settlement payment is being made in consideration of
the confidentiality provisions. After doing some research and
investigation, it is apparent that the Amos decision has the
plaintiff’s bar quite concerned, and for good reason.
Taxpayer Eugene Amos was a cameraman working under the basket at a
Chicago Bulls game when Dennis Rodman fell on him. The Worm (Rodman)
apparently tripped on Amos and others, twisted his ankle and then
kicked Amos for good measure. (It’s unclear whether he used his
injured foot, or not.) Amos went to the hospital, had some physical
complaints and then retained an attorney who negotiated a pre-trial
settlement with Rodman for $200,000. The settlement agreement
contained the standard release and settlement language, as well as a
rather long and detailed confidentiality clause.
Amos filed his taxes and did not declare any of the settlement
monies as taxable income. He took the position that the money was
exempt from taxable income based on IRC section 104(a)(2). That
section requires that in order for monies received in settlement of
a claim to be exempt from taxation, the settlement must be on
account of personal physical injuries or physical sickness—the type
of recovery that typically arises from a tort claim. During an
audit, the IRS concluded that Amos’ award was not due to personal
injuries and taxed him on the entirety of the $200,000 award. Amos
petitioned the Tax Court for redetermination of deficiencies arising
from the disallowed exclusion of the settlement award. The tax court
ruled for Amos, in part, and also for the IRS.
In support of his position that the money was exempt, Amos proffered
both a declaration by Rodman that said he entered into the
settlement agreement “to resolve any potential claims” and to avoid
“additional defense costs,” and testimony from Amos’ own attorney
that “Rodman paid the entire settlement amount at issue to
petitioner on account of his physical injuries.” The Tax Court
looked at the language of the settlement agreement and found that
“as part of the consideration” for the agreement and release—and in
addition to dismissing all claims against Rodman, the Bulls, and so
on—Amos had to abide by a detailed confidentiality agreement. The
court found that while the “dominant reason” Rodman paid Amos the
$200,000 settlement was to compensate him for his physical injuries
as a result of the incident, a significant portion of the
compensation was in exchange for the detailed confidentiality
agreement. Pursuant to that agreement, Amos promised not to: “(1)
Defame Mr. Rodman, (2) disclose the existence or the terms of the
settlement agreement, (3) publicize facts relating to the incident,
or (4) assist in any criminal prosecution against Mr. Rodman with
respect to the incident.” The court referred to these four items as
“the nonphysical injury provisions.”
The Tax Court said that when a “settlement agreement lacks express
language stating what the amount paid pursuant to that agreement was
to settle, the intent of the payor is critical to that
determination. (Cite.) Although the belief of the payee is relevant
to that inquiry, the character of the settlement payment hinges
ultimately on the dominant reason of the payor in making the
payment. (Cite.) Whether the settlement payment is excludable from
gross income under section 104(a)(2) depends on the nature and
character of the claim asserted, and not upon the validity of that
claim.(Cite.)”
Even though Rodman’s “dominant reason” for settling the case was
Amos’ personal injuries, the court believed there was pecuniary
value to the nonphysical injury provisions of the settlement
agreement, as well. (Of particular interest is the agreement not to
cooperate with any criminal prosecution—not what you’d call a
standard provision to a confidentiality clause in a personal injury
case.) Because the agreement did not allocate what amount of
consideration was being given in exchange for the physical injuries
versus the nonphysical injury provisions, the court allocated 60% to
the physical (thereby rendering $120,000 exempt from taxation) and
40% to the nonphysical (and taxed Amos on the remaining $80,000).
The court’s language about the intent of the settlement payor and
its apportionment of settlement monies in the Amos case has the
plaintiff’s bar concerned. Some writers have even suggested that
clients who are ill-advised about settlement agreements and find
themselves taxed on what they thought was an exempt award might have
a legal malpractice action against their counsel.
In light of Amos, plaintiffs’ attorneys may ask for the following
when it comes time to draft a settlement agreement in a medical
negligence or other personal injury action:
1) No confidentiality clause;
2) Specific apportionment of what amount of consideration is for the
physical injury component of the case and what amount is for the
confidentiality clause (or other nonphysical injury aspects of the
settlement such as an agreement not to defame);
3) A statement in the settlement document that no consideration is
being given for the confidentiality clause, or that a nominal sum
represents the consideration for the confidentiality clause (e.g.
$1);
4) A clear statement in the settlement papers that the case at issue
was one for personal injury and it is the intent of the payor that
the settlement monies are being paid to compensate for personal
injury only (or an apportioned amount, as suggested above);
5) Reciprocal promises of confidentiality without additional
consideration, so that each side’s promise of confidentiality is the
consideration for the promise of the other.
Some publications directed to the plaintiff’s bar have gone so far
as to suggest that plaintiffs should 1) seek extra compensation in
exchange for a confidentiality provision; 2) include an
indemnification provision which compels a defendant to indemnify the
plaintiff for adverse or unforeseen tax consequences if the
defendant insists on a confidentiality clause but will not agree to
one of the protective measures set forth above; and/or 3) seek a
private IRS ruling in advance of finalizing the settlement.
As a practical matter, the “protective measures” discussed herein
are for the benefit of the plaintiff and are the responsibility of
the plaintiff’s attorney, since the burden to prove that a sum
received in settlement of a legal claim is exempt from taxation lies
with the plaintiff/taxpayer. The question for defense counsel is
what to do if faced with a request that the settlement agreement be
modified to protect the plaintiff from an IRS finding that all or
part of his settlement is not exempt because it is consideration for
a confidentiality clause or some other nonphysical injury provision
in a settlement agreement?
It would seem obvious that one would never want to agree to
indemnify the plaintiff for unforeseen tax consequences. However,
there probably is no downside to a statement of apportionment (“$X
is being paid as compensation for plaintiff’s personal injury claims
and $X is being paid in consideration for plaintiff’s agreement to
keep the terms of this settlement confidential as set forth in
Paragraph A”), or to reciprocal promises of confidentiality, or to
the inclusion of a simple statement that the entirety of the
settlement monies are being paid to plaintiff on account of his
claimed physical injuries, or words to that effect.
One should also consider whether a confidentiality clause is really
necessary in any given case, particularly if the plaintiff attempts
to extract additional sums in exchange for his or her
confidentiality. If a confidentiality clause is necessary, then it
is wise to bring that up early in settlement negotiations. Several
writers noted that many times plaintiffs are faced with a
confidentiality clause for the first time when they are reviewing
the final settlement documents, which puts plaintiffs on the spot
and may lead to a demand for additional money in exchange for
agreeing to a nonphysical injury provision such as a confidentiality
clause. The last thing you want to worry about after reaching a
final settlement agreement for a particular sum of money is whether,
in light of Amos, the plaintiff will put the kibosh on the whole
thing because of the confidentiality clause and the possibility that
part of the settlement might be taxable.
[See “Plaintiffs’ Attorneys Beware: Little Known Tax Consequences
Associated with Confidentiality Provisions,” Sorrels and Choudhury,
Houston Business and Tax Law Journal (Vol. VI, 2006) 257, for a more
detailed discussion of the Amos decision and strategies for dealing
with its ramifications.] |
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